The Legal Beat

Franchise Negotiation Considerations

The wild world of entrepreneurship is a high risk, high reward realm in which to play. Those who step into the rocky waters of self-employment and business building turn in the security of steady and predictable compensation for the unpredictable ebb and flow of eating what they kill. A total lack of control over policy and business approach is exchanged for complete control over management, administrative duties, marketing and every other aspect of business operations. Indeed it takes a special kind of person to go out on a limb and attempt to start a business from scratch. For those quasi-special people who are brave enough to undertake running a business, but do not quite want to start one from scratch, franchising is a great option.

Operating a franchise is a good idea for the more risk-averse entrepreneur because franchises have proven systems that are articulated clearly and definitively in a franchise manual, and typically entail support from the franchisor to help make the business successful. I know, I know ... that sounds like the franchisor sales pitch doesn’t it? Well, I will temper my exuberance with a sampling of the legal issues a franchisee should consider when embarking upon a franchise venture – or otherwise find oppression from a new boss in the form of a franchisor.

Franchises typically entail licensing intellectual property from the franchisor, with that intellectual property being the basis upon which the franchisee will conduct its business. Therefore it is important to ensure you are licensing everything you will need to start up, operate and grow your franchise. Some unsuspecting franchisees find that after entering into a franchise agreement, they do not have the right to use certain valuable intellectual property owned by the franchisor that is useful, and in some cases necessary, to achieve the full profit potential of the franchise. When negotiating a franchise agreement, make sure you receive the right to use all names, trademarks, systems, processes, and other intellectual property you anticipate using to implement the franchise. If you don’t, you may be required to pay additional fees just conduct basic actions required to succeed in your franchise enterprise.

Franchisors often times upgrade their brand images, logos, facility standards, etc. When they do, they require their franchisees to incur costs to implement changes at their franchise location consistent with these changes. The costs associated with these changes can be very extensive, and unexpected. The best way to limit these costs is to establish a cap for the expenditures required to be undertaken in connection with such upgrades in the franchise agreement during initial negotiations. Moreover, include a reasonable notice provision requiring the franchisor to give you a sufficient amount of time to implement the changes. This will afford you the opportunity to budget and plan for the expense as the requirement comes down from the franchisor.

Another big matter to address in managing a franchise is the opportunity to be rewarded for the business you build. Franchisors love to horn in on a franchisee’s sale of the franchise. They will require a payment in connection with any sale of the franchise, usually some percentage of the sale price. This is sometimes in addition to a franchise fee that must be paid by the new franchisee; basically allowing the franchisor to double dip. While negotiating this provision away is usually contentious, it will make your franchise more marketable as you seek to exit and cash out down the road, and is worth the effort.

Franchising is a nice middle-of-the-road approach to entrepreneurship, but to get that real feeling of controlling your own destiny, fight hard to keep the strong arm of the franchisor from around your neck.

 

Contributed by Travis Townsend Jr. 

Licensing the Right to Sue for Third-Party Patent Infringement

IP Licensing is everywhere. Many of us were introduced to licensing practices during the 1990's when shrink wrap licensing was popularized by Microsoft and other software manufacturers. More recently, click-through (or click wrap) licenses have emerged. With the rise of shrink wrap and click-through licensing, most of us, whether wittingly or unwittingly, are or have been a patent or technology licensee. Whether you read the license or simply check the “I have read and agree to be bound by the foregoing terms” box before you hit the download button, you understand the basic concepts: you get some right to a licensed technology or product, usually the right to use that technology or product, subject to certain restrictions and conditions. This type of licensing is typically referred to as end-user licensing.

End-user licensing is conceptually similar to license arrangements between companies, which can be referred to as business-to-business, or B-to-B licensing. Basically, one company acquires some right to a licensed technology or product from another company. Patent rights licensed in B-to-B licensing arrangements, however, tend to be very different in many respects. One arrangement that is sometimes used by patent owners involves granting a licensee the right to sue third-parties for infringements of licensed patent claims.

