How to Complete Legal Due Diligence When Buying an Online Business

There are many elements to consider when buying a business, and one of these is completing the legal due diligence process. You wouldn’t buy a business without examining its sales data and expense reports first, and the same should be true when it comes to its legal practices and documentation.

In this article, we answer several key questions relating to the legal due diligence process, including:

• What is legal due diligence?
• When is legal due diligence necessary?
• Why is legal due diligence important?
• How long does the legal due diligence process take?

Please note: This article is not intended to be legal advice. It is simply an overview of what the legal due diligence process looks like and why it’s important. Please consult with your attorney for any legal counsel or advice.

What Is Legal Due Diligence and When Is It Necessary?

Let’s start with the most basic question: What is legal due diligence?

In essence, legal due diligence is the process of investigating documents or practices that carry legal implications. Typically, legal due diligence is performed by or on behalf of a potential buyer as part of the broader due diligence process, the goal of which is to reveal information relevant to investment decisions. As a buyer, there are several different areas of legal due diligence you should consider before closing the business transaction.

Employment contracts and contractor agreements

Does the business have employment contracts or contractor agreements in place? Ideally, the business you’re considering acquiring has detailed agreements in place that outline the working relationships it has with its employees and contractors. Of course, you want to be sure that all terms and compensation amounts adhere to their respective jurisdictions. For example, if the business has employees in California, the compensation outlined in the employment contracts should be consistent with California employment law, including minimum wage requirements.

Supplier agreements

Similar to employee and contractor agreements, the business should have supplier agreements. These agreements should outline the terms and conditions of all business transactions. They should also protect the interests of the business you’re considering acquiring.  

“In essence, legal due diligence is the process of investigating any documents or practices that carry legal implications.”

Warranties

If the business offers limited warranties, the terms should be clearly defined in language that is legally binding. For example, if you’re acquiring an eCommerce business that offers a one-year limited warranty for manufacturing defects, it should be spelled out in detail to avoid excessive warranty claims and legal issues.

Intellectual property protection

Many businesses rely heavily on their intellectual property for all aspects of their success. Therefore, before you acquire a business, make sure that its IP assets are well protected.

If the business has trademarks, do your research to ensure the trademarks are current and enforceable. Similarly, patents should be carefully verified. One of the last things you want is to acquire a business and then realize the previous owner’s IP claims aren’t correct. Do your research now and save yourself the headache later.

Intellectual property infringements

Just as it’s important to make sure other people or businesses can’t infringe on your IP assets, it’s also important to ensure your business isn’t infringing on other businesses’ IP. Therefore, do your research to ensure the business’s branding, messaging, and products don’t violate another business’s IP. 

Distribution agreements

If the business is a licensed distributor for other businesses’ products, make sure its licensing agreements are legitimate and up to date. Additionally, make sure the business has been upholding its side of the agreement. This helps ensure that the future of the relationship isn’t in jeopardy.

Compensation practices

Make sure the business you’re acquiring has been paying its employees or contractors based on the agreements in place. You do not want to acquire a business and immediately discover your employees expect you to make back payments based on the previous owner’s negligence. Even if you’re not on the hook legally, it could still be a major issue for you as the new owner. 

Accounting practices

In all cases, mergers and acquisitions (M&A) due diligence should include a thorough examination of the business’s accounting practices. For starters, the business’s accounting practices significantly affect how much insight you can gather from its profit and loss statements. For example, let’s say you’re considering acquiring an eCommerce brand. In such a situation, it’s essential to see monthly financial statements on an accrual basis to understand trends and seasonality.

Additionally, you’ll want to verify the business has been following the law in its accounting practices.

Pending lawsuits

If you acquire a business that has a pending lawsuit against it, you’ll only encounter headaches and frustration. Therefore, before completing a deal, make sure the business isn’t facing legal issues such as this. Hopefully, the seller will be transparent about any legal entanglement, but it’s still essential to do your own research to verify this.

