Legal Due Diligence When Buying a Privately Held Business

Sep 1

Due diligence is the process of testing the assumptions behind a transaction before the buyer becomes legally and economically committed. For a privately held business, that work is not simply a search for reasons to abandon the deal. It helps the buyer determine what it is buying, what risks will remain after closing, and how those risks should affect price, structure, closing conditions, and post-closing plans.

A good diligence process is proportional to the transaction, but it should be systematic. The following areas provide a starting framework.

Ownership, authority, and capitalization

Confirm that the seller owns what it proposes to sell and has authority to complete the transaction. Review:

Formation and governing documents
Ownership records and capitalization
Options, warrants, convertible rights, and minority interests
Board, member, or shareholder approvals
Subsidiaries, affiliates, and joint ventures
Liens, pledges, and restrictions on transfer
Prior issuances, redemptions, and owner agreements

Ownership disputes or incomplete records can delay closing and make later title questions difficult to resolve.

Financial obligations and liabilities

Legal diligence should be coordinated with financial and tax review. Examine debt instruments, guaranties, security interests, leases, deferred obligations, customer credits, related-party transactions, and off-balance-sheet commitments. Identify liabilities that will transfer by contract, remain with the acquired entity, or potentially follow the business under applicable law.

The agreement’s definitions of debt, working capital, transaction expenses, and assumed liabilities should match the financial model.

Material contracts

Build a contract inventory that includes customers, suppliers, distributors, lenders, landlords, software providers, licensors, independent contractors, and strategic partners. For each material agreement, consider:

Term, renewal, and termination rights
Assignment and change-of-control restrictions
Pricing and minimum commitments
Exclusivity, noncompetition, or most-favored-customer provisions
Indemnity and liability limitations
Service levels and unresolved defaults
Required notices or third-party consents

A valuable customer relationship may be less valuable if the contract can be terminated upon closing or cannot be transferred without consent.

Employees and workforce practices

Review employee and contractor classifications, compensation arrangements, bonus and commission plans, leave practices, benefits, restrictive covenants, employment agreements, handbooks, complaints, investigations, wage-and-hour issues, labor matters, and pending or threatened claims.

The buyer should also identify key employees, retention needs, benefit-transition issues, and communications that must be coordinated before and after closing. The transaction itself can affect morale and increase the risk of losing people whose knowledge is essential to the acquired business.

Litigation, claims, and investigations

Request information about pending, threatened, and recently resolved lawsuits, administrative charges, demand letters, subpoenas, regulatory inquiries, internal investigations, insurance claims, product complaints, and significant customer disputes.

Assess not only possible damages but also business interruption, defense costs, insurance availability, reputational impact, and whether the same underlying practice continues.

Regulatory and operational compliance

The relevant review depends heavily on the industry. It may include licenses, permits, environmental matters, professional regulation, government contracts, consumer protection, export controls, sanctions, anti-corruption, product regulation, workplace safety, accessibility, and industry-specific privacy or security requirements.

The buyer should confirm which permits transfer, which require notice or approval, and which must be obtained anew.

Intellectual property, technology, and data

Identify the intellectual property and technology needed to operate the business:

Trademarks, domain names, patents, copyrights, and trade secrets
Software and source-code rights
Inbound and outbound licenses
Employee and contractor invention assignments
Open-source software use
Privacy notices, data-processing terms, and security policies
Cyber incidents, vulnerabilities, and insurance claims
Data ownership, portability, retention, and deletion obligations

Confirm that the seller or target actually owns or has adequate rights to the technology, content, brands, and data the business relies upon.

Real estate and physical assets

For owned or leased property, review title, surveys, zoning, leases, amendments, landlord consents, environmental reports, maintenance obligations, casualty provisions, and options to renew or purchase. For equipment and inventory, confirm ownership, condition, liens, warranties, and whether the assets are sufficient to operate as represented.

Insurance

Review current and historical policies, coverage limits, deductibles, exclusions, claims, reservation-of-rights letters, and whether coverage is occurrence-based or claims-made. Determine whether tail coverage or transaction-specific insurance should be considered.

Turn findings into transaction decisions

Diligence is useful only when findings are translated into action. A finding may lead to:

A price adjustment
A special indemnity or escrow
A closing condition or required consent
A pre-closing corrective action
A representation or disclosure schedule
A decision to exclude an asset or liability
A post-closing integration plan
A decision not to proceed

Not every issue requires a confrontation. The objective is to place each material risk with the party best positioned to address it and ensure leadership understands what remains after closing.

Antitrust review is not limited to the largest companies

Certain larger transactions require premerger notification under the Hart-Scott-Rodino Act. Reporting thresholds change periodically. Even when a filing is not required, federal agencies may investigate a transaction that may substantially lessen competition, including some already-consummated acquisitions. A pattern of smaller acquisitions may also be relevant to agency analysis. Competitive overlap should therefore be considered early rather than treated only as a filing-threshold question.

Primary legal sources

This article provides general information and is not legal advice. Reading it does not create an attorney-client relationship. The appropriate diligence scope depends on the transaction, industry, jurisdictions, and available information. Businesses should consult qualified legal, financial, tax, and other advisers about a specific acquisition.

Planning to buy or sell a privately held business? Learn more about Project-Based Legal Services or request a consultation.

Seth Jewell