What Is Legal Due Diligence? The Purpose, Process, Required Documents and Costs of Legal DD in M&A

Hello, I'm Noriaki Asato, Representative Attorney at LegalAgent.

Once an acquisition target has been settled and the signing of a letter of intent is in sight, the question of "how far legal due diligence should go" begins to be considered. The purpose of legal DD is not to read every document of the target company without limit. Its proper role is to reach a state, within a limited investigation period, in which the buyer can accurately judge whether to proceed with the acquisition, whether the purchase price or transaction terms need to be revised, and which clauses to include in the definitive agreement (the SPA).

Legal due diligence (legal DD) is a procedure for investigating the legal issues and risks hidden in the target company or target business. Its area of responsibility differs from that of financial DD, tax DD and business DD, but because findings in legal DD are directly linked to the purchase price, the contract terms and post-closing integration work, it forms part of a single process carried out in coordination with the other specialists. If you would like to check the scope and overall picture of our support from the letter of intent (LOI) through legal DD, SPA negotiation and closing, please see LegalAgent's M&A Legal and Legal DD Support.

Four Decisions That Legal DD Supports

The results of legal DD are mainly used for the following four decisions.

• Whether to proceed with the acquisition, and the selection of the transaction structure
• Calculating the transfer consideration and reflecting findings in price adjustment clauses
• Reflecting findings in the conditions precedent, representations and warranties and special indemnities in the SPA
• Identifying the corrective matters and covenants to be carried over after closing

Cases where permits or licenses necessary for the business cannot be carried over, where core intellectual property rights do not belong to the company, or where a contract with an important business partner contains a change of control clause and is at risk of termination may impair the business value originally envisaged. When such serious issues are found, options include considering abandoning the transaction itself as well as redesigning the transaction structure.

However, changing the structure from a share transfer to a business transfer or a company split does not necessarily resolve problems relating to permits, licenses or contracts immediately. A business transfer may require obtaining new permits or licenses or going through succession procedures, and the transfer of contractual status requires the counterparty's consent. A company split is a method of universal succession, but the treatment of permits and licenses and the effect of contract clauses are examined separately. Whether succession is possible, and the procedures for it, are checked for each candidate structure.

Even for risks that do not warrant stopping the transaction, the facts discovered do not necessarily translate automatically into a price reduction or indemnification. Depending on the nature of the risk, the parties decide whether to make it a corrective matter before closing, deduct it from the purchase price, make it subject to indemnification for breach of representations and warranties, or have the buyer improve it after the acquisition, and then build this into the contract terms.

Scope of Investigation and Main Required Documents

The scope of investigation is not determined uniformly by the size of the target company alone. The items to be emphasized change depending on the industry, the transaction structure and the investigation period set. For example, for IT companies including SaaS businesses, the focus tends to be on terms of use, intellectual property rights and the personal information protection structure, while for licensed industries, the legality of administrative permits and licenses and the history of past administrative guidance are checked as a priority.

In practice, the main documents subject to review are as follows.

• Articles of incorporation, commercial register, shareholder register, procedures for issuing shares and stock acquisition rights, and minutes of shareholders' meetings and board of directors meetings
• Key transaction agreements, loan agreements with financial institutions, business alliance agreements, and contracts containing change of control (COC) clauses
• Business permit and license certificates, the state of legal compliance management, and documents relating to past administrative investigations, guidance and dispositions
• Intellectual property registration certificates and application documents, system development outsourcing agreements, and personal information and data use terms
• Work rules, contractual relationships with officers, employees and contractors, and labor-related materials such as unpaid wages
• Pending lawsuits, serious complaints from customers, contingent liabilities and debt guarantees given to third parties

Demanding the submission of all documents without limit from the initial stage places an excessive burden on the target company's staff and causes delays in the disclosure of important documents. After grasping public information such as registrations and websites and the business overview in advance, a prioritized disclosure request list is designed for each matter. In addition, where documents are not disclosed, it is important to confirm whether "the relevant facts do not exist" or "the facts exist but documents have not been prepared or kept," and to make clear in the report the scope that remains unverified.

