Five legal issues that reduce business value during due diligence

Many businesses operate successfully for years with informal arrangements, outdated agreements or contracts that simply cannot be located.

Common examples include:

• key customer relationships with no written agreement

• missing supplier contracts

• unsigned commercial agreements

• outdated terms and conditions

• contracts that have never been renewed or updated

From a buyer's perspective, contracts provide certainty; they help demonstrate the stability of revenue, define rights and obligations, and reduce operational risk.

Where important commercial relationships are not properly documented, buyers may question the reliability of future earnings and seek to adjust their valuation accordingly.

For many businesses – particularly those operating in technology, software, marketing, consulting or creative sectors – intellectual property is one of the most valuable assets that is being acquired. Yet it is surprisingly common to discover that ownership has not been properly documented.

Typical issues include:

• software developed by contractors without formal IP assignment agreements

• missing IP transfer documentation

• unclear ownership of branding or content

• legacy development arrangements that were never formally recorded

The question a buyer will ask is simple: does the company actually own the assets it claims to own?

If ownership cannot be clearly demonstrated, the buyer may see this as a material legal risk and seek additional warranties, indemnities or a reduction in purchase price. The stronger the IP position, the easier it is to justify value.

Shareholder issues often remain hidden until a transaction is underway. Businesses often grow without revisiting arrangements that were put in place years earlier. Unfortunately, those historic arrangements can become problematic when a transaction begins.

Areas that commonly create difficulties include:

• outdated shareholder agreements

• undocumented share transfers

• unclear ownership interests

• minority shareholder disputes

• inconsistent statutory records

Even where relationships between shareholders are positive, uncertainty around ownership can delay transactions and increase costs.

Buyers typically want confidence that all shareholders can participate in the transaction and that there are no unresolved corporate governance issues that could affect completion.

A strong management team can increase the attractiveness of a business. Poorly structured incentive arrangements can produce the opposite result. During due diligence, buyers will often review the following:

• EMI option schemes

• growth share arrangements

• bonus plans

• share incentive structures

• employment-related equity interests

Issues commonly arise where documentation is incomplete, valuation or tax requirements have not been satisfied, or arrangements have evolved without the appropriate legal guidance. In some cases, uncertainty regarding employee equity can create unexpected costs, disputes or tax implications.

Buyers want to understand exactly who owns what, who may be entitled to future payments and how management will be bound into the business following completion. Clarity in this area can significantly reduce transaction risk.

Many business owners are aware of minor historic compliance issues but assume they will not be relevant during a sale process. Unfortunately, due diligence has a tendency to surface these matters. Examples include:

• incomplete corporate records

• Companies House filing issues

• historic regulatory breaches

• missing board approvals

• undocumented corporate actions

Individually, these issues may not be significant. Collectively, however, they can create a picture of weak governance and poor record keeping. Buyers often assess, not only the issue itself, but what it says about the way the business has been run.

Addressing historic compliance matters before entering a sale process is usually far less expensive than trying to resolve them under transaction pressure.

One of the biggest misconceptions about M&A transactions is that value is determined during negotiations. In reality, much of a company's value is established long before heads of terms are signed.

Businesses that maintain robust contracts, protect their intellectual property, keep shareholder arrangements up to date, properly structure employee incentives and invest in good governance are generally better positioned to complete due diligence successfully. The businesses that achieve the smoothest exits are rarely those scrambling to answer a buyer’s questions; they have already laid the groundwork well in advance of a transaction.

Due diligence is not designed to find reasons to complete a transaction. It is designed to identify risk. The more risks a buyer uncovers, the more likely it is that value will be challenged, timelines will increase or additional warranties and indemnities will be demanded.

For business owners considering an exit in the coming years, the most effective way to protect value is often surprisingly simple: identify and address these issues before a buyer has the chance to find them first.