What you need to review for in M&A
If you’re buying a business, you obviously need to decide whether you would like to buy it. Beyond “should I buy” business strategy questions, buyers need to consider three key legal questions:
What am I buying, and can the seller sell it to me?
- What is the thing that I am buying? What comes along with it? E.g., are key customer contracts real? Do the contracts last as long as expected? Are the contracts generally okay (since, once you buy the business it will be like you signed the contracts yourself)? Does the target own key IP, like websites or trademarks?
- Does the person I’m buying from actually have the ability to sell it to me? Do they own it? Who has the authority to sell it to me?
- Are there any legal restrictions on buying the business? E.g., foreign ownership or antitrust issues. Or legal things that need to be done to make the sale happen? E.g., government notification or filing requirements.
Does it come with anything bad?
- Think especially about things that could cost more than the value of the acquired asset itself.
- Is there a (literal or figurative) hazardous waste dump in the basement?
- Are there any big outstanding risks, like pending or possible lawsuits, unpaid taxes, or underfunded pensions? (There are plenty of examples of acquirers having to pay up big for mistakes done before before they bought the business. Think of Bank of America having to pay billions for bad things Merrill Lynch did in 2008 and before.)
- Does the business have any dangerous indemnities? (An indemnity is a promise to pay the legal expenses of another.)
- Are there any key restrictions to operate on the business going-forward? Promises of exclusivity, non-competition, non-solicitation, or most favored nation treatment? Note that these restrictions sometimes extend to restrict the rest of the acquirer, and can be really dangerous when they do.
Does this transaction change anything?
- Will the deal trigger anything happening in the target? Mostly, the answers to this question are found in change of control or assignment clauses in contracts, which detail what happens when ownership of a business or contract happens.
- Note that the overarching questions are basically the same for many big purchases, like a house.
Why Contract Review Matters If Selling a Business
It’s pretty obvious why someone buying a business would care about what they were getting, and would have to do contract review. But why should the seller care?
Basically, the buyer is going to have these questions. So, to make sure that the seller is best positioned to answer the buyer’s questions, they should know the answers to the likely question the buyer is going to ask. Also, by knowing the answers well in advance, the seller can improve the answers.
For example, a seller might be able to get a customer or vendor to amend a contract (e.g., to get make a change of control restriction gentler). This process can take time (and might be a good thing to do with a yearly renewal), so it’s a good idea to start the review process well in advance, if you’re thinking of selling a business.
What Contracts Need To Be Reviewed For When Buying or Selling a Business
- What am I buying, and can the seller sell it to me?
- Does it come with anything bad?
- Does this transaction change anything?
These three questions drive what needs to be reviewed in acquisition-connected contract review. Reviews can range from highly burdensome to quite quick. Our sense is that regular acquirers tend to put heavier effort into more thorough reviews (though this may be because big acquirers tend to be larger, and larger acquirers have more to lose).
When considering what scale of review to do, it’s worth considering that bad acquisitions can cost a lot more than the money put into them. For example, Bank of America paid some $2.5B to acquire Countrywide Financial at what seemed like a good price in 2008, and ended up losing an estimated $40B on the deal. Not to say you shouldn’t make acquisitions—lots of deals work out very well—just that there is real risk involved. That risk can be partially mitigated through more thorough due diligence review. Since a lot of the risk in acquisitions lie in the target’s contracts, it can make sense to spend extra time there.
Lightweight vs. heavier reviews
A really light due diligence contract review might only focus on reviewing the target company’s most significant (“material”) agreements for change of control or assignment clauses. Basically, assume that (A) the target’s contracts are basically okay (their key customer, vendor, partner, finance, real estate, and people contracts are either solid or don’t matter) and they don’t come along with anything bad and (B) there is nothing important in non-material contracts. These assumptions can work out fine many times. But, when they don’t, they don’t.
If following a lighter-weight approach, here are two ways to mitigate risk:
- Try to figure out how the target does contracting. Talk to their general counsel (or whoever is in charge of contracting and the like) and see if they seem solid. What process do they follow in contracting? What issues do they care about in contracts? What portion of the time do they sign contracts on their form, what portion are negotiated, and what portion are on third party paper? Are there any legacy contracts that predate the current approach? Where are they, and what shape are they in? Partially, the answers matter. But, as much as anything, consider whether you are left with a general sense of comfort. If you buy the target, it will be as though you signed all their contracts yourself.
- Use contract analysis AI to review a wider range of contracts than you would otherwise review, for a broader group of data points. Though this might not be as good as thorough human review (or, better, thorough human-supplemented-by-AI review), it is better than not reviewing the contracts at all. Importantly, contract analysis AI can flag contracts where there might be issues that you would not have otherwise noticed. While contract analysis AI review is not free, it doesn’t have to be too expensive.
If doing a heavier review, you’ll look at a wider group of the target company’s contracts, for more data points.
Step 1: What to review
The first step is to figure out how wide to go in which contracts to review. The traditional approach is to focus on the most important contracts. While this generally makes sense, many will have experience with low dollar value contracts that contain important restrictions.
For example, in the earlier days of our previous business, we were more willing to sign up to small bad contracts because we were so anxious to get any deals going. As we grew, we got stricter on contracting. But our old contracts remained. (In our case, only for a bit - as ex-lawyers, we got rid of bad agreements when we could).
So, reviewing more contracts is better. Broader review costs time and money though. The easy way around this is to use contract analysis AI software to review more agreements. You can have a person (ideally supplemented by AI) review the most material agreements, and then have contract analysis AI review a wider swath. You can then only review contracts where the AI flagged potential issues. While contract analysis AI is unlikely to be 100% accurate (despite some vendors occasionally claiming otherwise), it can be pretty good.
18 of the world’s top-25 M&A law firms use the underlying AI that we helped build, so it must be okay. And the price and speed of contract analysis AI mean that it is now much more feasible to expand the scope of review.
Step 2: What to look for
The next step is figuring out what to review the target company’s contracts for. At a minimum, you’re going to review for change of control and assignment, to determine whether this transaction triggers anything (e.g., notification or consent obligations). Make sure to look at employment agreements too for these. Change of control-based payment triggers are relatively common in employment agreements (often also requiring termination), and can be costly.
Though less frequently occurring, these next provisions are also very worth reviewing, since they have the potential to cause a lot of risk:
- Most Favored Customer / Most Favored Nation (aka, “MFN”)
Exclusivity, non-compete, and MFN are all rare but can be an especially big deal when they occur. If you find them, first figure out if they restrict or advantage the target company. If they advantage the target company, that can be a benefit. If they restrict the target company, figure out if they bring in “affiliates.” If so, this has the potential to extend the restriction to other parts of the post-acquisition business. Courts can uphold these. Be careful.
These next provisions are also important and are worth reviewing for:
- Limitation of liability
Here, you’re trying to determine how the target stands on risk. Generally, you would like tighter outbound indemnifications (i.e., the target isn’t indemnifying for much), wider inbound indemnification, and potential liability limited.
It is also worth reading (and scanning with AI) a few random contracts (especially customer contracts, and any contract the target business does a lot of) to determine whether they’re generally something you would be comfortable with. After all, when you buy the target, their contracts are now yours.
Step 3: Business specific analysis
After that, review becomes more specific to the business in question, and commercially driven. You might, for example, consider reviewing contracts for termination and termination for convenience language (to figure out how easily the target (and the target’s customers) can get out of deals.
There are also a bunch of contractual items that can help with post-closing integration. There may be upside in reviewing for price increase or inflation adjustment clauses. Renewal dates, and autorenewal. You will need to know insurance requirements and SLAs. Data privacy terms can be critical. And more.