Several years ago, I had a client that was in an industry where this practice was heavily used. It provides a good example of one of the reasons why companies might license enforcement rights to another company. The industry was large, lucrative and was dominated by a handful of huge companies. Each of the top feeders owned a portfolio of patents that, if asserted against the others, would be crippling to the market. Specifically, each seemed to appreciate that launching a direct patent infringement assault against one of the other major actors would cause the target of the assault to counter with its own patent claims, which would most likely cause a chain reaction of escalating assaults which would ensure mutual self-destruction for all. To avoid that outcome, the patent holder would typically assign a patent, or more commonly license a right to sue on the patent, to a third party, who could then sue the target or otherwise enforce patent rights against the target. Although it was clear what was going on to anyone paying attention, this veil of plausible deniability was enough for patent holders to strategically slow down their competitors and prevent total industry meltdown.

The scenario above is just one example of how licensing the right to sue can be strategically used in patent cases. Be mindful, however, that patent licensing in this area is extremely nuanced and any strategy involving granting the right to sue to another party should be carefully thought out and well planned. As outlined in my April 26, 2010, Legal Beat blog post,  too often patent holders intend to grant a licensee the right to sue under a patent. But they only discover at the time of suit that the licensee can only bring suit if the patent holder is joined as a co-plaintiff or may discover that the licensee has no right to bring suit under any condition. This result can undermine the entire license strategy and might only be discovered after significant time has passed and after the licensee has paid substantial license fees to the licensor. Moreover, as outlined in my May 10, 2010, blog post, it is possible to arrive at a much more damaging result through poor licensing, where no one has the right to bring suit on the patent(s).

 
  Contributed by Tennell Lockett, partner at Townsend Lockett & Milfort, LLC

The Trademark Application Process

During my practice as an IP lawyer, I have noticed that my trademark clients routinely have a misapprehension about how long the trademark process will take. In fact, once, after what I thought was a thorough consultation with a client about their soon-to-be-filed trademark application, the client leaned back and said, “Okay. Good. I think I understand everything. So what am I looking at? A couple weeks? A month? How long before this thing is finalized?” I realized then that: 1) the IP bar, myself included, needed to do a better job informing clients and the public about this topic; and 2) my consultation session was not over. In that vein, I thought a brief overview of the application process might be helpful.    

As an initial matter, the United States Patent and Trademark Office will very seldom, if ever, immediately grant a federal trademark application after it is filed. In fact, it generally takes up to 5-8 months (or more) before a trademark office official, referred to as an Examining Attorney, will pick up your application to formally review it and start the substantive examination process. Once he has reviewed your application, the EA determines whether there are grounds to reject your application or whether other modifications or clarifications are necessary. If the EA finds grounds for rejection, modification or clarification, the EA will send you a response, called an Office Action, soliciting your response to his findings. These Office Actions are routine and you can expect at least one Office Action as a matter of course during the application process. You or your attorney will respond to the EA’s Office Action, either providing the EA with arguments to overcome his rejection, or providing clarification or amendments to your application to overcome his cited objections. There may be multiple rounds of this back-and-forth between you and the EA during this period.

Importantly, you have 6 months from the time any Office Action is mailed to respond to it. If you fail to timely respond, your application will go abandoned. There is a procedural mechanism that allows you to attempt to revive the application after it has gone abandoned, but you will incur additional filing fees and will need to submit compelling explanation and argument for your delinquency.    

If the examiner is satisfied with your amendments, explanations and comments, the examiner will approve your mark to be published for opposition. 

Your mark is typically published for opposition within 30 days of the examiner's approval of the mark for publication. Your mark will publish in the USPTO's Official Gazette for a 30-day opposition period. Any party who believes it would be harmed by the registration of your mark may file an objection (opposition) within that 30-day period with the Trademark Trial and Appeal Board. If the mark is opposed, the timeframe for that process varies, but it is usually a considerably lengthy period as TTAB oppositions are separate administrative proceedings and can easily take up to 6 months and substantially longer.

