This is the second of a ten-part series that may show you how the simplest-looking parts of a business deal can come back to haunt you.  Stay with it and read about how to avoid getting into trouble, instead of how to get out of trouble. Part I, which discusses letters of intent, can be found elsewhere in this blog.  I have published an abbreviated version of this whole series in the January 2014 issue of Nevada Business magazine. Here is the link, but I warn you – it is so abbreviated that it only has seven pitfalls, and there is much more to be said than what you will see in that article! http://www.nevadabusiness.com/2014/01/seven-pitfalls-avoid-negotiating-business-contracts/

Due Diligence – Too Little? Too Much?  Help!!

“Due diligence” is a frequently-used term in business deals. But what does it really mean, how much will it cost, and how long will it take?

Chapters can be devoted to each question.  Suffice to say, though, that unless you are selling something for cash up front, at an early stage of negotiations you should consult with your advisers about what unwelcome post-closing surprises there could be, and tailor your due diligence accordingly.

Suppose you are just buying some widgets – but what if the seller has pledged the widgets as collateral to secure a loan – will that lien remain on the widgets after you buy them? And where do you search to find out about the liens?

Or maybe you are buying a company that is well-positioned in an industry and has lucrative contracts that you will take over. But what if those contracts have a “change in control” clause that allows the contracts to be canceled when someone buys the company? And what if the other parties to those contracts want to use that clause as leverage to make you renegotiate on less favorable terms? Or what if those contracts have been in effect for many years, but if you examine them, you find that either side always has the right to terminate with 30 days’ notice? In those cases, the long life of those contracts might come to an abrupt end after you step in.

Or let’s say you are just buying certain parts of a company’s business, and they checked out OK.  But what if you didn’t do your due diligence on the company’s contracts that you aren’t buying, and it turns out that the company is breaching those contracts by selling other parts of its business to you – do you think that is just the seller’s problem? Try telling that to the plaintiffs who sue you for inducing the seller to breach those contracts, even though they aren’t even a part of your deal.

The list could go on and on about what could happen without due diligence. And the consequences of inadequate due diligence can be devastating.

In business deals, the time that attorneys spend on due diligence can far exceed the time spent on negotiating and drafting the contract.  As a result, the behind-the-scenes diligence work, which you might not even be thinking about, could wind up being far more expensive than the actual negotiations and contract work.

What is the take-away from all of this? Due diligence must be specifically tailored to your needs and expectations in your deal. Too little, and the surprises can be devastating. Too much, and you will have sticker shock when you get the legal bill.

In a contract to buy a business, the buyer often requests from the seller a long list of promises, referred to as “representations and warranties,” about the business.  If any of them are found to be untrue before the deal closes, the buyer might threaten to cancel the deal and demand an expense reimbursement, or try to renegotiate the purchase price, or all of the above.  If the problem is discovered after the closing, the buyer might demand reimbursement of part or all of the purchase price to compensate for being misled by false representations and warranties.

The representations and warranties section of a contract can be the lengthiest part of the document, and the details of it can be mind-numbing.  Often the buyer demands information about the business that the seller doesn’t even know.  For example, a buyer might want to know if any of the seller’s customers or suppliers have breached their contracts with the seller.  Or the buyer might want to know if, at any time since the beginning of recorded history, any hazardous materials were ever stored on or below the ground where the business is located.

On many subjects, the most that a seller can say is, “To the seller’s knowledge,….”  So if the buyer discovers a problem that the seller had no “knowledge” of, is the seller in the clear?  Or is this where the trouble begins?

Well, in most cases the seller is not like you and me, because we are both humans.  Sellers are usually business entities, with employees, officers, directors, stockholders, etc., each of whom might know something about the business that the others don’t know.  So when the seller says it has no knowledge of something, who exactly has no knowledge?  And what if the seller’s management has no actual knowledge about a problem but could easily have learned of it with a simple email or phone call to someone else down the line?  Does “knowledge” then mean “should have had knowledge”?  If the answer is no, are we rewarding the seller for carelessness?  If the answer is yes, then “knowledge” has taken on a quite different meaning.

The basic answer is that in the world of business contracts, you should not rely on a dictionary for the meaning of knowledge.  Your contract should contain a carefully drafted, lawyerly (ugh!) definition of that word.

If you are the buyer, you might want the seller’s “knowledge” to include whatever the seller’s management could have discovered through a reasonably thorough investigation or consultation with lower-level employees.  But the seller probably wants knowledge to mean “actual, current knowledge, with no further inquiry” of just a few named individuals who run the company (and be sure to name them).  And neither the buyer nor the seller wants to roll the dice and leave it to a judge or jury later to decide later on what knowledge means after a dispute arises.

So if you really want to know what is knowledge, be prepared for some tough negotiations and careful contract drafting.  Otherwise, you might wind up with “knowledge” of what you don’t even know, and it could cost you.