Understanding the business relationships that a target company has with its suppliers and customers will be a key aspect of the commercial due diligence process. To obtain such information, a review of the target company’s key commercial contracts will need to be completed. A review will enable potential buyers to:
- assess whether the existing contracts provide adequate protection to the target company. Consideration will need to be given to:
- whether the contracts have been formed on a standard or bespoke basis, as the construction of the contracts will provide understanding as to the complexity (legal and commercial);
- understanding their value;
- understanding the extent of each party’s contractual duties included within the commercial contracts; and
- establishing whether there are any onerous obligations.
- identify whether the contracts are a burden or a benefit to the target company and highlight those contracts which are revenue-generating contracts and those which are not profitable (or potentially no longer be fit for purpose). As such, distinguishing between these types of contracts will determine the relevance of each contract and focus can then be attributed to those contracts which are of a significant value to the business (and also identifying those which need attention to make them profitable, or alternatively those which should be exited if possible).
Do the contracts allow an exit?
It will be important for potential buyers to ensure that they receive the benefit of the contracts acquired from the target company. Where there is a change in the ownership of the target company, consideration will need to be given to any change of control provisions.
The inclusion of change of control provisions within a contract may trigger certain consequences. Such provisions may allow a supplier or customer to terminate a contract following the sale of the target company which could therefore put revenue for the buyer at significant risk. Alternatively, a change of control provision may simply require notification of a change in the ownership of the target company to a supplier or customer.
Further, the review should also identify the contractual length but also particularly whether either party to a contract has the right to terminate “without cause” (i.e. neither party is in breach, but a party can simply give notice to terminate) which would again put revenue at risk.
Following the purchase of the target company
Following an acquisition, the new owner may find that some of the terms contained within the acquired contracts may no longer be suitable for the business – i.e. certain terms or contracts may no longer be suitable where a large company acquires a small company. It may therefore be necessary to try, if possible, to renegotiate such terms so that the new owner can operate the business in a manner which appropriately meets the business’ needs. For example, when the contract was originally entered into, the target company may have subcontracted some of the services out to a third party because at the time it did not have the capability to perform those services itself - if the acquiring business has an in-house team providing a range of support services, these may be more appropriate – this could therefore potentially give rise to an additional income stream (or a cost saving by way of consolidation or synergies).