How to Complete a Due Diligence Contract Review
If you’re interested in acquiring another company, you’ll want to ensure you’ve carefully reviewed the target company’s contracts during the due diligence stage of a merger or acquisition after fully understanding what due diligence entails. While conducting due diligence, you’ll thoroughly analyze the qualitative and quantitative data of the potential acquisition target to help determine if the transaction will succeed or fail. Since a target company’s contracts can tell you if they’ll meet your financial and acquisition goals, evaluating contract documents is critical to a successful business purchase transaction.
Take a moment to learn more about how to conduct a due diligence contract review and the main elements to focus on when evaluating a potential purchase.
The Main Types of Contract Documents You Should Request From an Acquisition Target
During due diligence, it’s critical you request various documents, and then assess any contract issues that may arise and identify areas of concern you can further inquire about if necessary. Below you can find examples of the most pertinent contract-related documents you should ask for:
- Listing of all states or jurisdictions in which the seller company has any offices, employees, or business activities
- Listing of all states or jurisdictions in which the seller company is qualified to do business
- Certificates of incorporation, by-laws, operating agreements, and any other corporate governance
- Listing of any warranty issues, current or pending litigation, governmental investigations, etc.
- Copies of standard contracts used for clients and vendors
- Copies of current contracts with top clients
- Copies of active vendor agreements
- Copies of active lease agreements
How to Analyze Contract Documents
When evaluating the above documents, there are some key areas of focus or concern acquirers typically inspect. For example, when looking at the above documents, it is important to confirm corporate documents state the owners of the company are who you think they are.
Though checking who the owners are might seem like a basic “check the box” type of task, it is something that could easily hold up a transaction. What if one of the owners has passed away and the corporate legal documents have not been updated to reflect the change in ownership? This fact alone could cause major delays and even “kill the deal” if attorneys need to get an estate or heir to agree or sign off on the transaction.
Analyzing contract documents during due diligence is also an opportunity to gain an understanding of whether the company has any pending legal matters, warranty matters, or governmental inquiries. For some, even the thought of pending legal matters screams “red flag, red flag!” However, it doesn’t have to be that way.
When the acquirer knows what’s pending, they’ll have the opportunity to gain a fair and thorough understanding of the pending matters. With this understanding, the acquirer can make an informed decision as to whether it impacts the transaction proceeding.
If the pending legal matters are pervasive and related to the quality of work or employment practices, it could very well be a red flag that a cultural problem exists in the company that could steer an acquirer away. If the pending legal matters do not appear to be pervasive and/or are explainable, they may not be an issue, especially if the pending transaction is structured as an asset purchase with the buyer assuming no liabilities.
This contract evaluation section of due diligence also opens the door for the post-close need for tail insurance coverage if required by the acquirer.
What to Look for in Active Contracts during Due Diligence
When evaluating active contracts the acquiree is currently under, the acquiring company should note a few items in particular. These items include:
Are the contracts assignable?
Most client contracts are assignable at some level and with some effort. Understanding on the front end what effort is needed to get the contracts assigned to the acquirer is imperative to a smooth transaction. After all, the acquirer is primarily purchasing the acquiree’s book of work and, with that, their current contracts. These existing contracts are the positive cash flow the purchaser is expecting to be able to utilize in the near future post-close stage.
Are there any contracts the acquiree thinks will not be easily assigned?
Any contracts the acquiree thinks will not be easily assigned should be clearly communicated to the acquirer during the due diligence contract review phase.
Is the contract fulfilling a “set aside” requirement?
Oftentimes, government-based contracts will have provisions that a certain percentage of the contract must be awarded to a company with a small business set-aside. This set-aside requirement means a portion of the contract can only be awarded to companies that qualify, per the government, as a small business, minority-owned business, woman-owned business, or another disadvantaged business enterprise (DBE) classification.
Again, this requirement is not a deal killer. Rather, it’s a key point of understanding for the buyer as to what contracts might not be able to be renewed under the new ownership umbrella.
Why the Due Diligence Contract Review Stage Is So Important
As areas of concern are identified during the contract phase of due diligence, quickly documenting, sharing, and in some cases requesting supplemental information, plays a critical role in a successful acquisition. By thoroughly reviewing contracts and prioritizing important information, the leadership of the acquirer can make more informed decisions. For example, the contract phase can help leadership know if they should continue the transaction, stop the transaction, or change the M&A deal’s terms to accommodate identified concerns.
Turn to Thinc Strategy for Due Diligence and Contract Evaluation Assistance
At Thinc Strategy, we’re ready to help you acquire another business and meet your acquisition goals. Due to our experience assisting with many ownership transitions, you can trust our certified merger and acquisition advisors to help you create a contract evaluation plan and thoroughly review contract documents during the due diligence stage. Since we offer comprehensive M&A advisory services, we can also walk you through every stage of the expansion through acquisition process.
Learn more about our advisory services today. If you have any questions or want to schedule a complimentary consultation, please contact us.