Red flags in legal due diligence

Are you looking to sell your business, buy a company or enter into a strategic partnership? Then, after the initial discussions and the conclusion of an NDA (Non-Disclosure Agreement) or a Letter Of Intent, Term Sheet Or Memorandum Of Understanding, legal due diligence (‘DD’) is often one of the first next steps, alongside financial DD.

Due diligence acts as your safety filter. It is not a boring checklist, but an important tool for identifying risks in good time, before they affect your deal or investment.

Below, I list the most important potential points of attention and obstacles, referred to as red flags. By recognising these in good time, you can use them to your advantage.

What are red flags?

Red flags are signals that something may not be right beneath the surface. These are not minor details, but indications of possible claims, non-compliance or a business that looks better than it actually is. Anyone who ignores these signals will soon find themselves with problems.

8 common red flags (with examples)

1.Intellectual property (IP / IP = IPRs)

• The brands are not or only partially registered, models and/or patents are about to expire, or it was unclear who is the legal and actual creator of the software, the architecture, or who knows about the business-critical know-how (trade secrets).
• Why this matters: in many (tech) companies, the core value lies precisely in the IP. If intellectual property or (exclusive) licences are not properly regulated (e.g. not registered), your competitor may soon be on the market with “your” product.
• Example: when acquiring a software company, the history of its creators (own staff or freelancers, etc.) is not documented or only partially documented. Have copyrights been transferred or left behind with third parties? Is the software documentation available and, if so, is it up to date?

2. Lawsuits and legal claims:

• Are there any ongoing proceedings and is compensation being claimed or is there a risk of compensation being awarded? Does it concern business-critical know-how/patent, trademark model or simply an employment case?
• Why this matters: disputes cost money and management time – and can sometimes point to deeper policy issues or problems with complying with regular laws.

3. Contracts

• Are the clauses on termination and renewal clear? Are there differences in termination rights or are there significant price indexations?
• This is relevant because even one bad contract can disrupt the supply chain, for example, and thus affect profit margins. Sometimes a major customer or supplier may have to be let go because there is a change of control clause (different management/shareholder) and this is perceived as competitive. This can lead to losses.
• Example: the acquisition of the company (the “target”) means that a logistics partner who also works for the competitor may or even must leave, because otherwise there is a fear of critical information exchange (numbers, prices, time periods). Your business plan would then need to be adjusted after the takeover, or there would be no good business case given the purchase price.

4. Company structure

• Red flag: incomplete, outdated, unclear shareholder registers, frequent changes in share ownership, or ongoing disputes over shares can reveal all sorts of things, e.g. what sales, innovation or (dis)investment promises were made (and may not have been fulfilled or only partially fulfilled)? Or a shareholder was also a supplier and sees that coming under pressure.
• This matters because, for example, a lack of information about the type of shareholder or unclear control may predict a legal battle or difficult decision-making.
• Example: the “target” has issued several extraordinary AGMs twice in one year. This may indicate conflicts over strategy between management and shareholders and therefore the business model.

5. Violation of laws and regulations

• Are the correct permits in place; have fines been imposed; are there any ongoing investigations by, for example, the tax authorities, AFM, ACM?
• Why this matters: non-compliance may seem “administrative”, but it costs money in the form of fines, reputational damage or even the shutdown of a business unit.
• Example: an investigation by the tax authorities is found to be ongoing at a manufacturing company that is to be acquired. This could mean fines, poor administration, or unheeded tax advice.

6. Labour relations – HRM DD

• Red flag: many complaints, unpaid wages or contributions, frequent violations of labour law; high staff turnover;
• This matters because: staff are key, and if labour relations are poor and a reorganisation is implemented after the closing, this could be the last straw, leading to strikes and thus a loss of productivity and costs.
• Example: negotiations are ongoing with trade unions about the company collective labour agreement; there are HR files with repeated complaints or arrears in bonus or pension payments. This points to both management and HR problems.

7. Financial basis:

• Are the profit forecasts too ambitious; which KPIs (key performance indicators) were used? Has a lot been outsourced via leasing? Did many guarantees still have to be honoured? Are the figures comparable with competitors in the sector?
• Why this matters: results may have been embellished or there may be hidden debts that undermine the valuation and financeability of the deal.
• Example: a comparison with industry peers shows that margins are structurally lower. Is this due to a long-term, overly expensive purchasing contract or a delayed reorganisation, for example?

8. Competition

• Does the potential acquisition of the target mean market dominance that requires approval by the national competition authority or the European Commission?
• Has this already been investigated and validated with a report and confidentially discussed with, for example, the ACM?
• Example: which business units may need to be divested to avoid an ACM ban, who could be the potential buyer, and how much time might this take?

Why can’t you ignore this as CEO/business development team?

The red flags mentioned are not only legal in nature, but also operational, financial and market-oriented. For you, they determine the difference between a deal that adds value and a deal that consumes capital, time and attention. Such a red flag does not necessarily mean that you have to pull out, but it does mean that you should:

• make adjustments at the negotiating table (price, structure, conditions);
• ask more targeted, pointed questions;
• and demand additional guarantees or indemnities.

This is about risk avoidance and better deals.

Continue negotiations

Every red flag that you spot in time is an opportunity to improve the terms of the transaction:

• adjustment of the purchase price or earn-out;
• specific guarantees and indemnities;
• and deferred closing or additional conditions precedent or conditions subsequent.

Conclusion

Due diligence is a strategic tool for saying “no” to bad deals, but above all for structuring deals in a safer and stronger way.

Legal due diligence is therefore not a formality, but essential and gives you negotiating power. The sooner you spot issues, the more room for manoeuvre you have.

Do you have any questions about this article or other legal questions? Our specialised lawyers will be happy to assist you. You can reach us by email, telephone or via the contact form.