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Due diligence – ensuring a business acquisition benefits from the contracts

27th April 2023 by Sam Freeman

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If you have spotted a great business acquisition opportunity and the headline figures look superb, how do you know that you will be getting the value and benefits in the deal that you had hoped for? The key lies in the quality and depth of the due diligence carried out by your advisors, especially in regard to the transferability of the business contracts.

‘It is a sad fact, that some otherwise viable acquisitions have failed to succeed as a result of important contracts not being transferable to the acquiring business,’ says Sam Freeman, head of the corporate and commercial team with Laceys Solicitors.

Sam delves into the various aspects to consider when it comes to reviewing the business contracts as part of due diligence.

After you have reached agreement in principle on the main heads of terms with the owner of your target business, the due diligence process will soon begin.

Obtaining copies of contracts 

Our solicitors have a lengthy questionnaire and checklist of all the documents that you will need to see before you even consider exchanging contracts on the deal. This will require the seller to provide a copy of every contract that is relevant to their business. It is likely that you will be asked to sign a confidentiality agreement prior to the disclosure, and our solicitors can advise you on its terms.

When these documents arrive, you will need to do your homework and study them in detail, for example:

• if pages are missing or text is obscured, follow this up; or
• if a contract period has elapsed or a contract has the wrong parties named etc, again question this.

We will be happy to discuss any queries you may have at disclosure stage and can liaise with the seller’s solicitors regarding any missing or unusual documents.

It is vital that you have sight of a complete contractual ‘snapshot’ of the business at that moment in time.  By analysing the contracts in detail you will find out a great deal about the business, both for the better and for the worse.

Which contracts benefit or burden?

Not all contracts are created equally.  Some contracts will serve to benefit the business, in other words they serve as a type of asset that will bring in long-term revenue or other financial or reputational benefits. Other contracts will burden the business.  Some will do both. Some may appear to benefit, but when you look closely you discover they are in fact a burden.

In your own mind, you need to separate out and make a distinction between those that benefit and those that burden.  It is only by distinguishing between the contract types that you can really focus on the ones that matter to you.  For example, if you are targeting this particular business acquisition because of a valuable contract that it has in place, then check this particular contract in great detail. Does it do what you had hoped?

Likewise, if there are certain burdensome contracts that you would want to extricate the business from, can this be done? What are the penalties? Naturally, we can advise you on the legal issues here as part of our work on the business purchase.

Which contracts automatically transfer?

Once you have analysed and earmarked the business-critical contracts, you will need to know whether they will transfer with the business.  You cannot just assume they will transfer automatically, as there are various aspects to consider. 

Firstly, there is the method of acquisition. If you are buying the shares in a company then the contracting party is not changing, so it is possible that the contract will automatically transfer unless there is a ‘change of control’ clause that prevents this. If you are not buying the shares in the company, but just cherry-picking some assets, then it is more likely you will require the consent of the other contracting party to the transfer, which is known as ‘novation’.

Secondly, in certain business contracts there may be an ‘assignment’ clause which permits the transfer of the contract to the buyer which may or may not also require the consent of the other party or involve other conditions.

Finally, if the target business is not a company but another structure such as a sole trader or partnership, then the contracts will typically be personal to the owners of the business. Again, consent to the transfer is likely to be required or a new contract issued by agreement.

When is novation required?

Novation is a three party (tripartite) process whereby the original buyer and seller, would agree with you as the acquirer to transfer (or novate) the relevant business contract over to you. Once the novation has been completed, you would legally take on the contract.

A novation agreement requires all three parties to sign it to formalise the terms of the novation. A key term to agree will be whether the seller will remain liable for the pre-novation liabilities, or whether you will take over and assume this liability on their behalf. This will all be down to negotiation, and we can advise you on the strength of your position.

Depending on the circumstances, the third party may also seek to place some other conditions on their consent to the novation to protect their position.

How we can help

We will help you to navigate the transfer of business-critical contracts at the time of the acquisition, so that you can be confident about maximising the return on your investment.

Our solicitors will be with you at each step of the due diligence process, so that you are not held to ransom on consent conditions if you seek to novate or assign business contracts later down the line. 

If you need advice regarding a business purchase and the related due diligence, it is vital you speak with a corporate or commercial lawyer with the correct knowledge and experience as early as possible.

For an informal discussion, please contact Sam Freeman in the corporate and commercial team on 01202 377800 or s.freeman@laceyssolicitors.co.uk

This article is for general information only and does not constitute legal or professional advice. Please note that the law may have changed since this article was published.