How the Investigation Proceeds and the Deliverables

The legal DD process begins with research into public information and sending the list of documents to be disclosed. The typical flow then involves reviewing the data room, Q&A and interviews with relevant persons, and finally compiling the report. In matters where documents are disclosed in stages, verification proceeds in the order in which documents are disclosed, and if serious concerns that could affect the transaction decision are found, they are shared with the client early through an interim report.

A report, as the deliverable, is of little practical use if it merely lists legal violations and deficiencies in terms. It is important to analyze the degree of impact that the facts discovered have on the business and to present the recommended legal response with consistent logic. If the report organizes concretely whether correction is to be required as a condition precedent to closing, addressed through a special indemnity clause in the SPA or used in negotiating a reduction in the purchase consideration, the same report can be used both for the investment decision at the management meeting and for contract negotiations.

The Buyer's and the Seller's Perspectives

The main purpose of legal DD conducted by the buyer is to identify the potential risks it will assume through the acquisition and to reflect them in its investment decision and the protective clauses of the SPA. The matters a buyer should focus on when acquiring a startup are covered in detail in the Buy-Side Legal DD Checklist.

On the seller side, too, there are cases where sell-side DD (vendor DD) is conducted for the purpose of identifying the company's own issues and documentary deficiencies before they are pointed out by the buyer. As explained in Legal DD to Prepare Before Becoming the Seller, by organizing the shareholder register, the resolutions issuing stock options and the storage of key contracts in advance, the seller can grasp the matters likely to be pointed out by the buyer and consider in advance how to respond in terms of the sale conditions.

In addition, maintaining a contract register in normal times and recording the course of decisions so as to speed up the initial response to an acquisition review are also explained in detail in Steps for the Target Company to Prepare for Legal DD in Advance.

Factors That Affect the Duration and Cost

In addition to the transaction amount, the scope of the investigation and the volume of work affect the cost of legal DD. The actual number of work hours varies depending on the number of group entities subject to investigation, the spread of business locations, the total volume of disclosed documents and the number of past years covered by the investigation.

When requesting an estimate, communicate the target company's business overview, the transaction structure envisaged and your desired timeline. If this information is shared, it becomes easier to compare whether to conduct a focused investigation narrowed to key issues or an investigation covering the entire organization. Published fee examples and points to check in estimates can be found in M&A Attorney Fees: Fees for Legal DD, the SPA and Closing.

Reflecting Investigation Results in the SPA, and Legal Support

If legal DD and contract drafting are carried out separately, there is a risk that the risks found in the investigation will not be reflected in the contract clauses. If key contracts contain COC clauses, it is necessary to work out whether obtaining the counterparty's consent will be made a condition precedent to closing and how to set the termination right if consent cannot be obtained. In addition, where the amount of loss cannot be determined in advance, such as for risks relating to unpaid wages or litigation, the risk is allocated through the design of the representations and warranties clauses, the cap on indemnification and specific indemnity clauses.

The basic design of the SPA as a whole and the interaction between its clauses are explained in detail in Indemnification, Price Adjustment and Closing in the SPA (Share Purchase Agreement). At LegalAgent, we support the entire process from designing the document disclosure request list through data room verification and interim reports to reflecting findings in the SPA clauses. If you share the transaction structure, the target company's business overview and your desired investigation period at the stage of considering an acquisition or sale, we will present a design for the scope of investigation and an estimate.

The scope of our support is described in M&A Support, and the points to check regarding fees in M&A Attorney Fees and Estimate Items. The overall picture of reflecting due diligence findings in contract clauses is covered in The Structure and Key Clauses of an SPA (Share Purchase Agreement).

Frequently asked questions

What is legal due diligence?

It is a process of investigating legal issues and risks relating to the target company or target business in M&A, such as corporate organization, key contracts, permits, intellectual property, labor and litigation, and reflecting the findings in the acquisition decision, the price, the SPA and post-closing actions.

How long does legal DD take?

It depends on the size of the target company, the volume of documents, the scope of the investigation, the number of Q&A rounds and interviews, and the format of the report. Sharing an overview of the target company, the desired schedule, key focus areas and the state of preparation of the data room at the time of the estimate makes it easier to set the duration.

How are the results of legal DD reflected in the SPA?

They are allocated to pre-closing remediation, conditions precedent, price adjustments, representations and warranties, indemnification, post-closing covenants and the like. It is useful for the investigation report to set out not only the findings but also the recommended contractual responses.