Due Diligence Found a Problem. Now What? Price, Conditions, Warranties and Indemnities
Legal due diligence almost always finds something.
The contracts are thin. There may be unpaid overtime. The code written by an outside developer was never assigned. The largest customer's contract has a change-of-control clause. In a small Japanese company, the business with none of these is the unusual one.
None of that means the deal is off.
The purpose of due diligence is not to produce findings. It is to convert findings into deal terms — price, conditions to closing, warranties, indemnities, and occasionally the decision not to proceed. Due diligence that stops at the report has done half the job.
First, separate what matters from what does not
The first question about any finding is how much it could move the value or the decision.
An out-of-date internal seal management rule and a customer representing half of revenue who can terminate on a change of control are not the same kind of problem, even though both appear as a line in a report.
In practice findings sort into five groups:
- serious enough that the acquisition may not proceed
- must be resolved before closing
- should come off the price
- can be handled by contractual protection
- can be fixed after closing as part of running the business
A report that does not do this sorting leaves the buyer with forty items of apparently equal weight and no way to act on them.
The available responses
| The finding | Usual responses | The thinking |
|---|---|---|
| Potential unpaid overtime | Price adjustment / specific indemnity / warranty | Who bears a historical exposure that may or may not crystallise |
| Key customer's consent required | Condition to closing | If consent is refused, the value you are paying for has changed |
| IP in outsourced work not assigned | Rectify before closing / condition precedent | Get the assignment executed first |
| Pending litigation | Price adjustment / specific indemnity | Scope, cap and duration set for that matter |
| Problem with a licence | Condition precedent / change of structure | If it cannot be resolved, do not close |
| Minor internal policy gaps | Post-closing improvement | Not a reason to hold up the transaction |
Response 1: reflect it in the price
Where the exposure can be given a number, the price can absorb it.
If historical unpaid wages can be estimated within a reasonable range, that estimate can be taken off the purchase price.
But a reduced price does not make the problem disappear. Where the eventual loss cannot be bounded, or where the issue goes to whether the business can continue at all, a discount is the wrong instrument. You would be buying a known problem at a slightly better price, which is still buying the problem.
Response 2: have the seller fix it before closing
If the issue is capable of being cured, the seller can be required to cure it before completion:
- obtain an assignment of intellectual property from the outside contractor
- obtain the internal approvals that were never taken
- obtain consent from the key customer
- unwind related-party arrangements that will not continue
For anything genuinely important to the buyer, this should be a condition to closing rather than an obligation to use reasonable efforts.
The difference matters at exactly the wrong moment. An efforts obligation gives you a claim after you have completed and paid. A condition precedent means you simply do not complete.
Response 3: use representations and warranties
A warranty is the seller's statement that specified facts are true, backed by liability if they are not.
Typically:
- there are no material undisclosed liabilities
- there is no material default under the key contracts
- there are no material disputes other than those disclosed
- the company holds the rights it needs in specified intellectual property
Two cautions.
Warranties are not a substitute for due diligence. Doing little investigation and asking for broad warranties does not make a deal safe. Enforcing a warranty takes time and money, and a seller without assets cannot pay a judgment. What you get is a claim, not a remedy.
The SME Agency takes the same approach, treating warranties as something the parties should align on in light of the due diligence findings, the likelihood and impact of the risk crystallising, and how it has been reflected in the consideration.
Response 4: negotiate the indemnity
The indemnity is the money mechanism behind a breach of warranty or of the agreement.
From the buyer's side:
- what losses are covered
- what categories of loss are included
- how long a claim can be made
- what the cap is
- how small claims are treated
Where due diligence has identified a specific risk, it is worth considering a specific indemnity for that issue, outside the general cap and time limit that apply to the ordinary warranties — a pending employment claim, an open tax audit, an identified piece of litigation.
A general warranty package plus a carve-out for the two or three things you actually found is usually a better structure than an unfocused attempt to widen everything.
Response 5: change the structure
Where due diligence raises the possibility of significant off-balance-sheet liabilities, moving from a share transfer to a business transfer — where the assets and contracts taken on are specified — can be an option.
It is not a free move. A business transfer brings individual transfer of contracts and assets, employee consents and licence questions of its own. "Business transfer, therefore safe" is not a sound conclusion; the trade-offs are set out in share transfer or business transfer.
And sometimes: do not buy
Some problems cannot be contracted around:
- title to the shares cannot be established
- the largest customer will not continue, and the valuation assumed they would
- a licence essential to the business cannot be maintained
- the disclosure itself can no longer be relied on
Due diligence is not a procedure for completing an acquisition. It is equally a procedure for deciding not to. Walking away after spending a few hundred thousand yen on due diligence is a good outcome, not a wasted fee.
Whatever was agreed, put it in the contract
The seller may have said, in a meeting, that they will take care of the problem. People generally mean it when they say it.
If it is not in the agreement, the conversation two years later is about what was meant, and the answer depends on what can be proved. The fact that the SME Agency's third-edition guidelines devote considerably more attention to post-closing trouble than earlier editions says something about how often this happens.
In summary
Finding problems in due diligence is normal. What distinguishes a useful exercise from an expensive one is what happens next:
- assess how much each finding matters
- resolve before closing what can be resolved
- reflect quantifiable exposure in the price
- allocate what remains through warranties and indemnities
- and where something serious cannot be allocated, decline the deal
Legal due diligence is not done to produce a report. It is done to set the price and the terms of the purchase agreement. What to look for in the first place is covered in the ten-point checklist.