Legal Due Diligence: Key legal risks for the investor

Mainstream

Legal review of a company before a transaction is not just a collection of documents and a list of comments. It is an investment protection strategy.

The question is not whether the target has risks. There are always risks. The main question is which of these risks can destroy the value of the asset after the transaction, block operating activities or lead to unlimited liability of the investor.

Therefore, effective Legal Due Diligence is built around three objectives:

• Identify legal risks that are not visible from financial statements.
• Evaluate which ones are critical to business and transaction.
• Propose protection mechanisms: Special assurances, indemnity, conditional closing, restructuring or withdrawal from the transaction.

If these three objectives are not met before the contract is signed, the investor does not receive the asset, but a set of hidden liabilities.

When an investor needs a deep legal due diligence

Legal review is not only required when buying 100% of the shares. It is critical in any situation where the investor assumes the legal risks of another business.

• acquisition of a company, interest or business asset;
• Establishment of a joint venture with a local partner;
• Entering the capital through an investment round;
• acquisition of a distressed or distressed asset;
• structuring transactions across multiple jurisdictions;
• Entering a regulated market through the purchase of a player;
• post-integration verification after closing;
• Pre-IPO preparation of the asset;
• restructuring of the group with foreign participation;
• Deferred closing or earn-out transactions.

The mistake most investors make

Many investors start due diligence with the question:

“Does the company comply with the law?”

That's the wrong first question.

The right question is:

What legal factors could take away my control of the asset, cash flow, or the possibility of exiting the investment?

A formal legal due diligence, reduced to a description of statutory documents and a list of licenses, gives a false sense of security. The danger almost always lies deeper: Non-obvious contractual designs, historical corporate defects, sanctions chains, hidden litigation and regulatory risks that are not implemented immediately, but 12-18 months after closing.

Step 1. Determine the objectives and scope of the audit

The first thing that starts with Due Diligence is not the request for documents, but the understanding of the investment logic of the transaction.

Key questions before kick-off:

• Why does an investor enter an asset: Cash flow, technology, team, license, market, real estate?
• What are the key drivers of value?
• In which jurisdiction will the control be structured?
• Is there a full control or minority position?
• Is the investment being withdrawn and through what mechanism?

The answers to these questions determine the scope of the test. You can't test everything with the same depth. Legal review should be risk-oriented, not archival.

Step 2. Check the corporate structure and legal status

The corporate shell is the foundation. If it is cracked, the deal can be challenged and control lost.

It should be established:

• legality of the company’s creation;
• the powers of the persons signing the transaction;
• the presence of corporate approvals;
• history of issue and payment of shares / shares;
• absence of unaccounted rights of third parties (options, convertible instruments, priority rights);
• cleanliness of the chain of ownership;
• No restrictions on changing control (change of control)
• the validity of registration in the commercial register;
• compliance of statutory documents with mandatory norms;
• compliance with thin capitalization legislation.

Even a fully paid-up share may be encumbered by a hidden corporate dispute or minority option. Such defects are rarely seen in financial statements.

Step 3. Review significant contracts and obligations

The value of the business is based on its contracts. This is where the risks that can change the economics of a deal lie.

Key areas of analysis:

• contracts with key customers and suppliers;
• distribution, agency, licensing agreements;
• credit agreements, loans, sureties, guarantees;
• Contracts containing change of control provisions;
• agreements with the right of unilateral termination;
• contracts concluded on non-market terms;
• hidden obligations under indemnity;
• Exclusive and non-competitive terms;
• conflict of laws and jurisdictional clauses;
• Sanctions and export control provisions.

Special attention is paid to contracts without which the business will not be able to function after the change of ownership. Loss of a key contract due to a change of control is a classic reason for the destruction of value after closing.

Step 4. Evaluate regulatory risks and licensing regime

A regulatory environment is something that can stop a business at any point after a transaction.

It is necessary to check:

• availability and validity of all licenses and permits;
• the possibility of their preservation when changing control;
• compliance with industry regulation;
• Presence of regulations and inspections by regulators;
• regulatory history over the past 3-5 years;
• compliance of activities with the declared codes;
• obligations to the state (privatisation conditions, investment agreements);
• Risks of revoking or suspending licenses.

In some jurisdictions, the change of control automatically terminates the license. If the investor learns of this after closing, he receives an impaired asset.

Step 5. Identify judicial, arbitration and administrative risks

A target’s forensic history often tells more about a business than financial reports.

Analyzed:

• ongoing litigation and arbitration;
• completed disputes with unexecuted decisions;
• administrative proceedings;
• tax disputes;
• Claims from contractors and employees;
• Threats of action (pre-action letters)
• Risks of challenging transactions made before the acquisition;
• interim measures and arrests;
• Potential liability for historical violations.