Within approximately 3 months after the mark published in the Official Gazette, if no opposition is filed, the USPTO issues a registration for your mark.

Contributed by Tennell Lockett, partner at Townsend Lockett & Milfort, LLC

If You Can Keep a Secret, Let’s Do Business

One of the biggest fears of many business owners and managers is exposure of their company’s business plans and key secrets. Lots of businesses derive their value from the special things they know and do, the special ways in which they do them, and the special people for which they do them. But all business operations require interaction with outside parties whether it is with customers, vendors or contractors. These interactions can sometimes present situations where sharing confidential information is unavoidable. Then what? How do you get the appropriate people involved with your business without risking the loss of your valuable confidential information?

The first step in protecting your company from mass dissemination and misappropriation of confidential information is to limit disclosure to those instances when doing so is absolutely necessary and to those individuals to whom disclosure is absolutely necessary to further your objectives. Just because you’re considering hiring a vendor to help develop your marketing strategy it doesn’t mean that every single employee of the vendor needs to know your secret processes for doing business or who your target clients are. Make sure disclosure is made on a “need to know” basis. The smaller the number of individuals receiving the confidential information the more control you have in protecting it.

The next step is to require all parties who will be receiving the information enter into a tight non-disclosure agreement. Ensure that the NDA expressly defines “confidential information” and that the definition is comprehensive. Key items that must be covered in the definition of “confidential information” include: all company proprietary information, intellectual property, customer lists, business processes, trade secrets, and anything else the company wants to expressly prohibit from being disclosed. After thoroughly defining the information to be kept confidential, the NDA should expressly state the duty to keep the information confidential. The duty to keep confidential should state directly that the receiving party must not disclose confidential information to third-parties. It should also disallow the use of the information for the receiving party’s own benefit.

A good NDA should also contain clear policies and procedures that must be implemented to protect the information. Some examples of useful procedures include the prohibition of making duplicates, return delivery of materials once reviewed or upon completion of the relationship, or even destruction of the materials upon completion of the relationship. Consistent with my previous statement that the number of people receiving the information should be limited, it is good to provide language in the NDA that only permits the receiving party to disclose information to employees, partners, agents or officers on a “need-to-know” basis.

Don’t let fear of disclosing confidential business information prevent you from doing business. At the same time, take steps to protect your valuables. 

  Contributed by Travis Townsend Jr. 

Preparing an Adequate Private Placement Memorandum

In my previous entry, I discussed the risks of running afoul of the securities laws while issuing securities to raise capital for a business. The entry also outlined several exemptions to the registration requirements prescribed by the Securities and Exchange Commission (SEC) in the securities offering process. After publication of the entry I received several inquiries about how to go about providing information to prospective investors in a private offering and manner sufficient to meet the SEC standards. So I thought I’d write a follow-up regarding the primary disclosure document used in many private offerings, the private placement memorandum (PPM). Here’s the quick and dirty on PPMs.

The PPM is a memorandum that is intended to tell prospective investors, both sophisticated and unsophisticated alike, all information that is relevant to making an investment decision in the company that is offering securities for purchase. Thus, the PPM is the key vehicle for informing investors about the company, the people running the company, the securities they are purchasing and, most importantly, the risks associated with giving the company their money.

A thoroughly prepared PPM should include the names and expertise of all of the company’s directors, executives, managers, and other key agents including their work experience and age. The PPM should also include the company’s business plan, and explain the company’s key products and service lines. There should be some discussion about the market in which the company will be implementing its business strategy, the nature of the company’s competition, and the advantages and disadvantages experienced by the company in the implementation of its business. Additionally, every sound PPM details any material contracts held by the company, and also discloses any financial relationship between individuals who are helping the company raise capital through the sale of its securities.

