How to Review Customer Contracts for M&A

Customer contracts are a key factor in M&A deals - they directly impact revenue, obligations, and risks. A thorough review can help avoid overpaying, uncover hidden liabilities, and ensure post-acquisition success. Here's the process in a nutshell:

• Why It Matters: Contracts define revenue streams and risks. Missed details can lead to financial and legal challenges.
• What to Watch For: Focus on revenue stability, customer concentration, change-of-control clauses, and compliance issues.
• Steps to Take:
  1. Gather all contract documents, including amendments and schedules.
  2. Organize contracts in secure databases for easy access.
  3. Use a checklist to review key details like parties, dates, pricing, and renewal terms.
  4. Identify risks like vague terms, automatic renewals, and termination clauses.
  5. Consider mitigation strategies like price adjustments, escrow funds, or enhanced legal protections.
• Tools to Use: AI-powered software can speed up reviews, reduce errors, and highlight potential issues.

Proper contract review ensures a smoother deal and protects your investment.

What Lawyers Look for in M&A Due Diligence (Insider's Guide)

Getting Ready for Customer Contract Review

Taking a systematic approach to gathering and analyzing contracts is essential to ensure no critical details are overlooked. Establishing a structured framework helps keep everything on track during due diligence and minimizes potential risks. The first step? Gathering all the necessary documents.

Collecting Contract Documents

Start by pulling together a complete set of relevant documents - not just the main customer agreements, but anything that could influence the contractual relationships being acquired. Key document types to include:

• Corporate documents: Ensure you have updated records outlining the business entity, its structure, key stakeholders, and capitalization details.
• Customer contracts: Collect all primary agreements along with amendments, addendums, schedules, and exhibits.
• Financial reports: Include detailed records of assets, liabilities, and cash flow, covering at least the past three years.
• Tax records: Gather three years' worth of recent tax filings.
• Sales and HR documentation: Include sales data, employee agreements, and contractor contracts.
• Intellectual property records: Compile details on trademarks, patents, and any websites owned by the business.
• Technology and operations materials: Bring together IT resource lists, technology policies, vendor agreements, and personnel details.

Organizing Contracts for Review

Once you've collected all the documents, properly organizing them is key to a smooth review process. Start by understanding the specifics of the deal - what type of merger it is, who the involved parties are, the deadlines, and the overall goals. This helps you prioritize which contracts need immediate attention.

Store your documents in secure databases or virtual data rooms with tiered access to protect sensitive information. Classify contracts based on priority factors like revenue impact and deadlines. To stay organized, create a due diligence index that includes contract names, key dates, revenue figures, and document locations. Using contract management software can also help by automatically pulling out key terms and making the documents searchable [15, 16]. Once everything is sorted, a clear review checklist will keep the process moving efficiently.

Creating a Contract Review Checklist

A well-thought-out contract review checklist ensures consistency and reduces the chance of missing critical details. Your checklist should cover all the essentials: parties involved, dates, pricing, renewal terms, jurisdiction, and any potential red flags. Keep in mind that the level of detail required may vary depending on the size and nature of the transaction.

Start by verifying the basics - confirm all parties are correctly listed, dates are accurate, and pricing details are clear. Carefully review the entire contract, including attachments, exhibits, schedules, and related documents, ensuring all referenced materials are included and cross-references are accurate. Pay close attention to automatic renewal clauses, documenting whether the agreement will renew unless terminated by a specific date, as these can significantly affect revenue projections.

Before finalizing any agreement, make sure there are no blank fields left unaddressed. Be on the lookout for common red flags, such as vague terms, unilateral amendments, automatic renewals, high penalties, exclusivity clauses, or one-sided liability and indemnity provisions.

Lastly, factor in recent regulatory changes, like the 2024 Corporate Transparency Act (CTA) in the U.S., which requires certain reporting companies to file a beneficial ownership information (BOI) report with FinCEN. Ensure your checklist includes steps to verify compliance with these new requirements.

How to Review Customer Contracts Step by Step

With your contracts organized and your checklist in hand, it's time to tackle the review process. A step-by-step approach ensures you catch potential issues that could affect the deal's value or create challenges after the acquisition. This methodical process also helps deepen the review as you go.

Checking Contract Basics

Start by confirming that each contract is legally valid and properly executed. This means verifying full legal names, complete addresses, authorized signatures, and ensuring all signature pages are dated correctly. Watch out for missing initials or unsigned addendums, as these can affect enforceability.

Pay close attention to key dates - such as execution, effective, and expiration dates. Make sure they make sense and that no contracts have expired without proper renewal documentation. Also, confirm that all referenced exhibits, schedules, and attachments are included and properly labeled. Missing attachments can leave terms undefined, leading to ambiguity.

