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The Importance of Legal and Financial Due Diligence in M&A Deals

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Pre-deal due diligence is an essential component of any merger or acquisition. While a sense of the potential opportunity is what inspires any M&A deal, it is awareness of the risks and possible obstacles that shape its terms. Thorough due diligence not only provides a buyer with understanding of the seller’s business, but also provides assurance that the business is as represented by the seller. Alternatively, if any problems are identified before the deal is closed, this provides the opportunity to remedy them prior to closing or to specifically address them in the acquisition agreement.

Types of due diligence can include information technology (IT), reputational, regulatory, intellectual property, operational, commercial, real estate, and environmental, social, and governance (ESG). While it is ideal for all aspects of a potential acquisition to receive the attention necessary to ensure that no detail is overlooked, the timeline of a deal may require prioritizing areas of focus for inquiry. At the same time, the fear lurks that overlooking something critical will crater the post-transaction value of the deal or expose the merged entity or purchaser to unanticipated liability or risk. To minimize the risk of unpleasant surprises after a deal is signed, financial and legal due diligence should be as thorough as possible.

What Financial and Legal Due Diligence Uncover

Due diligence in M&A transactions examines and analyzes both internal and external sources to develop a baseline understanding of the target organization. The list of questions to be asked and its length will vary depending on the industry, the size of the deal, and the reason for the acquisition. Financial and legal due diligence are the cornerstone of informed decision-making and mitigating risk, however, making them a critical area to concentrate on.

Financial due diligence is intended to facilitate decision-making and negotiation as the deal is in progress as well as informing planning and execution. To do so, it must provide a complete understanding of the company’s financials, including but not limited to:

  • Balance sheets
  • Cash flows
  • Quality of earnings
  • Accounting compliance and review of GAAP (generally accepted accounting principles)
  • Securities and Exchange Commission (SEC) reporting compliance
  • Valuation and financial modeling
  • Operating or SG&A (selling, general, and administrative) expenses
  • Any significant financial and/or operating trends

Legal due diligence is intended to expose any past or pending legal liabilities that could come with the deal. This can involve:

  • Legal history review
  • Bankruptcy searches
  • Review of past and pending litigation
  • Identification of any unpaid judgements or liens
  • Legal entity mapping and preparation of post-close filing
  • Legal obligation review
  • Analysis of debt structure and credit

The Challenge of Legal Due Diligence

Legal due diligence is a particular challenge for many dealmakers. First, rapidly evolving global regulations raise the risk of overlooking new and changing laws. More importantly, in the context of an M&A deal, what you don’t know can hurt you. Hidden liabilities that go unnoticed before a deal closes could significantly diminish the value of an acquisition, inflicting serious financial and possibly reputational damage on a successor company through the legal risks they unwittingly inherited.

The picture can be especially complex if the target organization has acquired other businesses in the past. This can result in them having legacy liabilities that can be passed on to the acquiring organization, even if the original company responsible no longer exists. Digging down to uncover the details of ownership and accountability for such risks is no easy task. However, identifying these legal liabilities through meticulous due diligence early enough to address and mitigate them through the deal framework is essential.

Expert Legal Guidance for M&A Deals

In a merger or acquisition, the stakes are high, overlooking legal exposure from an acquired company can have costly, long-term repercussions. The experienced business law attorneys at Bridge Law LLP can provide the expertise to guide painstaking due diligence that ensures you have all the relevant facts to shape your deal and protect your interests. Our team provides the highest quality legal services in the M&A market for your domestic and international transactions. To learn more about how we can assist your business at every stage, contact us here to schedule a consultation.

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