Even a seemingly minor dispute can escalate into systemic risk if it involves underlying assets, business reputation or licenses.

Step 6. Checking intellectual property

For technological, industrial and consumer assets, IP is the core of value. Errors in this zone can deprive the investor of the right to the product.

The following shall be checked:

• the presence of rights to trademarks, patents, know-how, software;
• IP chain (who is the author, whether there is a transfer of rights from employees and contractors);
• License agreements and their terms;
• absence of violations of the rights of third parties;
• risks of patent disputes;
• IP object registration in key jurisdictions;
• rights to domain names;
• confidentiality and commercial secrecy regime.

If the key software or technology is not owned by the company but is used under a license that cannot be transferred, the investor may be left without the technological foundation of the business.

Step 7. Examine employment and pension obligations

Job risks are often underestimated. Meanwhile, labor disputes, unsecured relationships, and unfunded pension plans can generate serious financial losses.

It is necessary to check:

• structure of labor relations (labor, civil law, management);
• Employment contracts with key employees;
• obligations to pay bonuses, options, golden parachutes;
• compliance with migration legislation;
• the existence of collective agreements;
• pension plans and their funding;
• history of dismissals and disputes with employees;
• compliance with labor protection standards;
• risk of retraining relationships with self-employed or contractors.

In transactions with an international element, a separate focus is the transfer of personnel, the change of the controlling person and the application of foreign labor law.

Step 8. Asset check: property, equipment, rights

The ownership and rights to use the fixed assets must be legally, not factually, confirmed.

Analyzed:

• legal documents for real estate;
• cadastral and registration cleanliness;
• burdens, easements, arrests;
• lease agreements and their terms;
• Ownership of equipment (including leasing);
• permits for construction and operation;
• environmental burdens;
• rights to natural resources.

Buildings built without permission or on a disputed site are not an asset, but an encumbrance. In international transactions, it is important to take into account the differences in registration systems and the possibility of recognition of rights abroad.

Step 9. Assess sanctions, anti-corruption and compliance risks

Even a strong business can become toxic if it involves sanctioned individuals, corrupt schemes, or money laundering.

Checked:

• presence in the chain of ownership and counterparties of persons under sanctions;
• jurisdiction of origin of capital;
• compliance with export control and currency regulation;
• history of interaction with public officials;
• Use of agents and intermediaries in high-risk regions;
• Internal compliance system;
• the presence of investigations by regulators;
• Compliance with GDPR and local data laws.

Sanctions risk can completely block settlements, banking services and raising financing. The mistake here is not market share, but access to the international financial system.

Step 10. Develop a risk map and protection plan

The result of Legal Due Diligence should not be a report of hundreds of pages, but a structured map of risks with an assessment of their impact and mechanisms for militation.

An effective risk map includes:

• risk identification;
• category (corporate, contractual, regulatory, judicial, IP, labor, sanctions);
• probability of implementation;
• impact on cost, control or operating activities;
• possible safeguards (assurances, indemnity, special closing conditions, restructuring);
• recommendations on negotiations;
• Post-deal minimization plan.

A report that simply lists the problems doesn’t help the investor. It helps with a report that provides a negotiating tool and a defense structure.

What really matters is: formal vs. strategic approach

How to strengthen your position before the start of the transaction

Deep Due Diligence does not begin in the data room, but in the structuring stage of the transaction.

Before transferring documents to the investor, it is desirable:

• agree on a detailed Term Sheet or Letter of Intent;
• include exclusivity and a cost clause when withdrawing from the transaction;
• determine the perimeter of the inspection and the format of information disclosure;
• obligate the seller to provide access to key counterparties;
• to establish the obligation to keep the business as a functioning enterprise (standstill);
• provide a mechanism for refunding expenses if hidden risks cause the transaction to be abandoned;
• include the seller's obligation to sign the expanded Representations & Warranties.

The earlier a lawyer is involved in a transaction, the less space there is for surprises at the final stage.

Common mistakes of the investor in legal due diligence

1. Legal risks are often out of balance, but their implementation can nullify the financial model.
2. Risks are concentrated at the level of parent entities, IP holders, offshore companies and related parties.
3. After closing, key customers may leave because their contract terminates when the control changes.
4. In many jurisdictions, a change of ownership requires new licensing, which can take months.
5. Corruption violations prior to the transaction may result in the liability of the new owner.
6. The verbal promises of the seller are worth nothing unless they are made into contractual representations & wars and indemnity.
7. If the developer of the software code has not transferred the rights to the company, the business hangs by a thread.
8. Risk discovered but not removed after closing can be realized with delay and destroy synergies.