If you find discrepancies between the main contract and its attachments, document them so they can be resolved before closing. Once the foundational details are in order, shift your focus to the terms that directly impact revenue and obligations.

Reviewing Important Contract Terms

The next step involves diving into the financial and operational terms that influence the target company's revenue and obligations. Check pricing structures, payment terms, and penalties to get a clear picture of cash flow and margin pressures.

Examine payment terms carefully, including due dates, late payment penalties, and requirements for security deposits or guarantees. Be on the lookout for extended payment terms or slow payment histories, as these can affect working capital after the acquisition. Also, review any minimum purchase commitments or volume requirements the target company must meet to maintain favorable pricing or avoid penalties.

Take a close look at warranties, service levels, and performance criteria. These obligations might carry over post-acquisition and may require specific resources or capabilities. Pay special attention to clauses involving unlimited liability or broad indemnification, as these could pose significant financial risks. Document any unusual or one-sided terms that might need renegotiation. Finally, evaluate clauses that are triggered by changes in ownership to anticipate potential disruptions.

Finding Change-of-Control Clauses

Change-of-control clauses can significantly impact contract continuity after an acquisition. These provisions may allow customers to terminate agreements, renegotiate terms, or require consent before the deal can proceed. Identifying these clauses early is crucial for planning and mitigating potential customer departures or renegotiation costs.

"Change of control clauses define ownership changes triggering contract modifications or termination rights to manage customer contract risks effectively." - aaronhall.com

Look for language that addresses ownership transfers, mergers, or asset sales. Some clauses are triggered by any change in ownership, while others activate only when control shifts beyond a specific threshold, often 50% or more. Document the exact triggering events and any notification requirements, as failing to provide proper notice could breach the contract.

Check for consent requirements that might delay or complicate the transaction. Identify clauses granting unilateral termination upon ownership change, as these could pose a risk to revenue.

Change-of-Control Element	Key Considerations
Triggering Events	Ownership percentage thresholds, merger definitions, asset sale provisions
Notification Requirements	Timelines for customer notification, required documentation, approval processes
Customer Rights	Termination options, renegotiation rights, consent requirements
Remedies	Cure periods, alternative arrangements, penalty provisions

Once you've mapped out the risks tied to change-of-control clauses, it's time to address compliance and dispute issues.

Checking Compliance and Disputes

Regulatory compliance is another critical area to review, as non-compliance can lead to significant liabilities or operational challenges post-acquisition. Ensure contracts adhere to industry-specific regulations, data privacy laws, and international trade restrictions. Pay extra attention to contracts involving government entities, healthcare organizations, or financial institutions, as these often come with stricter compliance requirements.

Review any documented disputes, claims, or performance issues. Even minor disputes can escalate after the acquisition, particularly if customers are unhappy with service levels or contract terms. Look for recurring issues that might indicate deeper problems requiring attention.

"Contract review ensures clarity, fairness, and legal compliance. It helps identify risks, align expectations, and prevent future disputes."

Check for modifications, waivers, or side agreements that may not be reflected in the main contract. Informal arrangements, such as verbal commitments or handshake deals, can create unforeseen obligations. Document any such agreements mentioned during employee interviews, as they may need formalization or renegotiation.

Lastly, review termination and breach provisions to understand what events could lead to contract cancellation. Some contracts include broad termination rights that customers might use if they’re uncomfortable with the ownership change. Understanding these provisions will help you assess the customer base's stability and plan retention strategies for the post-acquisition period.

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Spotting Problems and Managing Risks

After diving into the details of contract terms and compliance, it’s time to focus on identifying potential pitfalls and figuring out how to handle them effectively. Spotting red flags early and putting the right strategies in place can save you from unnecessary costs, wasted time, and future headaches.

Common Contract Warning Signs

Certain contract issues should immediately grab your attention during a review. For instance, unbalanced clauses that tilt heavily in favor of the customer can lead to unfair agreements. These might include unlimited liability provisions, one-sided indemnification demands, or penalties that disproportionately affect the target company.

Vague terms are another red flag. If the contract lacks clear definitions for things like scope of work, performance standards, timelines, or payment processes, you’re looking at a recipe for confusion and disputes. This can become especially troublesome when merging the acquired company’s operations with your own.

Be wary of automatic renewal clauses that lock the business into agreements with escalating costs or unfavorable terms over time. Similarly, unfavorable jurisdiction clauses can make resolving disputes more expensive and complicated by requiring litigation in faraway or inconvenient locations.