If there is any significant litigation threatened or pending against the company, or any prospective bad company happenings, the company should not be shy about including this information in the PPM. While it is never fun to bare bad news (or potential bad news) to anyone, especially those to whom you are trying to sell, it is important to give the full unadulterated snap shot of the company, bad with the good. Otherwise you may find yourself being chased down by the SEC for making material misrepresentations due to the omission of key information. As mentioned in my previous entry, those material misrepresentations may have you reminiscing on your childhood days playing the Monopoly board game. Do not pass go, do not collect $200; go straight to jail. Except this time it will take more than rolling a double to get out of jail.

Remember, the purpose of the PPM is disclosure, disclosure, disclosure. Therefore, in addition to the items outlined above, the PPM should include anything about the company within the knowledge of company management relevant to making an investment decision. Company insiders stand in a unique position in that they know more about the company than anyone not affiliated. Thus there is an expectation that management should know what is important about the company, and there is an obligation upon management to ensure that information is passed along to investor prospects. This is true even if such information does not fit neatly into the typical category of things disclosed in a PPM.

A properly prepared PPM, when complete, should be in a form such that anyone with basic reading comprehension skills can pick it up, read it, and know everything about the company that may impact their investment. If that’s not the case, the PPM is deficient and tweaking needs to be done until the PPM is an accurate written approximation of the company.

 Contributed by Travis Townsend Jr. 

How Do I Protect My Screenplay or Script?

Some time ago, a potential client approached me with a common problem. Someone had stolen, well, allegedly stolen, his screenplay and had translated it into a popular, critically-acclaimed feature film. As with many similar cases, the screenplay was not stolen like jewels might be stolen by a jewel thief. That is to say, such thefts are rarely as dramatic as might be envisioned. No sneaky midnight burglar. No oil painting hiding a wall-mounted family safe. No safe-cracking techniques using stethoscope and white glove. No thief making off in the night with a million dollar screenplay. What actually happened was far more pedestrian. This individual had casually shared his screenplay with a number of industry actors during a few discussions and some years later an A-rated major motion picture debuted with strikingly similar themes, characters and storylines.

As the individual continued the story, a single thought ran through my mind: man, I wish he had come to speak with me years ago. Had he spoken with me much earlier, I would have given him some very simple advice that possibly could have saved him a lot of heartache. Below are a few thoughts that you will want to consider before having any discussions or making any deals concerning your screenplay.

First, you want to “hardwire” protection into your screenplay or script.  By that I mean, you want to include as many original, creative and fresh elements into your work as possible. The protections directed to this area of the law are constructed to protect expression, not ideas. Consequently, you want to include a large number of memorable and colorful quotes, detailed descriptions of original scene settings, creative or unconventional dialogues and plot twists, and other creative literary elements of this nature. If you disclose a firefighter screenplay to hypothetical producer James Hollywood, you will have very little protection simply by virtue of Mr. Hollywood’s subsequent production of a movie about a firefighter. You will, however, have a much stronger position if Mr. Hollywood’s movie includes creative elements that are common with those appearing in your screenplay.

Second, be sure to register your work. I strongly recommend getting a federal copyright registration for any screenplay or script that you believe to be worth sharing with any third-party. Information about acquiring appropriate copyright protection can be found at www.uspto.gov . In addition, there are other registration or date-authenticating services that you will want to consider in the case of screenplays or scripts. For example, it is typically advisable to register you screenplay with the Writers Guild of America. Submissions may be registered online at www.wgawregistry.org.

Third, use appropriate confidentiality and/or nondisclosure agreements with any third-parties prior to disclosing your screen play.

