How a Legal Audit can help avoid a deal falling through at the last minute

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Patrick Peake
Corporate Solicitor
Waterfront Solicitors LLP
Patrick.Peake@waterfrontsolicitors.com

Starting out as a company can be at turns exciting and exhausting, with every day presenting new challenges. What is often lost in the mix of dealing with suppliers, finding premises and making new business contacts is the need for everything to be legally documented. This may not seem like a major issue in the early days, when the main concern is making enough profits to survive. However, when the time comes to seek external investment or sell your business, a third party can get extremely concerned at the lack of paperwork detailing the various changes the company has undergone since its inception. Many deals fall through for this very reason for the third party can see the lack of documentation as too much of a risk.

A legal audit is a way of avoiding this problem by getting your lawyers to conduct due diligence on your company, similar to one that would be undertaken by any potential investor or purchaser.

The legal audit process usually takes the form of a detailed questionnaire, followed up by meetings to discuss any issues that arise.  It will deal with key areas of a company such as: commercial contracts; corporate structure; employment; and Intellectual Property (IP). The process is designed to tease out any issues which could present difficulties in the run up to a sale or investment and then put in place the documents that should have been drawn up at the time.

An audit usually starts by focusing on the basic legal requirement that every company should have a register of members. This is a record of anyone who has been a shareholder and/or director of the company and also contains a tracker of any share issues or transfers. Often this can be put together fairly quickly during due diligence if the shareholders have remained the same during the company’s life span. The picture is much more complicated if the company has undergone various changes in shareholders, issued new shares pursuant to share options or changed the board members. An audit would ensure that an up to date and accurate register of members is in place.

I am often amazed as a corporate lawyer at the sheer wealth of regulations necessary to bring about ostensibly simple transactions. A classic example of this is a share buy back which seems a straightforward idea-it is just a company buying back shares from a shareholder after all. However, this is one of the most frequent matters that is not formalised correctly and often the necessary paperwork has not been filed with Companies House. A legal audit would show this up and could easily rectify the oversight prior to formal legal discussions with third parties. What a company wants to avoid is perfecting a share buy back at the time of the purchase or investment. This is because a former shareholder could extract a considerable price for their shares as they know that a whole deal may rest on the shares being bought back by the company.  It is much easier and less time pressured if the transaction is documented before a third party is on the scene.

Employment contracts are often overlooked as people may think that because everyone knows each other there is no need for terms to be documented. However, any buyer would get nervous at this, particularly due to the raft of employment legislation in the UK. Thankfully drawing up a contract can be done easily during a legal audit.

Share options are an increasingly popular way for companies to attract the best talent without having to pay a substantial salary. These are sometimes granted on nothing more than a handshake which would alarm any interested third party. Options should always be in the form of a formal share option agreement so that everyone knows what has been granted and to ensure that you have not inadvertently given 25% of the company to someone who has only worked there a few months.

IP is a notoriously complex area, with many things like websites, branding and technical information created without anyone being quite sure who owns the IP to them. For example, if an employee creates anything while working for the company then the IP will be owned by the company. By contrast, when a consultant creates something such as a website, the consultant will retain the IP. This is because, in the absence of a formal agreement saying something to the contrary, the consultant has not legally assigned the IP to the company.

IP forms a key aspect of a legal audit, particularly with companies in the technology sector, for it goes a long way to ensuring that the company actually owns everything that they say or think they do.  Far better to deal with this issue when there is not the pressure of a completion deadline and, similar to share buy backs, when a contractor is unaware of the reasons for documenting the assignment.

All of these issues, and numerous others which crop up when someone else takes a look at how your company has been organised, are not insurmountable. They can be resolved by your lawyers going through the history of your company.

At Waterfront, we fully appreciate that the main focus of companies of all shapes and sizes is to ensure it is a commercial success. Getting paperwork drawn up is no one’s idea of fun (unless perhaps you are a lawyer) but once done, a legal audit will save time and spare unnecessary stress during a due diligence process.

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