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Due Diligence 101: Top Five Contract Issues

Bruce Teichman, EVP and Partner
Cogent Growth Partners

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Quick Summary from Bruce

When a buyer acquires an IT service business, one of the key deliverables of the transaction is the customer contracts. In many ways, this is the core value of a service company acquisition. Here at Cogent, we’ve been involved in hundreds of IT provider M&A deals and have gained unique insights into the issues that come up on a regular basis in M&A transactions.  In this summary of my presentation, I discuss a number of critical contract related issues that the sellers must consider when preparing their company for a merger or acquisition.

Ensure You Have All Customer Agreements In Writing
In the course of due diligence, we often find that some number of contract documents are absent from the files, despite prior execution of written agreements with customers.  It’s crucial to have a process to retain all agreements with customers as well as vendors, and employees and ensure they are on hand prior to initiating due diligence.

Ensure All Agreements Are Fully Executed and Digitized
In addition, some businesses may have all their contracts in place but find that some of those contracts are not actually signed by the customer. Conducting a thorough audit is essential to ascertain the status of contracts, including their execution and digitization. The accessibility of contract documents is crucial, as the inability to demonstrate contracts or provide signatures may raise concerns about the company’s operations.  It’s also a great idea to ensure that these signed contracts are stored digitally and readily available as PDFs.

Ensure All Agreements Are Current
Furthermore, considerations extend to contract expiration, where even if contracts are fully signed, there may be instances of expiration several years ago. While billing and payments may continue, it is crucial to confirm that contracts are still valid as a buyer will be concerned that customers may use the lack of a current contract to terminate service after the company has been sold. Auto-renewal language in contracts, spanning one to three years, can be advantageous for seamless continuation.

Ensure All Contracts with Addendums are Complete
The inclusion of addendums over time introduces complexities, especially when the latest addendum is presented without the original. Legal experts emphasize that an addendum lacking the original document is not legally binding, underscoring the importance of preserving the integrity of the complete contract.

Ensure All Contracts Are Assignable
Finally, the concept of assignability is vital, as most contracts feature an assignability clause determining the ability to sell contracts to another party. It is common for contracts to require customer approval before a new entity can assume control, adding a layer of complexity during ownership changes. Proactively addressing assignability in contracts can alleviate challenges for the seller in obtaining customer consent during a company sale.

Being proactive in addressing these contract issues before the due diligence process will greatly improve the probability of a successful outcome, maximize enterprise value and reduce the time spent and issues encountered in completing the sale of the company.