Fourth, use common sense. Trust your natural reservations. If you do not understand something, do not do it. Too often, writers are pressured into disclosing content they are not really comfortable with disclosing. In addition, I strongly discourage unprotected mass screenplay mailings. I may be more cynical than most but, in my view, the practice of mass mailing is generally dangerous in just about every field in which screenplays are valued. I also have a similar distrust of verbal agreements in such industries. On verbal agreements here, I have two maxims, the second of which governs the first: 1) Unless you have absolute trust with whom you are dealing, get it in writing. 2) Trust no one absolutely. If there is ever a question, trust your instincts.

 Contributed by Tennell Lockett

Raising Capital for Your Business without Imprisonment

There are no business fire drills like those caused by an emerging company with prospective investors chomping at the bit to pump money into the company. This is especially the case when the company is staring down the exhaustion of its cash on hand before the next payroll. It’s not uncommon for clients and prospects to call me with urgency to discuss an equity financing transaction that has to happen immediately. I am very much obliged to help them because, after all, that’s what I do. Just call me “the Fund-raiser,” because I get your company’s paper up.

While corporate finance must be done quickly sometimes, it is necessary to avoid running afoul of the Federal and State securities laws when doing so despite the haste. If you believe you can simply agree with someone to sell a certain percentage of your company for a set price, take a check for the agreed upon amount, and be okay to operate business with that cash and your new co-owners, you are risking your entire business and personal freedom to boot! Selling ownership in your company constitutes the issuance of securities, and Federal and state laws establish some very stringent requirements that must be adhered to lest you subject your company to repayment of all money received from such sale plus penalties. And if the prospect of paying back all the money raised, plus penalties isn’t trouble enough, you also run the risk of being imprisoned for up to five years if you violate certain securities law provisions. Yes, raising capital is serious business. Take it lightly and the consequences could be devastating.

I would be remiss if I told you how ghastly the improper issuance of securities can be without sharing some insight on how to do it right. The first thing required to offer shares of your company for sale is registration of the company and shares to be sold with the Securities and Exchange Commission (SEC). This registration process along with the required maintenance reporting is cost prohibitive to most emerging companies, but fortunately the SEC has established several exceptions to this requirement. The most commonly used exceptions to registration are based on the SEC’s “private offering” exemptions pursuant to Reg D of the securities laws.

There are three major exemptions under Reg D that serve emerging companies well when offering shares of their company for purchase to raise capital. They are commonly recognized as Rule 504, 505 and 506 exemptions. In summary, the requirements for an offering made under each respective rule are as follows:

Rule 504

• The company can only sell up to one million dollars in securities over a 12-month.
• The company cannot solicit or advertise the securities publicly.
• The company must promptly file a Form D notice of sale with the SEC.

Rule 505

• The company can only sell up to five million dollars in securities over a 12-month period.
• The company cannot solicit or advertise the securities publicly.
• The securities can only be sold to accredited investors and up to 35 non-accredited investors, and
• The company must promptly file a Form D.

Rule 506

• The company can sell an unlimited dollar amount of securities over a 12-month period.
• The company cannot solicit or advertise the securities publicly.
• The securities can only be sold to accredited investors and up to 35 non-accredited investors, but those non-accredited investors must be sophisticated and have sufficient knowledge and experience in financial matters to make them capable of assessing the investment your company is offering.
• The company must give documents to the non-accredited investors thoroughly disclosing relevant information about the company.
• Company representatives must be available to answer questions about the company from investors.
• The company must promptly file a Form D.

In each of the aforementioned situations, the securities offered will be “restricted” and thus may not be freely re-sold without meeting the SEC’s resale exemption requirements. Another important requirement for any securities offering is that the information provided to prospective investors not be misleading. Mislead the investors and you put yourself in the zone of danger for the harshest punishments. But if you offer your securities pursuant to the requirements of Rule 504, 505 or 506, and do not mislead investors, you can get that much needed capital, avoid claims for repayment and stay out of prison. Remember, your push to build a world leading business will take a significant detour if you have to do a stint behind bars and give back all of your working capital.

 Contributed by Travis Townsend Jr. 
 

