Legal due diligence is the process by which a buyer’s attorneys systematically review the legal health of a target business before committing to a purchase. It is not glamorous work, but it is among the most valuable work done in any transaction. The goal is not to find reasons to walk away from a deal—it is to understand exactly what you are buying, identify risks before they become your problem, and negotiate appropriate protections into the purchase agreement. Here are the legal red flags that appear most frequently, and what they mean for buyers.
Pending or Threatened Litigation
Disclosed litigation is manageable; undisclosed litigation is dangerous. A seller’s representations about the absence of pending or threatened legal proceedings are among the most important in any purchase agreement. Review any disclosed litigation carefully with counsel to assess the likely outcome, estimate potential exposure, and determine whether an indemnification holdback, escrow, or purchase price adjustment is appropriate. Pay particular attention to employment-related claims and customer disputes, which are often the canary in the coal mine for deeper operational or cultural issues.
Change-of-Control Provisions in Key Contracts
As discussed in previous posts, the assignability of a target company’s contracts is a fundamental issue in any acquisition. Beyond simple anti-assignment clauses, some contracts include explicit change-of-control provisions that give the counterparty the right to terminate the agreement if the ownership of the contracting party changes. Losing a major customer contract at closing because it contained a hidden change-of-control trigger can materially alter the economics of a transaction. Every material contract should be reviewed for assignment restrictions and change-of-control rights before closing.
Employee Classification Issues
Businesses that rely heavily on independent contractors rather than employees face potential exposure under federal and state labor laws if those workers were misclassified. Worker misclassification liability can include unpaid payroll taxes, benefits, overtime, and civil penalties—and that liability can travel with the entity in a stock acquisition. Buyers should request and analyze the terms of all independent contractor relationships and, where there is genuine uncertainty, obtain specific indemnification protection for pre-closing misclassification exposure.
Regulatory and Licensing Gaps
Confirm that the target company holds all licenses, permits, and regulatory approvals necessary to operate its business legally, that those authorizations are in good standing, and that they are either transferable or can be re-obtained by the buyer after closing without significant delay or expense. In regulated industries, this due diligence is not optional—it is the foundation of the transaction.
Undisclosed or Contingent Liabilities
Environmental contamination, product liability exposure, tax deficiencies, and lease obligations are among the most common forms of undisclosed contingent liability that surface post-closing in deals that lacked rigorous due diligence. A thorough review of the target’s tax returns, correspondence with regulatory agencies, real property leases, and insurance claims history can surface exposure that would not otherwise be apparent from the financial statements alone.
No due diligence process eliminates all risk—but a thorough one ensures you are making an informed decision. The goal is not a perfect target. It is a clear-eyed understanding of what you are acquiring, so that you can price the risk appropriately, negotiate the right protections, and move forward with confidence.
The Business Lawyers at Beresford Booth have extensive experience in all aspects of business, mergers and acquisitions. We can help you through the entire process of a business purchase. Contact us at info@beresfordlaw.com or (425) 776-4100 to see how we can help.