Whether you're buyer or seller, legal due diligence serves an important (different, yet complementary) purpose in any M&A transaction.
In addition to getting a deal done, both buyers and sellers have an interest in not wasting time or resources. Due diligence allows the parties to identify and assess risks, potential 'deal-killers' or 'sticking points' as quickly as possible.
Generally, this will include a strategic review and assessment of legal liabilities, financial records, intellectual property issues, material contracts and regulatory compliance matters. In the construction industry, meaningful and realistic assessment of operations – including completed, ongoing and committed projects, schedules and budgets – will also be critical to valuation and understanding of associated risks. From a seller's perspective, it follows that having this type of information ready, accessible and organized can significantly reduce potential delays, critical roadblocks and walkaways during the deal process.
Understanding outstanding financial and contingent liabilities
As with any M&A transaction, it is important for a buyer to have a good understanding of the general financial liabilities of the target company. For this reason, financial statements – including accounts payable, accounts receivable, cash accounts, vendor balances and lease obligations (capital and operating) – are often a top-of-the-list line item in a due diligence requisition for any acquisition.
For construction companies, the financial picture of each project is also highly relevant. Particular attention should be paid to work in progress and its impact on cash flows and revenue recognition. Issues of importance may not be apparent on the face of financial statements. For example, it will be important to understand (and inquire about) projects with delayed or non-payment issues or when the target company may have significant outstanding claims for or against it.
Over and above the terms of a balance sheet, other financial documentation and instruments that the target company may have supplied should be requested and provided. Items such as bonding capacity or letters of credit are material considerations in the construction context. However, these items are not necessarily represented on a balance sheet until any surrounding uncertainty is resolved.
Given the frequency and materiality of payment and claim issues in the construction industry, prospective sellers are well-served by having a good account of the status of any payment issues or outstanding disputes, as well as a clear path forward for resolving those issues.
On the flip-side, potential buyers of construction companies should spend time understanding the scope of the target company's active and recently completed project and any outstanding liabilities. This includes warranties and ongoing or contingent commitments in connection with those projects. The buyer will almost invariably be faced with any unresolved issues after the transaction is completed. In relation to warranty claims, a buyer should request (and it is attractive where a seller can provide) a summary of facts, status, possible outcomes, insurance considerations and a financial estimate of quantum of potential liability for any known warranty claims.
Understanding the business and risks on paper
Another critical piece of due diligence is reviewing the target business' contracts. Construction projects are driven in large part by contracts, which are often lengthy and complex.
A construction business' contracts will generally include a combination of clients, subcontractors, general contractors, owners, suppliers and partners. Complicating matters further is the industry reality that the role a construction company plays in the context of a particular project may vary significantly. For example, a general contractor on one project may be subcontractor on another project, and a co-developer or joint venture partner on yet another.
Understanding the typical relationships the target company is in – be it as an owner, contractor, subcontractor, supplier, joint venture partner or a combination – provides significant insight into how to interpret ongoing obligations. Each role comes with unique considerations and potential liabilities. This understanding is an important tool to address potential integration challenges that can arise when combining different business roles and operations post-closing.
Contracts galore
Given the length and complexity of these contracts, and the fact that many construction companies enter dozens, if not hundreds, of material contracts each year, simply locating and confirming the scope of such contracts is a key task for both buyers and sellers. These 'contracts' can include a large variety of forms going under different names depending on the role that bid documents, general conditions, addendums, notices to proceed, change orders, other relevant project documentation and related permitting and regulatory correspondence play. All of these documents should be requested and provided as part of the due diligence process.
With respect to specific terms for review, the primary focus is typically related to project and obligation scope, deadlines, penalties, warranties, contingencies and onerous go-forward obligations (minimum spends and restrictive covenants, for example).
This is in addition to the non-industry specific inclusions that could create layers of risk – such as enforceability of contracts, rights or obligations of indemnification and the presence of clauses that could affect the transfer of ownerships such as 'change of control' or assignment provisions. It is key to remember that construction contracts often contain technical terms and jargon relating to building standards, materials and methodologies. Counsel with construction industry-specific experience is extremely beneficial to navigate and make sense of even standard deal terms in this context.
For buyers, ensuring they have received an accurate package of current and recently completed project contracts will be important for assessing any potential issues that may jeopardize the sale. The contracts will also give an indication of the target company's upcoming/committed performance obligations, compliance with local legislation (such as builders' lien or prompt payment legislation) and particular dispute resolution concerns (such as choice of law or choice of forum clauses).
For sellers, ensuring that the package of project contracts is 'ready-to-go' for the buyer's review instills confidence in the target company's record management and organization. Plus, it reduces follow-up requests, and associated delays, for missing contracts.
Other important considerations
Like each business, each business deal is unique, with its own set of specific considerations and challenges. What might be a critical issue in one acquisition could be minor in another. This variation requires a tailored approach to due diligence. Other (non-exhaustive) things to watch for on review, or to anticipate will be considered 'material considerations' to be compiled, understood and presented in connection with the sale of a construction business may include:
ONE Regulatory/legal compliance: For example, for the buyer, does the target company have all required permits and licences to perform the projects it is performing? For the seller, what are the permits and licences in place and what is the compliance status of each such permit and licence? A buyer is interested in knowing whether there has been any instances of non-compliance or dialogue with applicable regulators on the subject, as well as how the seller has got comfortable in claiming a complaint status. For a seller, in addition to answering questions, this often looks like compiling correspondence and any assessments (environmental or otherwise) that have been required or may have been completed in connection with any projects.
TWO Target structure/related party influence or control: How a target company is structured and how decisions are made internally in the context of how a business operates can be an important part of understanding the associated risks. For example, are there any unique supplier and subcontractor relationships/dependencies involving parties related to or affiliated with the seller? Are there any key or critical pieces of equipment being leased to the target company but owned (or guaranteed under a lease) by a related party or affiliate?
THREE Labour and employment and immigration: As is the case in most M&A transactions, it is also critically Important to assess the qualifications, certifications and experience of the workforce. This includes key personnel critical to project completion and understanding any legal and financial obligations in relation to that workforce. Depending on the scope and scale of the business and whether there are any cross-border projects, or projects involving employees or agents of the business operating on both sides of the border, understanding and mitigating immigration considerations and processes may be of fundamental importance to preserve deal value. Please see our previous article on immigration considerations during an M&A transaction for further discussion of this topic.
FOUR Other market risks: As it relates to quality of construction and project performance, both buyer and seller will want to be able to answer the question – what is the reputation of the target business in the market? What are the relationships like with key clients, sub-contractors and suppliers? What are these relationships anticipated to look like post-acquisition?
Getting ready for your next construction M&A transaction
In many ways, buying or selling a construction company is just like buying or selling any business. Due diligence serves as a crucial tool for transparency and informed decision-making in transactions. This ensures that both buyer and seller can move forward with confidence and clarity. However, for those unfamiliar with the particulars of the construction industry, leveraging construction-specific legal support during the deal process helps buyers protect their investment. This support can also position buyers and sellers alike to maximize value – making it a strategic move in any construction company acquisition.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.