Red Flags in Legal, IP, and Financial Due Diligence — And How to Address Them Proactively

In the world of software and technology M&A, due diligence is where deals are made—or quietly fall apart. For founders and CEOs preparing for an exit, understanding what buyers scrutinize in your legal, intellectual property (IP), and financial documentation is not just a defensive move—it’s a strategic one.

At iMerge, we’ve seen otherwise promising deals stall or collapse due to avoidable red flags. The good news? Most of these issues can be identified and resolved well before a buyer ever sees your data room. Below, we outline the most common red flags across legal, IP, and financial domains—and how to proactively mitigate them to preserve valuation and deal momentum.

1. Legal Red Flags: Contracts, Compliance, and Corporate Structure

Common Issues

• Unclear ownership of equity or cap table discrepancies
• Missing or poorly drafted customer, vendor, or employment agreements
• Non-compliance with data privacy laws (e.g., GDPR, CCPA)
• Pending or threatened litigation
• Improper entity formation or foreign subsidiary issues

Proactive Solutions

• Clean up your cap table: Ensure all equity grants, SAFEs, convertible notes, and option pools are properly documented and reconciled. If you’ve had multiple rounds of financing, consider a third-party cap table audit.
• Standardize contracts: Use consistent, lawyer-reviewed templates for customer and vendor agreements. Ensure all key contracts are signed, stored, and easily accessible.
• Review compliance posture: Conduct a privacy and compliance audit, especially if you handle user data. Buyers will expect clear policies and evidence of adherence to applicable regulations.
• Resolve legal disputes early: Even minor litigation can spook buyers. If possible, settle or disclose any legal matters with clarity and documentation.

As we noted in Completing Due Diligence Before the LOI, addressing these issues early can significantly reduce friction during the negotiation phase and increase buyer confidence.

2. Intellectual Property Red Flags: Ownership, Protection, and Infringement Risk

Common Issues

• Unclear IP ownership—especially from contractors or former employees
• Open-source software usage without proper licensing documentation
• Missing or expired trademarks, patents, or domain registrations
• Inadequate IP assignment agreements

Proactive Solutions

• Audit IP ownership: Confirm that all code, content, and inventions are owned by the company—not by freelancers, founders, or third parties. Ensure all contributors have signed IP assignment agreements.
• Document open-source usage: Maintain a clear inventory of open-source components and their licenses. Buyers will want to know you’re not exposed to copyleft risks (e.g., GPL).
• Register and renew IP assets: Ensure trademarks, patents, and domains are registered in the company’s name and are current. This is especially critical for SaaS and consumer-facing platforms.

Buyers often ask, “How do I protect my IP during buyer due diligence?” (source). The answer starts with having clean, well-documented IP ownership and usage policies in place long before diligence begins.

3. Financial Red Flags: Quality of Earnings, Revenue Recognition, and Accounting Practices

Common Issues

• Inconsistent or non-GAAP financials
• Improper revenue recognition—especially for SaaS or subscription models
• Deferred revenue not properly accounted for
• Unexplained fluctuations in margins or customer churn
• Commingled personal and business expenses

Proactive Solutions

• Prepare GAAP-compliant financials: Even if you’re not required to, aligning your financials with GAAP standards signals maturity. Consider a Quality of Earnings (QoE) report to validate your numbers.
• Clarify revenue recognition policies: SaaS companies should clearly define how and when revenue is recognized. Misalignment here can lead to valuation haircuts or earn-out structures.
• Separate personal and business expenses: Clean books are essential. If you’ve run personal expenses through the business, normalize them and be transparent in your financial disclosures.
• Track key SaaS metrics: Buyers will scrutinize metrics like ARR, MRR, CAC, LTV, and churn. Ensure your data is accurate and benchmarked. For more, see SaaS Key Performance Metrics and Valuation Multiples.

Financial red flags are among the most damaging because they directly impact valuation. As we’ve discussed in Website Valuation and Discretionary Earnings, buyers will discount for risk—and unclear financials are a major source of it.

4. Cultural and Operational Red Flags: The Intangibles That Matter

While not always documented, buyers increasingly assess cultural and operational fit. Red flags here include:

• Key person risk: If the business is overly reliant on a founder or CTO without a succession plan
• High employee turnover or poor Glassdoor reviews
• Inconsistent internal reporting or lack of KPIs

These issues can be addressed by building a strong second layer of leadership, documenting processes, and fostering a transparent, data-driven culture. Buyers want to see that the business can scale—and survive—without its founders at the helm.

Final Thoughts: Preparation Is the Best Defense

Red flags don’t always kill deals—but they do slow them down, reduce leverage, and often lead to price adjustments or unfavorable terms. The most successful exits we’ve advised at iMerge are those where founders took the time to anticipate buyer concerns and address them proactively.

Whether you’re 12 months from a sale or just beginning to explore your options, a pre-diligence audit across legal, IP, and financial areas is a smart investment. It not only protects value—it creates it.

Founders navigating valuation or deal structuring decisions can benefit from iMerge’s experience in software and tech exits — reach out for guidance tailored to your situation.