It is widely acknowledged that, when preparing for mergers, acquisitions, or investment rounds, legal due diligence is essential. It’s more than just a formality. For investors, M&A due diligence helps mitigate risk and protect their investment, which can be a substantial amount of capital. For business owners, a due diligence exercise is a chance to prove the value and credibility of their company. The same is true of the due diligence process for startups and new businesses. Everyone benefits from a clean bill of health.
However, when M&A legal due diligence uncovers red flags, deals can be delayed, devalued, or even abandoned altogether. This article, which doesn’t constitute formal advice, is intended to walk you through the most common legal due diligence red flags, provide a due diligence checklist for investors, and outline how your business can prepare to avoid them.
Why Legal Due Diligence Matters in M&A and Investments
The term legal due diligence is used to describe a series of activities that assess a company’s compliance, records, contracts, liabilities, and more before any M&A transaction takes place.
Due diligence prepares investors and acquirers by discovering exactly what they’re buying. It is the legal equivalent of looking under the bonnet of a car you’re intending to buy. The process also helps sellers. Successful due diligence demonstrates their business represents a sound, low-risk investment for purchasers. When done well, it is a smooth and seamless process that benefits all parties and reduces legal risks associated with mergers and acquisitions.
Without a period of due diligence, investors risk inheriting unforeseen legal issues, while businesses risk a lower valuation or, in extreme cases, having a deal collapse entirely. That’s why engaging experienced due diligence solicitors is always highly recommended to help all parties reach a satisfactory outcome.
What Are Red Flags In Due Diligence?
As we’ve established, corporate due diligence can reveal legal risks in mergers and acquisitions activity. Examples range from minor discrepancies, such as those in record-keeping, to major contractual problems and ongoing disputes. We have highlighted some common examples below.
Unclear or Missing Corporate Records
When corporate records such as Articles of Association, Shareholder Agreements, or Companies House filings are missing, outdated, or inconsistent, it raises immediate concerns that all is not well. Investors want clarity around shareholding, voting rights, and director authority. If documents are incomplete or contradictory, it suggests poor governance and leaves room for disputes; both count as red flags.
Weak or Non-Existent IP Protection
Intellectual property is often a company’s most valuable asset – whether it’s software, branding, or creative content. If IP isn’t correctly registered, assigned, or protected, it creates uncertainty about ownership and value. Copyrights, trademarks, and patents must be secure. Confusion over who owns the rights to key assets definitely counts as a red flag that can quickly derail negotiations. Timely advice from an appropriately qualified copyright or trademark solicitor can get things back on track.
Contractual Disputes or Gaps
Any investor’s M&A legal due diligence exercise should look closely at any commercial contracts held by the target organisations to ensure they are legally sound, enforceable, and favourable. Issues such as vague termination clauses, missing liability provisions, or poor drafting are always major red flags. They suggest ongoing risk exposure and leave buyers wondering what other liabilities might be hidden beneath the surface.
Employment Law Issues
Employees are the backbone of most businesses, but employment law is also one of the most complex risk areas. Missing or non-compliant employment contracts, poor record-keeping around holiday or sick pay, redundancy, disputes, poor staff relationships, and failure to account for TUPE in transfers are all red flags that may trigger investor concerns. It’s always advisable to get an expert employment law opinion should you discover problems.
Pending Litigation or Regulatory Breaches
As you might imagine, an ongoing dispute, regulatory penalty, or compliance failure can be devastating red flags for any deal. Investor legal due diligence that identifies such issues flags not only a significant reputational risk but also a legal issue. Should a company be managing unresolved problems, such as a data protection breach, a health and safety violation, or customer litigation, investors are likely to see a reason to renegotiate terms or walk away entirely.
What Really Derails a Deal?
From the investor’s perspective, due diligence red flags aren’t just inconveniences; they have a direct impact on a target company’s valuation. A red flag, once discovered, means the value proposition has changed and the deal needs renegotiation. Investors may ask for contractual caveats, further warranties or additional warranties to save the agreement; often in addition to lowering the price. Of course, if the sums no longer add up, the likelihood is that the M&A deal may be abandoned altogether. Many purchasers have walked away from an opportunity after finding one or more issues during a due diligence exercise. The bottom line? Investors hate the uncertainty that comes from red flags. If the risk gets too great, the M&A deal may not be worth pursuing.
How Businesses Can Prepare and Avoid Red Flags
The good news is that many due diligence red flags can be avoided. Businesses should take a proactive approach, working with specialist solicitors to review and update legal matters before entering negotiations.
Conducting an internal review using a due diligence checklist, for example, can help identify and resolve issues early, presenting investors with a cleaner, more attractive business free from M&A red flags.
Choosing the Right Legal Partner for Due Diligence
When it comes to protecting your interests, finding the right legal partner for M&A activity is vital. You need a team of experts in corporate law that understands the specific complexities of mergers, acquisitions, and investments. At Jamieson Law, our due diligence solicitors work with businesses at every stage of growth – from startups preparing for funding rounds to established companies navigating cross-border acquisitions. Our role is to protect your interests, undertake a legal due diligence checklist, reduce risks, and keep deals moving forward smoothly.
Considering M&A activity? Why not speak to Jamieson Law? Our due diligence solicitors in Scotland, Ireland, and across the UK regularly advise on M&A issues and avoid legal red flags.
Frequently Asked Questions
What are the biggest red flags in legal due diligence?
The most common red flags include missing contracts, unresolved disputes, weak intellectual property protection, and compliance failures. Each of these issues can impact investor confidence and reduce deal value.
Can red flags during corporate due diligence reduce a company's valuation?
Yes. Unresolved legal risks often result in investors lowering their offer, demanding additional protections, or walking away from the deal entirely.
How long does legal due diligence take?
The process typically takes between four and six weeks, depending on the size and complexity of the business. Startups with straightforward structures may complete due diligence faster, while larger companies with multiple subsidiaries may take longer.
Do startups need legal due diligence before investment?
Yes. Even at early funding stages, investors will expect a level of investigation. The due diligence process for startups is often most important during equity financing rounds, where ownership rights, IP, and contracts play a central role in the valuation.