Anything else

While the above list covers many of the elements you’ll want to consider during legal due diligence, it is by no means an exhaustive list. Each business is different, so it’s essential to consult with both your Advisor and attorney. Doing so can help you determine the steps you should take to complete legal due diligence.  

Why Is Legal Due Diligence Important When Buying a Business?

There are several key reasons why legal due diligence is important when buying a business. A few of these include:

• Brand stability
• Liability protection
• Peace of mind

Brand stability

In order for a brand to be stable, it needs to have strong IP protection in place. For businesses that rely heavily on branding, this is absolutely essential.

If you’re considering acquiring a business that has trademark issues, that could be concerning. If other businesses decide to use your branding, it could spell disaster for your entire business. 

The same is true for patents. If a business relies on a specific patent to maintain market share, it could become a significant issue if the patent is deemed unenforceable. For this reason, you don’t want to overlook a seller’s claims relating to IP. By doing careful due diligence and examining each IP legal document with a fine-toothed comb, you can identify potential IP issues before you invest a significant sum of money.  

Liability protection

By doing legal due diligence, you can minimize your exposure to legal risks. If a business doesn’t follow the correct practices, you could encounter an unpleasant surprise after the acquisition.

Making sure the business has been adhering to its responsibilities set forth in its employment contracts reduces the chances that employees will take legal action against you in the future. And, in the unlikely event they do take unfounded legal action, you’ll be in a much better position to defend yourself.

Similarly, it’s important to ensure the business has been upholding its legal obligations to its customers or clients. If it hasn’t been honoring its warranty policy, for example, that could create a significant liability issue. Similarly, let’s say the business sells a hazardous product and doesn’t have the required disclaimers. In such a situation, it may be exposed to significant legal risk. By following the right legal due diligence and financial due diligence processes, however, you should be able to steer clear of businesses that set you up for costly legal issues or failure.

In addition to helping you identify potential legal risks related to employees or customers, the legal due diligence process can help you avoid risks related to other businesses. For example, let’s say you’re considering acquiring a business that is in violation of another business’s patents. In such a situation, you may want to reconsider your acquisition decision.

“It’s important to ensure the business has been upholding its legal obligations to its customers or clients.”

And of course, every entrepreneur wants to avoid unpleasant visits from the IRS and other key authorities. If the business’s tax returns don’t show revenue that appears on its internal transaction documents, that should be a red flag. Even though you didn’t do anything wrong, such wrongdoing could come back to haunt the business later. 

Peace of mind

There’s one additional benefit to completing a thorough legal due diligence process: Peace of mind. 

If you skip over the legal due diligence process, you expose yourself to unnecessary legal risks after the acquisition. Not only could such risks end up being costly, but they could take your attention away from growing the business. After all, it’s difficult to concentrate on implementing new strategies when your mind is preoccupied with stressful calls from your lawyer or legal team.  

By making sure the business isn’t exposed to significant legal risks, it’s easier to feel confident about what you’re getting yourself into. In turn, this allows you to spend less energy worrying about the “what ifs” and instead focus your attention on high-growth activities.

How Long Does the Legal Due Diligence Process Take?

There are several factors that can impact how long a proper due diligence process takes. In some cases, the process can take many months. In others, it can be as short as just a couple of days.

Typically, larger deals require a longer due diligence process. Even if the business is well organized, there’s simply more documentation to sift through to ensure the necessary contractual protection is in place in all the key areas. On the other hand, let’s say you’re acquiring a small Amazon business with just one supplier. In such a situation, the legal due diligence process may be relatively straightforward.

Additionally, businesses with a large number of employment contracts or supplier agreements can require a lengthier legal due diligence process as well. Each document should be carefully reviewed by an attorney, which, of course, takes time.

Although this article is a great starting point, it’s important to speak with an attorney to establish the legal due diligence checklist that is right for you. By doing your homework and asking the right questions, you’ll be well on your way to acquiring a great business you can enjoy growing for many years to come.