Pros/Cons/Tips Buying Company Facing a Lawsuit

October 16, 2024

by a searcher in New Milford, CT, USA

Looking for advice on purchasing a company that is facing a lawsuit. Specifically: (1) due diligence - what to look out for especially on balance sheet; (2) purchase price adjustment - how to estimate future risk and reflect that in purchase price/multiple; (3) escrow holdbacks - how much and indemnity provisions - types? (3) adverse judgement insurance - should the buyer or seller pay for this? who offers this type of insurance?

Or is this a "run don't walk" kind of scenario?

Thanks for any and all input

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Reply by a searcher
from INSEAD in Brussels, Belgium

It depends what the lawsuit is but generally speaking I would not necessarily see it as a red flag. If it can't be quantified and impacts the fundamentals of the business it is a red flag, but if it is "just" a customer or supplier dispute I wouldn't be too worried as long as it can be properly quantified and the impact is not large vs. size of the business. You already listed the way to get through it. In order of preference: directly reduce the price but that will be difficult if the liability has not yet crystallized or get a special indemnity in the SPA where you get a $ for $ compensation - in the second option it is always preferable to have some escrow holdback but you need data to be able to justify how much of an escrow. In my experience insurance will not pay for elements identified in DD (unless you pay exorbitant fees which in my opinion then don't make the insurance worth it).

Reply by an investor
from Northwestern University in Naples, FL, USA

Requires asking lots of questions including: Why the suit? Is this a one-off incident or typical of what you will see when operating? Magnitude and probability of losing? Downsides if you win (ex lose key customer / supplier)? Is this indicative of other shady practices at the company or is it frivolous? Can you buy assets and have seller retain the risk & use escrow to protect against a loss? What happens to your insurance rates if you lose or the suit goes for a long time? How much of a distraction will this be to you while running the company? Why is the seller selling now given the uncertainty around the lawsuit?

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