The business is performing well, the financials are in order, and there is serious interest from a buyer. The terms of the deal have already been laid out in a letter of intent (LOI). Yet the success of the acquisition is not yet guaranteed. The buyer first wants to thoroughly scrutinize the company during a due diligence review.
As M&A attorneys, we regularly see that companies appear attractive at first glance, but doubts arise during due diligence because legal matters have not been properly addressed. Sometimes a seller isn’t even aware of this, even though it can put pressure on the purchase price or even jeopardize the entire deal.
What findings cause a buyer to negotiate a lower purchase price, demand additional guarantees and/or indemnities, or even walk away entirely?
Below are 5 common legal red flags during due diligence.
1. The most important agreements were never put in writing
Many small and medium-sized business owners operate for years based on trust. That works fine—until a buyer asks for documentation regarding customer contracts, supplier agreements, partnership agreements, or exclusivity rights. If those agreements exist only verbally, the buyer cannot determine whether they will remain in effect after the acquisition. This directly affects the continuity of the business, and it is precisely that continuity that is a key assumption in any acquisition.
2. Dependence on a single major customer
A company that generates more than 25% of its revenue from a single customer is vulnerable. This is especially true when the contracts are short-term or include change-of-control provisions that give the other party the right to terminate the agreement as a result of an acquisition. Buyers look not only at today’s revenue but, above all, at the predictability of tomorrow’s revenue.
3. Ongoing disputes or dormant claims
Not every dispute leads to a deal falling through. At the same time, uncertainty about potential liabilities makes a buyer cautious. The buyer will ask themselves: What financial risks do I face after I become the owner of the target?
4. Key employees are not sufficiently retained
In many companies, crucial knowledge is held by one or a few individuals (key personnel). If it is uncertain whether these employees will remain after the acquisition, or if clear non-compete and non-solicitation clauses are lacking, this poses a risk. After all, what will remain of a company if the knowledge needed to run it is lost?
5. Permits and certifications are under scrutiny
Certain business activities require permits, quality marks, or certifications. During due diligence, these are checked to ensure they are in order and transferable. A buyer wants to be certain that they can continue the business activities after the acquisition.
The common thread
These 5 red flags have one thing in common: regardless of whether they actually lead to problems, they create uncertainty. It is precisely this uncertainty that a buyer can use to negotiate a lower purchase price or additional protections. In the worst-case scenario, it could prompt a buyer to walk away from the deal entirely.
A seller doesn’t necessarily need to have high revenue to secure the strongest negotiating position. It’s just as important to identify and address risks in a timely manner (and, of course, preferably before the buyer discovers them). In any case, remember this golden rule: a buyer pays for potential but negotiates based on risks.
