M&A Transactions: How Legal Due Diligence Protects Your Future Business?
Contemplating an acquisition of a company in Kazakhstan? Knowing how legal due diligence (“Legal DD”) can help protecting your future business should be of potential interest to you.
Legal DD is one of the key steps in the business acquisition process. It allows you to understand the current status of the target company and to identify any available problem areas. During a due diligence exercise lawyers like doctors detect sore spots, which may eventually lead to “disease progression” and negative implications. Therefore, Legal DD seeks to warn an investor about the problems of the target company so that the investor makes an informed decision as to whether the contemplated investment or purchase of a business is indeed beneficial. Once you decide to acquire the business, respective legal findings can be used as leverage in negotiations with your business partner.
In this note, we would like to share our thoughts on importance of Legal DD in any M&A transaction. Legal DD reveals potential risks, which may affect the outcome of the entire transaction.
1. Identify the Deal-Breakers
Each company has its own business history. Some companies never had any change of control. In other companies the shareholding changed quite often. Any change of control may be subject to corporate and statutory formalities and/or restrictions. Failing to comply with those formalities by previous owners in the past may jeopardize your good title to the acquired shares and many ultimately put your investment at risk. Hence, one of the key aspects of Legal DD is to assess the legitimacy of all previous changes of control in the target company’s shareholding structure.
2. True Value of a Target Company
Behind any company there are certain assets, such as proprietary rights, licenses, and government-issued permits to carry out certain activities. Good title searches in relation to registered assets will give you a certain comfort that these assets are legally owned by the company and are free of any lien or any other third party claims.
The recent trend in Kazakhstan business environment demonstrates high demand in so-called “shelf companies”, i.e. companies with a license/permit for a particular type of business activity. At the moment of transaction such companies may be dormant. Accordingly, if you are interested in a company for the sole sake of its license, a due investigation of a validity of the license is quite important. Doing business absent a license may lead to both administrative and criminal liability. In addition, the risk of license revocation/cancellation due to non-compliance with licensing terms and conditions or qualification requirements makes the value of such company reduce to zero since the license is the most important asset of the company at the time of acquisition. Therefore, all these legal matters/risks are thoroughly reviewed and further reported to the buyer as part of Legal DD.
3. Save Money
Absent Legal DD, there is always a risk to acquire a company with debts. Legal DD, among others, identifies the company’s financial and contractual obligations by reviewing commercial contracts and loan agreements. Knowing the financial status of the company can help in negotiating the purchase price with your counter-party.
Business activities are often subject to regular state audits, which may result in the government agency issuing orders or instructions to rectify/cure violations by the company of regulatory or industry specific requirements. Generally, failure to follow such instructions or prescriptions may result in administrative sanctions for the company. Absent due investigation of this matter as part of Legal DD, it can potentially turn into a post-acquisition surprise in the form of an administrative fine for the investor.
4. Intellectual Property Matters
Intellectual property (IP) rights are the company’s business assets. IP rights of the target company may include a trademark/a utility model/an industrial design that add on value for the transaction. Therefore lawyers recommend conducting a thorough review of IP rights status before acquiring companies (checking registration/legal protection matters).
5. Skeletons in the Closet
Most of acquisitions are followed by organizational changes to the company. Such changes may include dismissal of the previous management and appointment of new executives. An investor should be aware of the so-called “golden parachute” clauses in employment agreement of dismissed key managers. A special employment termination arrangement in the form of severance payments is guaranteed to the target company’s executives in case of dismissal. As you can imagine, the amount of such compensation may be significant and the investor should therefore be keen on learning about such potential "surprises" before entering into transaction, and use these findings when negotiating the purchase price.
6. Litigation History
You may not be aware of the fact that the target company has recently lost a lawsuit and is under the risk of incurring financial expenses, losing its important assets, permits and licenses, etc. The purpose of Legal DD in this regard is to warn you about such risks or to assure you that there are no pending or ongoing cases.
The Legal DD findings are presented in the form of a report. The DD report outlines key deal issues, associated risks and recommendations as to how to mitigate the risks (either through conditions precedent or representations/warranties/indemnities). You can use the Legal DD report in your commercial negotiations with your counter-party, and most importantly it will help you make an informed business decision.
Information contained in this Client Update is of general nature and cannot be used as legal advice or recommendation. Please note that Kazakhstan is an emerging economy, and its legislation and legal system are in constant development. Should you have any questions or want to discuss matters addressed in this Client Update, please contact us.
