Every successful business owner has ambition to grow, scale, and take his/her company to the next level. However, there’s one critical, often overlooked aspect that can make or break a business’s ability to get to that level: legal documentation. As advisors to private equity firms and small businesses alike, we know that seizing opportunities is crucial for businesses looking to grow.
Whether your business is a startup or well-established, ensuring that the company’s legal paperwork—whether it be contracts with outside parties, partners, or employees—is essential to successfully attract outside investment. While it is tempting to focus solely on revenue growth, strategic expansion, and increased profitability, poor quality, ambiguous, or disorganized corporate documentation can severely limit your ability to scale, attract investors, or successfully exit.
The Silent Killer of Deals: Incomplete or Poorly Prepared Legal Documents
What is often overlooked by business owners is that serious investors expect to see—in addition to a promising business model—a competently organized legal structure supported by a comprehensive paper trail. Moreover, as businesses grow, the complexity of their operations and relationships increases; and, while businesses often focus on achieving their business objectives, tidying up the company’s legal foundation can fall by the wayside.
During the due diligence process, outside capital will conduct a thorough review of all the business’s corporate records. If your organizational documents, intellectual property agreements, or employee contracts are disorganized, incomplete, or poorly drafted, it raises concerns about potential risks and liabilities for many reasons. First and foremost, investors might assume that an oversight in the organization’s legal documentation could indicate a broader tendency to cut corners in business operations. This undermines any efforts to market the organization as a well-oiled operation, while also compromising the company’s and its principals’ credibility, regardless of sincerity. Second, and perhaps more importantly, sloppy paperwork gives rise to contingent or undisclosed liabilities. Below are some hypothetical examples where legal paperwork can jeopardize business transactions.
Hypothetical example: A private equity firm is set to acquire a mid-sized manufacturing company. During due diligence, it is discovered that the company’s legal documentation failed to disclose a series of contingent liabilities related to a long-standing legal dispute with a supplier. The firm walks away from the deal, citing the inability to trust the accuracy of the company’s financial and legal records.
Hypothetical example: A venture capital firm considers a major investment in a startup. However, the company’s shareholder agreement contained unclear clauses regarding intellectual property ownership and equity dilution rights. After prolonged attempts to clarify the agreements, the VC firm renegotiates the investment at a significantly lower valuation, citing the risk posed by potential legal disputes.
Hypothetical example: A multinational corporation plans to acquire a fintech startup. The legal due diligence revealed that the startup’s contracts with key clients did not comply with financial services regulations, rendering them potentially void. The acquiring company demands renegotiated terms, including a substantial escrow holdback to account for regulatory compliance risks.
Hypothetical example: An investor group is in talks to fund a logistics company. During review, it became apparent that several key client contracts were unsigned or improperly executed, leaving revenue streams unprotected. The investors withdraw their nonbinding offer to fund, citing inadequate legal safeguards for their investment.
Hypothetical example: A strategic acquirer discovers that a seller’s financial statements rely on accounting practices inconsistent with the representations in the purchase agreement. In other words, the legal documents failed to align representations with the company’s actual practices. The deal collapses, with the acquirer citing a breach of trust in the due diligence process.
Hypothetical example: A software company’s acquisition includes an earnout provision contingent on future revenue milestones. The earnout clause in the contract is vague, failing to specify calculation methods or what constituted eligible revenue. In the best case, the diligent acquirer postpones the deal until the clause is rewritten, leading to delayed closing and revised terms unfavorable to the seller.
The same concept holds true for potential business partners. When forming or expanding joint ventures, partnerships, or other strategic alliances, clear, enforceable, and well-drafted agreements are critical to prevent misunderstandings. For example, a thriving company that has an operating agreement which does not sufficiently address key provisions like adding new partners, transferring ownership, handling disputes, or dividing profits and losses, leaves the company vulnerable to unnecessary (and costly) risks that could have easily been avoided had the original founding documents of the company been revisited. If a partner believes that he or she can freely syndicate their interest in the company and does so, then it could trigger defaults on behalf of the company in the event that such transfer violates a covenant or restriction in a financing agreement. Businesses that lack buttoned-up agreements and well-maintained records are simply not attractive partners, no matter how strong their growth potential may be.
