U.S. company acquisitions & JVs: An explanation of the due diligence process for foreign buyers
Law firm Masuda Funai provides an overview of the steps foreign companies need to go through when targeting U.S. companies for acquisition or joint venture
The importance of a robust due diligence process
The United States can provide huge opportunities for foreign companies but entering the large U.S. market requires preparation and careful execution. This article, co-authored by Tom P. McMenamin and Reinhold F. Krammer, attorney members at Masuda Funai in Chicago, continues our series of articles on doing business in the United States.
Many foreign companies start their efforts through sales representatives or distributors. Others establish a small U.S. sales focused subsidiary as their first step. And many others will, as an initial step or later, accelerate their efforts through an acquisition or a joint venture (“JV”). These last two can provide a quick platform from which product offerings and sales can be expanded. But preparation and careful research is even more critical with acquisitions and JVs because the risks of unknown factors, as well as the potential downsides, are considerably greater.
A three step due diligence process
In considering an acquisition, the foreign company should conduct an investigation of the target (“Target”). This “due diligence” usually has three parts:
- Financial and tax due diligence, normally conducted by an accounting firm designed to confirm the accuracy of the financial information of the Target, including the quality of its earnings
- Operational due diligence, normally handled by the buying company but sometimes by a management firm specializing in this area, the objective of which is to expose any risks in the products, production processes, and performance and execution of the business of the Target; and
- Legal due diligence. This article summarizes the scope, procedures and objectives of the legal due diligence of the Target in an acquisition context.
The five objectives of the due diligence process
The legal due diligence process has five key aims:
- To confirm the legal status, internal governance and legal procedures of the Target
- To determine the ownership of assets (and any liens held by third parties on such assets)
- To inventory the contractual obligations of the Target, as well as any litigation in which the Target is involved
- To review the employment situation at the Target, including any union contracts, executive employment agreements and employee benefit plans; and
- To explore insurance arrangements and other important risks. Where the Target has real estate facilities, the legal due diligence investigation will also include an environmental assessment of the Target, with such assessment being conducted by environmental engineers.
Examples of risks unearthed during due diligence that can influence a deal
Let us mention two examples of risks that were uncovered for clients during legal due diligence. In the first case, the Target had decent earnings and good products/performance. But it had some traditional employee benefits, including a pension program. Further investigation of the pension revealed an unfunded liability that was greater than the proposed purchase price itself. Our client wisely walked away.
In the second case, the Target had solid financials and a good customer base but our review of the sales contracts revealed that the Target’s contracts with three of its five largest customers had “Change of Control” provisions. If ownership of the Target changed, then the customer could terminate the supply contract. Our client raised this concern with the Target who arranged meetings with the large customers and our client. The customers were comfortable with our client and gave waivers. The acquisition proceeded and our client has excellent relations with the customers.
In most situations, the legal due diligence starts shortly after the signing of a nonbinding letter of intent. The drafting and negotiating of the purchase agreement normally starts at the same time. In the past, the lawyers conducting due diligence would send their client a lengthy, comprehensive report at the end of their investigation; today, however, the timetables for acquisitions are shorter and the lawyers send frequent, interim reports regarding specific matters. Most clients prefer the new style as it enables them to focus on particular issues as they arise.
Timescales and schedules involved in acquisition
In most cases, the legal investigation of a U.S. Target will be completed within 30 days and can be very detailed or minimal - the client decides how deeply the due diligence will be performed. Some matters might linger on as the Seller’s representations and schedules to the purchase agreement are being finalized. The representations and schedules usually will consist of lists of:
- The Target’s assets (including real estate, personal property and intellectual property)
- Threatened and pending litigation
- Insurance matters
- Employment benefits.
The schedules are prepared by the Target; the buyer then compares the information in the schedules against the findings of the legal due diligence investigation.
Risk reduction and reassurance
A properly conducted legal due diligence will spot legal and business risks that the buyer can evaluate prior to closing the transaction. If the buyer proceeds with the acquisition, then the legal due diligence will also have increased the buyer’s knowledge of the legal aspects of the Target’s business that the buyer must operate once the deal is completed. If risks are exposed, the Buyer can walk away, seek indemnification or demand other types of assurance/protection from the Target.
In summary: do your research
No matter how a foreign company enters the U.S. market, it will require research and investigation. When compared to expansion through organic growth, expanding into the U.S. through an acquisition can provide greater opportunities in a shorter time period but German companies should first conduct an appropriate due diligence investigation of the Target in order to understand and minimize the risks of assuming Target’s business.
For more information
Please contact Tom McMenamin, partner and president at Chicago law member Masuda Funai and a key member of the alliance's International Corporate Finance / M&A Services Group. A version of this article originally featured in the German American Chamber of Commerce 2016/17 Midwest Report.