Intellectual Property As a Career Path

A while back, a good friend of mine announced that she wanted to be an IP lawyer. She had a simple question: “what do I need to do?” My facetious response: “run away from yourself as fast as you can.” In truth, I had not given it much thought and did not have a good answer for her. While too late to be of any help to my friend, below are a few measured thoughts for any person considering IP as a career option.

1. Identify your general area of interest. Many people question whether a technical background is necessary. Some undergraduates change their major. Some graduates go back to school to obtain a technical degree. Actually, it depends on what you want to do. Keep in mind that IP is an immensely diverse field. Some IP practices are directed to entertainment, business deals, managing or obtaining copyright or trademark portfolios, and require no technical application. For others, a technical background is required. For example, in order to obtain patents on behalf of clients, you will need to have a technical background in order to become a member of the patent bar. Identifying your area of interest will assist you in obtaining any necessary qualification.

2.  Identify a law school with a good IP program. In addition to law school rankings, you also want to consider the rankings of the IP programs at those schools. The caliber of program makes a difference. The obvious advantages are the quality of professors and school resources. Do not overlook, however, the value of developing relationships with some of the brightest minds in the field (both professors and peers), which often prove helpful after graduation. Below is U.S. News and World Report’s most recent ranking of IP law school programs:

1)      University of California - Berkeley

2)      Stanford University

3)      George Washington University

4)      Boston University

5)      New York University

6)      Columbia University

7)      University of Michigan - Ann Arbor

8)      University of Houston

9)      Duke University

9)      Franklin Pierce Law Center

3.  Identify a place of employment. This may sound obvious, but it is never too early to conceptualize the type of environment in which you want to work. Large firm? Mid-size firm? Boutique shop? Do you want to join a solo or shadow an agent? Where do you want to live geographically? Are you flexible moving, if necessary?  Having an early general awareness of the type of work environment that you desire will help you steer your path in the proper direction.    

4.  Get a mentor.  IP law is extremely nuanced. In addition to the general skill set required of any practitioner, IP typically requires a knowledge and mastery of specialized practices, laws, rules, procedures, phraseology and usages. Most IP fields are compromised of surprisingly close-nit networks of individuals and social circles. There are often informal, unwritten rules that guide the practice. For example, the entertainment and IP litigation practice areas have many, well-established procedures and customs that you would be pressed to find in any written rules or literature because they have evolved from the historical practice. A good mentor can assist you in navigating through these fields. Likewise, a good mentor can put you in touch with the right people and organizations. 

5. Be active.  Getting there is only half the fun. Once you have begun your career, you have to build your practice. Constantly meet people. Be active in IP-specific organizations (local and national), bar communities and civic and social groups. Publish were possible and speak publicly as often as possible.

Contributed by Tennell Lockett

My Company is Organized and Ready to Go…I Think?

You have spent months preparing your business plan, doing market research reading consumer reports, interviewing prospective customers, talking to other business owners about pitfalls, the whole nine yards. You have scoped out a lease for your business, selected the bank you want to house your operating account, found insurance providers for your health and business operation liability respectively. Your staff has been identified, thoroughly vetted, sold on your dream and are ready to hop on board. You have even gone ahead and filed your company’s Articles of Incorporation with the Secretary of State’s Corporations Division and received a certified copy of them back stamped “Filed.” All set to operate right? Not exactly.

While filing Articles of Incorporation is necessary to formally organize a business corporation, it is not sufficient. There are numerous small businesses in existence that have Articles of Incorporation as their sole organizational document. This is the case because it is not readily apparent from reviewing the Secretary of State’s website that more needs to be done than just filing the Articles.  Not to mention, most “How to form a corporation” entries on the Internet do not go into detail about everything that is required. To be fully organized and positioned to do business with third parties properly, there are several additional organizational items that must be prepared.

