When a buyer or investor reviews documents during the diligence stage of a deal and asks,“what’s going on here?”, it’s often too late to save the deal. By then, expectations are set, andwhat should have been a routine formality can quickly become a deal-breaker. In most cases, the underlying cause is overlooked legal housekeeping.
There are a few common diligence issues, discussed below, that derail transactions, along with practical steps to address them.
Common Diligence Issues
Equity and Cap Table Misalignment
Investors care about ownership. If your cap table doesn’t add up, if there are undocumented equity promises, or if founders never actually signed equity agreements to memorialize what thecap table outlines, investors will treat that as material risk, not simply a nuance. Intent alone does not resolve ownership questions once capital is involved.
Intellectual Property Ownership
If your company claims technology or branding but can’t show clean ownership, that’s a red flag. Missing IP assignments from former founders or contractors who contributed to key aspects of the business before the company existed or during formation are common problem areas. Buyers expect clear ownership of the assets that create value.
Informal Deals
Handshake agreements, oral promises or nonstandard compensation arrangements may work for a company until it comes time for diligence, when buyers expect clarity. Simply put, if an arrangement exists, it should be documented; if it does not, it should be addressed (either clearly memorialized or unwound) before diligence begins.
Document Expectations
There are a handful of documents that every sophisticated buyer will expect to be able to closely review, and that includes the following:
This includes stock or membership agreements and ledgers, option and warrant agreements, equity agreements, convertible promissory notes, subordination andintercreditor agreements, and any side letters affecting economic or voting rights, all of which depict the overall picture of financial arrangements involving the company.
Founders’ agreements, incentive award agreements, vesting schedules, employment or consulting agreements, and any severance or change-of-control arrangements, which, in combination, clearly outline the company’s control, incentives, and ongoing obligations.
Buyers expect to see executed IP assignment and confidentiality agreements from all founders, employees, and contractors. Gaps here, especially relating toindividuals involved in early development, are a common diligence concern and can be a significant buyer deterrent.
This includes any agreements memorializing revenue sources – strategic partnerships, supplier arrangements, and any contracts with exclusivity, change-of-control, or consent requirements that could affect a transaction.
If these documents do not align with reality, buyer attention shifts from proceeding with next steps to reconciling underlying issues, which can ultimately jeopardize the transaction.
Best Practice for Transaction Readiness
“We’ll Fix It Later” Almost Never Works
Founders often assume diligence is the time to tidy up paperwork, but that is rarely the case.Once issues surface, leverage shifts, and credibility is questioned. Buyers begin asking for price reductions, escrows, and more buyer-favorable terms including expanded indemnities, extended survival periods for representations and warranties, additional closing conditions, post-closing covenants, and expanded information or audit rights. Additionally, some issues (such as missing IP assignments) may not even be easily fixable without relying on relationships with those who were involved in the early stages of the company, which introduces additional uncertainty.
Consistent and Ongoing Preparation Matters
Companies that wait for diligence periods to address legal housekeeping issues are often forced to address those issues under less favorable circumstances including time pressure and reduced leverage. These issues should be addressed and maintained on a regular basis to avoid being putthat position. Legal preparation and documentation protect your valuation and allow fortransaction readiness. When buyers and investors see a business that has its internal structure in order, they can focus on valuation and strategy rather than risk mitigation, and that should always be the goal.
If you’d like assistance reviewing your documents and corporate structure to ensure your company is in the best possible position for a transaction, please contact us.
