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Legal due diligence before a purchase: what is examined, and what to do with what is found

Legal due diligence is not a ritual. It is the process of establishing what exactly is being bought and what comes with it. The important output is not the defect found but what is done with it: a price reduction, an indemnity, a condition precedent or walking away. This page covers the review and its translation into deal terms.

“Not every defect kills a deal. Some of them kill a price.”

Adv. Erez Sapir
Hands examining documents and figures on a desk, illustrating due diligence
Adv. Erez Sapir, Head of Commercial Law
By Adv. Erez Sapir
Updated · About a 6-minute read
Book a consultation02-5953322

Why it is done, and what happens when it is not

A buyer of a business is not only buying customers and equipment. They are also buying what comes attached: contracts that bind, claims not yet filed, debts not recorded, and licences no longer in force. Due diligence is how you establish what is actually entering the transaction.

Skipping it does not avoid the risk; it buys the risk unknowingly. And the practical difference is large: a defect found before signing is a negotiating point, while the same defect after signing is a claim.

The review is not meant to find a perfect deal. Perfect deals do not exist. It is meant to allow accurate pricing of the risk and to make sure it is allocated to the right party.

What the review covers

Corporate. Certificate of incorporation, articles, register of shareholders, minutes, shareholders agreements, options and undertakings to allot. This is where it sometimes emerges that the ownership position is not what was presented.

Contractual. Material customer and supplier agreements, and in particular change of control clauses, which let the other side terminate on the acquisition. A key contract with such a clause can change the value of the deal.

Employment. Employment agreements, seniority and entitlements, provisions, classification of employees against contractors, and confidentiality and non compete clauses.

Intellectual property. Who owns the mark, the code and the content. See the gap described on the non-disclosure agreement page.

Regulation and licensing. Including business licensing and the compliance of the premises with planning and building law.

Litigation and security interests. Pending proceedings, registered charges, guarantees and off balance sheet commitments.

Shares against assets, and the difference in review

Two deal structures, each with its own review logic.

Share purchase. The buyer steps into the shoes of the shareholder and the company continues with all its liabilities, including unknown ones. The review must be broad, because whatever is not examined comes along.

Asset and business purchase. Defined assets are acquired and in principle the liabilities remain with the seller. The review is more focused, but different work is added: assigning every contract, licence and engagement separately, sometimes with third party consent.

The choice between them is a legal and a tax decision at once, and it is best made before the review begins, because it determines the scope of the review.

The five recurring findings

Intellectual property not owned by the company. Code or design developed by an outside contractor with no assignment clause. This is the most common finding in technology deals, and it is usually fixable before closing.

A change of control clause in a key contract. Found by reading the contract to the end.

Misclassified contractors. Someone engaged as a freelancer for years on terms resembling employment creates retrospective exposure.

Oral agreements. Promises to employees or customers that appear nowhere in the documents and only in correspondence.

Gaps between the share register and reality. Options promised and never allotted, or transfers never recorded.

What to do with a finding

This is what separates a report from actual work. Every finding has four routes, chosen by severity and probability.

Price reduction. Where the loss can be quantified. Simple and effective.

Condition precedent. Closing is conditional on the defect being cured beforehand, for example completing an assignment of intellectual property. This is the preferred route where a cure is possible.

Indemnity and escrow. The seller undertakes to indemnify against the risk, and sometimes part of the consideration is held in escrow for a period. Here it is important to set a cap, a period and a minimum threshold, otherwise the undertaking is not worth much.

Walking away. Where the finding is material and can be neither cured nor priced.

The rule: a report that ends with a list of findings is not a finished product. It becomes one when each finding is translated into a clause.

Timing and order of work

The order that works: a non-disclosure agreement, then a term sheet setting price, structure and an exclusivity period, then the due diligence, then drafting the agreement on the basis of the findings, then closing.

Two practical notes. First, ask for exclusivity for the review period. Diligence costs money, and there is no sense funding it while the seller runs an auction.

Second, review in order of risk rather than alphabetically. Start with ownership, intellectual property and the key contracts, and only then go into detail. If a deal breaking problem is going to surface, better that it surfaces in the first week.

And if you are the seller

This page is also read by people intending to sell, and here one thing is worth saying: reviewing yourself in advance pays.

A seller who finds the defects before the buyer does can fix some of them, and prepare an explanation and a price for the rest. A seller whose buyer finds them first is in a weak position in every negotiation that follows.

Three things worth putting in order before starting a sale process: secure ownership of intellectual property, make sure the share register and minutes are up to date, and collect the material contracts in one place.

Legal support

We conduct legal due diligence for buyers and prepare companies for sale. The report we deliver is not a list of findings but a table in which each finding is translated into a recommendation: reduction, condition precedent, indemnity or withdrawal, with a severity assessment. The accounting and tax aspects we coordinate with the accountant on the deal.

To reach us: 02-5953322 in Jerusalem, 03-3030430 in Tel Aviv, WhatsApp 050-4411343.

Questions and answers

Frequently asked questions about legal due diligence

What does legal due diligence cover?
A corporate review of constitutional documents and the ownership position, a review of material contracts and in particular change of control clauses, employment matters and classification of personnel, ownership of intellectual property, regulation and licensing, and litigation, charges and guarantees.
What is the difference between a share purchase and an asset purchase?
In a share purchase the buyer steps into the shoes of the shareholder and the company continues with all its liabilities, including unknown ones, so the review must be broad. In an asset purchase defined assets are acquired and liabilities in principle remain with the seller, but every contract and licence must be assigned separately.
What is the most common finding?
Intellectual property not owned by the company, usually code or design developed by an outside contractor with no assignment clause. It is the most common finding in technology deals, and it is usually fixable before closing.
What is done with a finding once discovered?
Four routes: a price reduction where the loss can be quantified, a condition precedent requiring a cure before closing, an indemnity and sometimes escrow of part of the consideration, and withdrawal where the finding is material and cannot be cured. A report ending only in a list of findings is not a finished product.
When is the review carried out?
After a non-disclosure agreement and a term sheet setting price, structure and an exclusivity period, and before drafting the binding agreement. It is advisable to require exclusivity for the review period, and to review in order of risk: ownership, intellectual property and key contracts first.
I am the seller. Should I review myself?
Yes. A seller who finds the defects before the buyer can fix some and prepare for the rest. Three things worth putting in order in advance: securing ownership of intellectual property, updating the share register and minutes, and collecting the material contracts in one place.

All department pages

Commercial law

Before you buy a business, or sell one

Tell us the deal structure and what you have already seen. We will scope the review by order of risk and translate every finding into a deal term.

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