If you are looking to acquire a company, you are going to want to conduct thorough due diligence on that target company to ensure there are no skeletons in the company’s closet.  There are many important areas that purchasers focus on when conducting due diligence, ranging from reviewing the target company’s capitalization table to delving into its incentive compensation plans, from confirming there is no pending or threatened litigation against the company to ensuring there are no filed liens against the company’s assets, and beyond.

In today’s installment of Top 3 with Lindsay, we focus on one of the other critical areas of due diligence – review of customer contracts.  If a purchaser is in the shoes of the seller after the transaction closes and succeeds to the seller’s obligations under the contracts, it is imperative that the purchaser have a complete understanding of the scope and impact of these obligations before proceeding with the deal.  Here, we will walk you through three of the top provisions that buyers should focus on when reviewing a target company’s customer contracts.

• Restrictive Covenants. Purchasers will want to understand any restrictions the target is subject to under its customer contracts; especially any non-competition, non-solicitation or non-hire provisions.  It is important that the purchaser closely review the scope of these restrictions.  For example, an often-overlooked issue is to whom, exactly, do the restrictions apply.  Parties often assume the restrictions apply only to the party named in the contract (i.e., the target entity), but there are many instances in which the restrictions apply to the named party and its parents and affiliates.  Without carefully reviewing the scope of these provisions, a purchaser can unknowingly step into a contract that restricts itself/the target company (which the purchaser may be comfortable with), but also its broader organization (which its parent companies and affiliates may be uncomfortable with) from competing or soliciting in various areas for an extended period of time.
• Other Covenants. Purchasers will also want to understand whether the target is bound by any other obligations.  For example, (i) whether the target can only staff a project with the individuals listed on a schedule to the agreement and any changes thereto require the customer’s consent (which, among other things, could significantly hamstring the purchaser’s ability to hire, fire and staff its employees), (ii) whether the employees staffed on a project need to complete specified training annually and provide evidence of the completion of such training (with failure to do so possibly providing the customer with grounds to terminate the project) and “(iii) whether there is a most favored nations provision in an agreement with a customer (whereby the target agrees that it will not provide another company with the services or products under the agreement at a better price than it provides to that customer).
• Client Concentration.  We all know that purchasers have a limited amount of time to conduct diligence on a company – whether because resources are scarce or because the target might walk away from the deal if the purchaser drags out the diligence process too long.  Accordingly, purchasers should consider whether they need to limit the scope of their review (for example, to the target company’s top 10 clients) and how heavily weighted the top clients are to the overall economics of the target company  (for example, if the top 2 clients bring in 80% of the revenue to the target company , then the purchaser would want to work with the target company on a plan to ensure an orderly transition so as not to jeopardize those relationships after the deal closes).