You are not a director of the company you’ve filed Articles for just because you say so. A formal election of initial directors must take place by way of an organizational meeting, or an organizational consent in lieu of a meeting, whereby the incorporator officially takes action to put them on the Board. Similarly, you are not the CEO of your corporation just because you say so. Again, a formal appointment must take place by way of an organizational meeting, or consent in lieu of such meeting, whereby the initial directors officially appoint the initial officers of the corporation. Moreover, the initial directors of the corporation should ratify and approve the filed Articles, adopt bylaws of the corporation, and ratify all prior actions of the incorporator to ensure the effectiveness of all things done to get the corporation organized before their election.

The aforementioned procedural steps may seem unnecessary, but thorough third-party service providers and potential business prospects will request you produce records of such procedures as a prerequisite to engaging in business with them. Most financial institutions will not even permit a corporation to open a business account without providing full governing documents that include bylaws and director and officer elections. As your business grows, you may want to enter into financing arrangements and banks will want to see proof of management from inception to date before lending you substantial sums of money. Vendors and customers seeking to enter into significant business transactions with your business will want assurance that the people negotiating and executing deal documents are properly authorized to do so.

The more successful you are, the more important it becomes that you did things properly at the inception of your business. So get out the gate correctly. A few simple steps in addition to filing Articles of Incorporation will round out your company’s organization process to set a sound foundation for its successful future.

 Contributed by Travis Townsend
 

Kick the Tires Before You Buy

There are essentially two types of used car purchasers in the world. First there is the “price buyer.” A price buyer typically visits various dealers, checks for prices on the car makes and models of choice, and buys the desired car at the lowest price, satisfied that the best deal was obtained … until the car breaks down several times over the next six months. The second type is the “tire kicker.” Tire kickers do what price buyers do, with the added steps of having their own mechanic inspect the cars, retrieving car histories, and peppering salespeople and prior owners with questions. Tire kickers, request price breaks and extended warranty coverage based on the items their research uncovers, and they rarely leave the lot without scoring a good deal and good protection against unanticipated breakdowns of the vehicle. Tire kickers let the items under the hood dictate the deal they will accept.

Tire kickers set a great example for those seeking to purchase a business. The deal you accept when buying a business should be dictated by a sound due diligence review. Checking transaction prices and deal terms of acquisitions involving similar businesses is a good way to begin, but it is imperative you investigate the target from top to bottom before setting a purchase price and entering into a binding acquisition agreement. An attractive offering price may very well be your good fortune. It could also be the bait for a bad deal. The only way to know is to dig into the components of the business and its operations, and see what’s what.

Reviewing the target’s financial statements is no brainer. If you’re looking to buy a business you probably understand the importance of profit and loss statements, cash flow analysis and balance sheets. But where many business acquirors get in the weeds is the legal due diligence review. A poor legal diligence review can leave an acquiror at risk of a total loss of investment dollars when the smoke settles.

A thorough legal diligence review is required to ensure, among other things, that the transaction is properly authorized and approved. This helps to limit costly court disputes regarding the validity of the transaction after the deal has closed and money has exchanged hands. A legal review is also necessary to accurately determine the current ownership of the target and its assets, and to determine who should be involved in the items transferred in the transaction. The last thing an acquiror wants is to find out it did not receive the shares or assets it paid for because there were some unaccounted shareholders or property owners out there of whom it never heard.

Additionally, a detailed legal review process can also help determine whether major contracts will be terminated, or whether penalty payments to third-parties are required in connection with the company sale. This is important because lost profits from major contracts and penalty obligations inherited by the buyer impact the value of the business. If armed with this information, an acquiror acting like a tire kicker can ask for a reduction of the purchase price or get an indemnification obligation from the business seller.

Remember, companies that look very sharp from the outside can have some real serious problems on the inside. So don’t be a price buyer. Do your homework and check underneath the hood before taking the proposed purchase price and terms. Otherwise you might be stuck with a business that’s a lemon.

 Travis Townsend Jr. is managing partner at Townsend Lockett & Milfort, LLC