Investor checklist: 15 Questions Before Signing

1. Is the legal structure of the transaction consistent with the investment objective?
2. Who is the real beneficiary of the asset and are there any hidden rights of third parties?
3. Have all corporate approvals been received?
4. What are the changes of control clauses?
5. Are key licenses retained after the change of control?
6. Are there any current or potential legal disputes that threaten the business?
7. Who owns the rights to the key intellectual property?
8. Are there any unofficial employment relationships and unclosed pension schemes?
9. Are there any sanctioned persons or jurisdictions in the chain?
10. Are there any historical corruption schemes or compliance violations?
11. What assets are owned and which are leased or leased?
12. Are there hidden encumbrances on the property?
13. Does the asset comply with environmental regulations?
14. What risks can be taken after the closure?
15. What are the security features of the Share Purchase Agreement (SPA)?

What is a Legal Due Diligence Strategy?

A strong strategy is built on five levels:

1. Scope & Strategy Determination of the verification perimeter based on the drivers of the value and the structure of the transaction.

2. Document Discovery & Analysis Collection, systematization and in-depth legal analysis of corporate, contractual, regulatory, litigation and IP documents.

3. Risk Assessment & Quantification: Risk assessment and risk categorization and assessment of potential impact on cost, control and operating model.

4. Mitigation Structuring Development of a negotiating position, indemnity conditions, special assurances, conditional deposit of the transaction amount, deferred closing or restructuring.

5. Post-Closing Protection Plan to eliminate identified risks after the transaction, transfer of licenses, settlement of compliance violations, integration of legal functions.

Without the fifth level, even a well-conducted audit can leave an investor with inherited problems.

FAQ

Can I cancel the transaction as a result of Legal Due Diligence?

Yes, if the risks make the transaction commercially meaningless or create an unacceptable legal burden. That is why the verification must be completed before the signing of binding documents or the SPA must contain a condition precedent that allows you to exit the transaction without loss.

What is the time limit for full legal due diligence?

Depends on the size and complexity of the business, jurisdiction, and willingness of the seller to disclose documents. The standard horizon is 2 to 6 weeks of intensive work, but it is critical to set aside time for analysis, not just for gathering.

Can I rely on the seller’s report (Vendor Due Diligence)?

Vendor Due Diligence is useful as a starting point, but it will never replace independent verification conducted in the best interests of the buyer. The investor should understand what questions the seller might not have asked himself.

What if the hidden risks were discovered after the closure?

Use the mechanisms of Representations & Warranties, indemnity and, if provided, the conditional deposit of a part of the price. That is why it is so important to put protection in the spa.

What are the most common risks that lead to a rejection of the transaction?

Loss of key contracts in the event of a change of control, invalidity of rights to the underlying technology, uncontrolled regulatory risks, hidden litigation with large amounts and sanctions chains that make it impossible to settle in the necessary currencies.

Can you conduct due diligence in multiple jurisdictions at the same time?

Yes, and in international transactions, it is necessary. It is important that the team has experience in coordinating multi-jurisdictional due diligence and understands how the risks of one jurisdiction are projected onto another.

Related services

• International M&A, Joint Ventures & Strategic Investments
• Corporate Structuring & Cross-Border Transactions
• Regulatory, Licensing & Market Entry
• International Commercial Contracts
• Sanctions, Export Controls & International Compliance
• Intellectual Property Protection & Technology Transfer
• International Arbitration, Commercial Litigation & Cross-Border Disputes
• Multi-Jurisdictional Asset Tracing & Enforcement

Related material

• How to structure an international M&A deal without making critical mistakes
• Representations & Warranties in SPA: How to Protect an Investor
• Joint ventures: Legal risks and controls
• Sanctions Compliance with the Purchase of Foreign Assets
• How to Protect Intellectual Property in International Transactions
• Post-deal integration: legal roadmap
• Vendor Due Diligence vs. Buy-side Due Diligence: key differences
• How to check the foreign counterparty and its beneficiaries
• How to exit international investment: Legal mechanisms for exit

Conclusion

Legal Due Diligence is not a description of what a company has. It is a strategic identification of what could deprive an investor of value, control, or exit from a transaction.

A truly strong audit doesn’t just list the risks. It gives investors the tools to make decisions: enter into a transaction, change its terms or refuse without loss.

In international investment, M&A and joint ventures, the winner is not the one who signs the fastest. The winner is the one who understands before signing what legal risks he buys with the asset and how he will manage them after closing.