Imagine you’re negotiating a major investment in your company from a potential capital partner. The partner is prepared to offer a premium for its stake, but they uncover inconsistencies in the corporate structure—as it turns out, you failed to properly paper a conversion from debt to equity, and the stake that the capital partner has is diminished.
The examples above are illustrative of real-life examples that attorneys witness on a daily basis and vary dramatically in scale depending on the company. Here are some real-life examples where insufficient legal documentation resulted in a failed or dramatically reduced value of the underlying transaction:
(2017): Verizon initially agreed to acquire Yahoo’s core internet business for $4.83 billion. However, after Yahoo disclosed two massive data breaches affecting over a billion user accounts, Verizon raised concerns about the adequacy of Yahoo’s due diligence and its disclosure of risks. Verizon renegotiated the deal, reducing the purchase price by $350 million. The breaches highlighted Yahoo’s inadequate handling of cybersecurity and legal responsibilities, impacting the valuation.[1]
(2020): LVMH agreed to acquire Tiffany & Co. for $16.2 billion. During the process, LVMH tried to back out, citing poor financial performance by Tiffany during the COVID-19 pandemic and regulatory issues in France that delayed the closing. While not purely a legal documentation issue, the attempt to terminate the deal involved scrutiny of Tiffany’s disclosures and legal obligations under the agreement. While the deal eventually went through, the final price was lowered by $425 million after renegotiation.[2][3]
(2019): SoftBank had committed to a significant investment in WeWork and was expected to follow through with a $3 billion share buyout. However, during due diligence, it became apparent that WeWork’s governance documents were poorly structured, allowing excessive power to CEO Adam Neumann and creating conflicts of interest. Additionally, key liabilities and losses were not clearly disclosed. SoftBank pulled out of the $3 billion buyout and scaled back its investment, citing legal and governance concerns.[4]
(2020): Sycamore Partners agreed to buy a 55% stake in Victoria’s Secret from L Brands for $525 million. During the COVID-19 pandemic, Sycamore claimed that L Brands had violated terms of the deal by furloughing employees and failing to maintain operations as usual. Sycamore used the alleged breaches to terminate the deal, leveraging ambiguities in the legal documentation regarding material adverse effects.[5]
Preparation Today, Growth Tomorrow
During and after due diligence is when we, as attorneys, often see significant changes in deal structuring—often once it becomes too costly for a small business to walk away. The obvious change is a price reduction, but beyond direct financial consequences, the more prepared party to the transaction (likely an acquiring company or an established partner) may (rightfully) demand additional representations and warranties, indemnities, exculpation, management rights, and securitization. In our experience, businesses that proactively ensure their legal documentation is accurate, up to date, and comprehensive are better positioned for smooth and profitable scaling, and any business without its legal documentation in order always has a distinct disadvantage.
Conclusion
It is not often that a business starts with all their legal paperwork in perfect order. Many startups and small businesses focus first on establishing their roots, particularly when they are built with sweat equity, whether that be through landing material vendors, obtaining the necessary permits, or securing office space. It may be that a business has experienced hypergrowth and does not have the manpower, or the principals do not have the time and energy, to focus on graduating to the next level in terms of their organizational documents. However, as businesses reach new milestones, its legal documentation must evolve alongside it.
Bottom line: What seems like a minor oversight today can have profound consequences down the line.
Opportunistic business owners and founders simply cannot afford to wait until a critical moment to discover that the organization’s documentation is holding them back. A strategic review of your company’s legal documentation today ensures that your business is prepared for whatever comes next—whether that’s a new round of funding, a strategic partnership, or a leveraged exit. By addressing potential issues today, you’re not only protecting your business from future risks but also positioning it for growth and success.
[1] https://www.reuters.com/article/business/verizon-yahoo-agree-to-lowered-448-billion-deal-following-cyber-attacks-idUSKBN1601EK/
[2] https://www.reuters.com/world/europe/tiffany-shareholders-back-lvmh-takeover-ending-long-drawn-dispute-2020-12-30/
[3] https://www.bbc.com/news/business-54732132
[4] https://www.vox.com/recode/2019/9/23/20879656/wework-mess-explained-ipo-softbank
[5] https://www.reuters.com/article/business/l-brands-sycamore-agree-to-call-off-victorias-secret-deal-idUSKBN22G2TR/
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