Why You Shouldn’t Buy a Business Without Legal Due Diligence

Purchasing a business in the millions? Legal due diligence is a must. How about $500k, $100k, or even $30k? A common misconception among small business buyers is that legal due diligence is unnecessary because of the lower price tag. Assessing the need for legal due diligence on a target business based solely on the purchase price is a costly mistake. 

Just like you wouldn’t buy a business without looking at its assets, revenues, and accounts payable (financial due diligence), you shouldn’t buy a company without confirming that it’s lawfully formed, operating in good standing, doesn’t have active litigation or unsettled disputes, has well-drafted and enforceable contracts, has a clear ownership structure, and has been complying with labor laws. These items, among others, constitute “legal” due diligence, and they can have just as big an impact on the value of a company as its profits and losses. 

There are several excellent reasons to conduct due diligence before committing to purchase a business, some with short-term consequences and others with long-term effects. Immediately, proper due diligence can help shift the risks between the buyer and seller and impact the final purchase price. Contractual terms are often negotiated based on due diligence findings and, in extreme cases, the decision to buy a business hinges on those findings. 

An Example – One of many realities.

You’ve got your eyes set on a shiny, luscious IT business with some hefty contracts. We love those five to six-figure, multi-year contracts with companies having significant IT needs! Thank you, recurring and locked-in revenue. The seller tells you about these contracts and, frankly, the $500,000 they’re asking is a steal. You forego due diligence, despite your best pal Full Circle Business Law, PC’s urging, and you miss the part where the contracts with clients have “no assignment” clauses. You’re only buying the assets of the business, not the shares, so the assignment of those contracts to you is vital. Your purchase agreement doesn’t make closing contingent on the successful assignment of these agreements. 

The sale closes and the seller notifies the clients that their contracts have been assigned to the new buyer, your amazing new corporation. The clients point to the “no assignment” clause and, not only do they claim the seller breached their contracts by assigning the agreements without the clients’ consent, but they refuse to assign the contracts to your new company. Suddenly, you find yourself having overpaid for a company whose most valuable assets you DO NOT OWN. You’re frantically calling Full Circle Business Law and asking our attorneys how they can unwind your purchase and get your money back. Assuming you prevail, which is not a guarantee, you will have spent tens of thousands (or hundreds of thousands) of dollars litigating the matter. 

Proper due diligence would have, at a minimum, revealed that those valuable contracts contained a restriction on assignment. Your attorneys could have negotiated to require the seller obtain written consent from each client prior to closing and, failing to secure said contracts, could require an adjustment to the purchase price or some other agreed-upon remedy. 

Value Beyond The Purchase Price

The purpose of due diligence isn’t only to protect the price you’re paying for a business, it’s also to protect from the potential liability you’re walking into, which can far outstrip the relatively meager cost to purchase the business in the first place. Let’s say you’re paying $250,000 for a modest vitamin supplement company with a brand name that has value and will continue to be used. Without proper due diligence, you don’t discover that the name not only doesn’t have a federal trademark registration, but it also infringes on another company’s mark. Well, you don’t discover this until you’ve poured significant resources into expanding your new company’s footprint and increasing brand awareness. You end up on the radar of the company whose mark you’ve been infringing upon, and you get an initially friendly cease and desist letter. It’s been a couple of years since you bought the business and you estimate you’ve spent just as much developing this business and its brand as you did to purchase it. You’re faced with a choice: change the name and re-brand, spend more money, or challenge the cease and desist, again spending more money. 

The real value of any target company extends beyond dollars and cents, and your attorney can help determine the hidden factors that might affect the purchase of your next business.