5 Hidden Liabilities Found During Legal Due Diligence in a Business Transaction

Mergers and acquisitions do not happen overnight. A deal will move through several stages—formulating, locating, investigating, negotiating, and integrating. For a broader overview of that process, we have a full series on our YouTube channel walking through the M&A lifecycle and what buyers and sellers can expect at each stage.

Today, we're focusing on one specific part of the lifecycle, the investigating step. During this stage, the buyer conducts due diligence to understand the business, confirm key assumptions, and identify any risks before moving forward with the transaction.

Due diligence helps buyers identify any hidden liabilities that could affect the value of the business, change the structure of the deal, or create problems after closing. Some liabilities might be obvious, whereas others might be hidden in contracts, employee files, licensing issues, or compliance practices. Keep reading for five hidden liabilities that might be uncovered during the due diligence process.

Pending Litigation

Pending or even threatened litigation can affect the value of a business. A lawsuit does not necessarily prevent a deal from moving forward, but it does require a careful look. Buyers need to understand the nature of the claim, the potential exposure, the stage of the dispute, whether insurance may apply, and whether the issue could continue after closing.

Litigation risk can also extend beyond formal lawsuits. Demand letters, employee complaints, customer disputes, government investigations, and unresolved settlement discussions may all signal potential liability.

For sellers, it is important to identify these issues early. Failing to disclose known disputes can lead to problems later, including indemnification claims or allegations that the seller misrepresented the condition of the business.

Intellectual Property Infringement

A company's intellectual property can be one of its most valuable assets. But it can also be a source of hidden risk.

During diligence, buyers should confirm that the business actually owns or has the right to use the intellectual property it relies on. This could include trademarks, copyright, trade names, software, website content, logos, proprietary processes, and licensing agreements.

These issues matter because the buyer may be purchasing a business that depends on assets it does not fully own. In some cases, intellectual property problems can lead to infringement claims, rebranding costs, business interruptions, or loss of value after closing.

Change of Control

Many important contracts for business have clauses and provisions addressing what happens in the event of a sale or change in ownership. A customer agreement, vendor contract, lease, loan agreement, franchise agreement, or licensing agreement might require consent before the transaction can close. In some cases, these agreements may also allow the other party to terminate the agreement when the ownership changes.

Regulatory and Antitrust Noncompliance

For highly-regulated industries, regulatory issues can become a serious problem that arises during due diligence.

Depending on the industry, diligence may need to address permits, professional licenses, industry-specific regulations, environmental requirements, data-privacy obligations, advertising rules, healthcare regulations, franchise laws, or government-contracting requirements.

If a transaction will affect competition in a particular market, antitrust concerns might also arise. Even smaller transactions can cause concerns if the buyer and seller are direct competitors, operate in a concentrated market, or have contracts that restrict pricing, territories, customers, or suppliers.

Regulatory and antitrust issues are especially important because they can affect whether the transaction can close, whether approvals are needed, and whether the buyer inherits compliance problems post-closing.

Employment and Labor Law Breaches

Buyers should review wage-and-hour practices, employee classifications, independent contractor relationships, commission plans, restrictive covenant agreements, employee handbooks, leave policies, discrimination or harassment complaints, workplace safety issues, and benefits practices.

Common red flags include misclassified employees, unpaid overtime, undocumented bonus or commission arrangements, inconsistent discipline practices, unresolved employee complaints, and contractor relationships that function more like employment relationships.

These issues can become expensive after closing. A buyer may inherit employee disputes, wage claims, morale issues, or compliance problems that were created before the transaction. In some deals, employment liabilities may also affect purchase price, indemnification terms, or whether certain employees are retained after closing.

Why These Issues Matter

When hidden liabilities are identified early, the parties have more options. They may adjust the purchase price, require a specific issue to be resolved before closing, obtain third-party consent, modify the transaction structure, add indemnification protections, or set aside funds in escrow.

For buyers, diligence helps avoid surprises after closing. For sellers, preparation can make the transaction smoother and reduce the risk of last-minute delays.

The best time to address these issues is before the deal is signed, before closing deadlines are approaching, and before the parties are too far into the process to make practical adjustments.

If you are considering buying or selling a business, experienced M&A counsel can help identify these issues early and structure the transaction with those risks in mind.