A heavy reliance on a single customer or supplier is another risk to watch for. If the target company depends too much on one relationship, losing that customer or supplier could have a serious impact on the business’s value.

Missing integration clauses can also cause headaches. Without a clause confirming that the contract represents the complete and final agreement, verbal agreements or prior understandings could resurface and create additional obligations.

Lastly, assignment and subcontracting restrictions may limit your ability to operate efficiently. If the contract requires customer approval to assign rights or subcontract obligations, you could find yourself stuck with certain vendors or unable to optimize supplier relationships for cost savings.

Addressing these issues early is critical to preserving the value of your deal.

How to Reduce Contract Risks

Once you’ve identified risks, there are several strategies you can use to manage them. Price adjustments are a straightforward way to account for additional costs or risks. By lowering your offer, you can directly reflect the financial impact of the identified issues.

Another option is to tweak the deal structure. For example, you could include earn-out provisions that tie part of the purchase price to future performance or arrange for seller financing, where payments are deferred based on the business’s success. An extended transition period can also keep the seller engaged and invested in the business’s performance after the acquisition.

Escrow arrangements are useful for dealing with uncertain liabilities. By holding back a portion of the purchase funds, you’ll have a financial safety net to address any contract-related issues that might arise later.

In cases where multiple contracts are problematic, consider an asset purchase instead of a stock purchase. This approach allows you to pick and choose which contracts to assume, leaving the troublesome ones behind with the seller.

Finally, add enhanced legal protections in the purchase agreement. Strengthen representations and warranties to address specific risks, and include extended indemnification periods or special indemnity clauses to provide extra financial protection.

Risk Mitigation Strategy	Best Used When	Key Benefits
Price Adjustment	Risks are quantifiable	Simple and directly offsets costs
Earn-out Provisions	Revenue is uncertain	Links payment to performance, sharing risk
Escrow Arrangements	Liabilities are unclear	Reserves funds for emerging issues
Asset Purchase Structure	Contracts are problematic	Selective contract assumption; limits liability
Enhanced Indemnification	Specific risks are known	Provides targeted financial safeguards

Clearly documenting these steps helps ensure everyone involved understands what’s being done to address the risks.

Recording Findings and Reporting Issues

Thorough documentation is essential for managing risks and keeping stakeholders informed. A detailed red flag report is a great way to summarize findings and outline actionable next steps for each issue. This report should prioritize the most critical risks, detailing the issue, its implications, and its severity (high, medium, or low).

For each flagged issue, include a brief description, recommended next steps, and categorize the findings - such as financial terms, compliance concerns, change-of-control provisions, performance obligations, or termination risks. This makes it easier for stakeholders to grasp the scope of the problems.

An executive summary at the start of the report can highlight the most impactful findings, ensuring senior decision-makers focus on the key areas that could affect deal value.

Remember, not every red flag means the deal is doomed. Many issues can be resolved through renegotiation, additional legal protections, or requiring the seller to address the problem before closing. The goal is to identify challenges early and tackle them head-on, rather than being blindsided after the transaction is complete.

Using Technology to Speed Up Contract Review

Technology plays a crucial role in minimizing risks during due diligence, especially in M&A transactions. Manual contract review can slow down the process significantly, but AI tools are changing the game by making it faster and more efficient. For example, AI-powered contract review software can reduce a 92-minute review to just 26 seconds while cutting down the margin for human error by up to 10%.

These advancements go hand in hand with earlier discussions about risk identification, as they simplify data analysis and minimize oversight. Modern AI systems can automatically extract essential data - like dates, payment terms, and involved parties - and flag clauses that might pose legal or financial risks. They also verify compliance, which has been a game-changer for legal teams. Glenn LaForce, Chief Knowledge & Innovation Officer at Holland & Knight, captures this transformation:

"Kira empowers our lawyers to work faster and more precisely, enhancing the overall quality of our due diligence process."

Leslie Gold, Senior Knowledge & Innovation Attorney at Paul Weiss, echoes this sentiment:

"The associates feel like, 'if I don't have Kira, I can't function.'"

Using Platforms Like Kumo for Contract Data Management

While AI-driven contract review tools handle detailed document analysis, platforms like Kumo provide a centralized system for managing all your transaction data. Kumo’s features include a centralized contract repository, automated search and filtering tools, and AI-powered tagging and categorization to streamline document organization.

Security is a top priority during M&A transactions. Look for platforms that offer features like secure document sharing, version control, and tools for tracking dates and obligations. These capabilities help assign tasks and monitor progress effectively. Collaboration tools enhance team communication, while advanced features - such as AI-driven insights, self-service portals, and analytical dashboards - add valuable context to due diligence by highlighting transactional details and contract values. To protect sensitive information, prioritize solutions with access controls, encryption, and two-factor authentication that meet industry regulations.

Once your contracts are well-organized, the next step is to compare them systematically.

Building a Contract Comparison Table

Digitizing and organizing your contract data makes building a comparison table much easier. AI tools can automate the process, quickly identifying inconsistencies, redundancies, and opportunities for standardization. These automated systems can perform data abstraction and analysis at least 75% faster than human reviewers.

Using automated tools ensures every document is analyzed consistently, reducing variability and minimizing the risk of errors. These systems not only improve accuracy but also cut costs during negotiations. Jonathan Polin, Head of International at Howard Kennedy and Co-Chair of the Meritas M&A & Private Equity group, explains the value of these tools:

"These tools enable us to focus on the more meaningful and profitable parts of the business... It's not just the efficiency and the time saved, it also helps us be more skillful as lawyers. Clients are paying us for our knowledge and expertise, not to trawl through documents and create precedents."

When setting up your comparison framework, opt for AI solutions that offer transparency in their decision-making processes and prioritize data privacy and security. By combining the efficiency of AI with human expertise, you can ensure bulk data is processed effectively while professionals focus on strategic decisions and risk evaluation. Regularly reviewing and updating AI models will help maintain their reliability and performance over time.

Summary: Main Points for Customer Contract Review

Reviewing customer contracts is a critical step in M&A due diligence, as it can significantly shape the success of a deal and its integration. As Thomson Reuters aptly states:

"Due diligence is the heart of a successful merger or acquisition."

This process uncovers valuable information about the target company's revenue stability, business partnerships, and potential hidden risks. These insights are essential for making informed decisions, as highlighted throughout this guide.

When conducting a contract review, focus on key areas like assignability, change-of-control clauses, and any deal blockers that could arise during closing. These factors are pivotal in determining whether vital customer relationships will endure post-acquisition and continue to contribute to stable revenue.

With 60% of mismatched M&A expectations tied to inadequate due diligence, it's crucial to analyze every contract in detail. This helps identify hidden risks, liabilities, or unfavorable terms that could disrupt future operations.

AI-powered tools, such as Kumo, can help streamline the contract review process. However, these tools need proper training and oversight to ensure accurate results.

Clear and structured documentation is another cornerstone of effective due diligence. Using organized checklists ensures consistency, makes data easy to track, and facilitates smooth communication between your review team and decision-makers.

Ultimately, investing in a thorough customer contract review process pays off throughout the M&A lifecycle. It’s a crucial step to safeguard against risks and ensure a seamless transition, reinforcing its importance in any due diligence strategy.

FAQs

What are the main risks to watch for in customer contracts during an M&A review?

When examining customer contracts during an M&A transaction, pinpointing potential risks is crucial to avoid surprises that could derail the deal. One major red flag is contractual non-compliance, where agreements fail to meet legal or regulatory standards, potentially leading to significant hurdles. Another concern is undisclosed liabilities, which could bring unforeseen financial strain.

Pay close attention to enforceability issues, such as ambiguous or invalid contract terms, as these can weaken the agreement's legal standing. Be wary of restrictive clauses, including exclusivity or non-compete provisions, which may limit future business opportunities. Also, evaluate termination or breach risks, as these could disrupt key revenue streams. Finally, review customer creditworthiness and their ability to meet performance obligations to ensure the business remains stable and dependable post-transaction.

How can AI tools make contract reviews faster and more accurate during M&A due diligence?

AI tools are transforming how contract reviews are handled in M&A by processing vast amounts of documents at lightning speed, slashing review time by as much as 80%. These tools don’t just save time - they also improve precision, spotting key details and potential risks that manual reviews might miss, all while minimizing errors.

By simplifying this complex process, AI allows teams to concentrate on high-level strategic decisions. It ensures compliance, reduces risks, and optimizes both time and resources, making the entire review process far more efficient.

What are the best ways to address risks found in customer contracts during an M&A deal?

To manage risks in customer contracts during an M&A transaction, begin with a thorough review of key elements like change-of-control clauses, auto-renewal terms, and exclusivity agreements. Focus on high-value and high-risk contracts first to ensure your efforts are directed where they matter most.

Verify that all agreements meet legal and regulatory requirements. If necessary, negotiate amendments to clarify transfer rights or address potential liabilities. Tools like indemnity clauses and other risk-sharing mechanisms can offer additional protection against unforeseen complications. Finally, implement a strong contract management system to track obligations and ensure a seamless post-deal integration.

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