Customer Concentration Risk: Why It Matters

Financial due diligence gets all the attention. But legal issues can destroy a business acquisition just as fast—and they're often harder to fix.

Here's your complete legal due diligence checklist and exactly what to look for in each area.

## Why Legal Due Diligence Matters

**Real Examples:**

**Case 1:** Buyer purchased a restaurant for $400k. Three months later, discovered the seller was operating without proper health permits. City shut them down until compliance. Cost: $75k in lost revenue + $25k in fees.

**Case 2:** Buyer acquired a service business. Six months later, former employee sued for unpaid overtime going back 3 years. Seller knew, didn't disclose. Settlement: $140k.

**Case 3:** Buyer bought a retail store. Lease had a non-compete clause preventing sale of certain products. Major revenue stream eliminated overnight.

Legal problems you inherit can cost more than you paid for the business.

## Corporate Structure & Ownership

### 1. Verify Ownership

**Documents to Request:**
- Articles of incorporation / formation
- Operating agreement / bylaws
- Stock certificates or membership interests
- List of all shareholders/members
- Any buy-sell agreements

**What to Verify:**
- Seller actually owns what they're selling
- No disputes over ownership
- All equity is accounted for
- No outstanding claims or liens

**Red Flags:**
- Ownership structure is unclear
- Missing documentation
- Recent ownership changes
- Disputed ownership claims

### 2. Corporate Good Standing

**Check:**
- Business is properly registered
- Annual reports filed
- State business licenses current
- Tax clearance certificates available
- No dissolution or suspension

**Where to Look:**
- Secretary of State business database
- County clerk's office
- State revenue department
- Professional licensing boards

## Contracts

### 3. Customer Contracts

**Review All Active Contracts:**
- Terms and duration
- Termination clauses
- Change of control provisions
- Assignment restrictions
- Payment terms
- Performance obligations

**Key Questions:**
```
- Can contracts be assigned to new owner?
- Do customers have termination rights on ownership change?
- Any guaranteed pricing or terms?
- Volume commitments or minimums?
- Warranty or service obligations?
```

**Red Flags:**
- Change of control termination rights
- Cannot be assigned
- Below-market pricing locked in
- Major obligations remaining

### 4. Vendor/Supplier Contracts

**Review:**
- Supply agreements
- Exclusive supplier arrangements
- Volume commitments
- Pricing terms
- Assignment provisions

**Watch For:**
- Exclusive dealing requirements
- Minimum purchase obligations
- Personal guarantees required
- Vendor financing outstanding

### 5. Lease Agreements

**Critical Review Areas:**
```
- Expiration date and renewal options
- Rent and escalation terms
- Assignment and sublease restrictions
- Landlord approval requirements
- Personal guarantees
- Permitted use restrictions
- Maintenance and repair obligations
- Early termination provisions
```

**Must Do:**
- Read complete lease, not just summary
- Talk directly to landlord
- Get landlord consent in writing
- Understand renewal terms
- Check property tax and CAM charges

**Deal Breakers:**
- Lease expires soon with no renewal option
- Landlord won't approve assignment
- Above-market rent with long term
- Non-compete clauses affecting business
- Landlord planning redevelopment

### 6. Employment Agreements

**Review:**
- Key employee contracts
- Non-compete agreements
- Severance obligations
- Commission structures
- Bonus plans
- Benefits packages

**Key Issues:**
- Change of control provisions
- Severance triggered by sale
- Golden parachute payments
- Non-compete enforceability

## Litigation & Disputes

### 7. Pending Litigation

**Request Complete Disclosure:**
- All pending lawsuits
- Threatened claims
- Demand letters received
- EEOC or labor claims
- Customer disputes
- Vendor disputes
- Insurance claims

**Don't Accept:** "There's nothing significant."

**Do:** Get signed representation that there are NO claims or disputes of any kind.

### 8. Litigation History

**Check Public Records:**
- County court records
- Federal court PACER system
- State appellate court records
- Arbitration awards (if available)

**Look for Patterns:**
- Frequent customer lawsuits
- Employee claims
- Vendor disputes
- Regulatory actions

**Red Flags:**
- Pattern of similar claims
- Recent uptick in litigation
- Undisclosed judgments
- Liens on business assets

## Regulatory Compliance

### 9. Licenses & Permits

**Verify All Required Licenses:**

**Business Operations:**
- General business license
- Professional licenses
- Industry-specific permits
- Health permits
- Building permits
- Fire safety permits
- Signage permits
- Zoning approval

**Professional Requirements:**
- Individual professional licenses
- Continuing education current
- No disciplinary actions
- Board certifications

**Status Check:**
- All current and not expired?
- Any pending renewals?
- Any violations or citations?
- Can licenses be transferred?

### 10. Industry Regulations

**Depending on Industry, Check:**

**Food Service:**
- Health department inspections
- Food handler certifications
- Alcohol licenses
- Violation history

**Healthcare:**
- Medicare/Medicaid enrollment
- HIPAA compliance
- Professional liability insurance
- Board certifications

**Manufacturing:**
- Environmental permits
- OSHA compliance
- EPA regulations
- Waste disposal permits

**Retail:**
- Sales tax permit
- Seller's permit
- Product safety compliance
- Import/export compliance

## Employment Law

### 11. Employee Classification

**Review:**
- Employee vs. independent contractor status
- Exempt vs. non-exempt classification
- Overtime calculations
- Break policies

**Why It Matters:** Misclassification can trigger:
- Back wages and overtime
- Tax penalties and interest
- Benefits obligations
- Government fines

**How to Check:**
- Review IRS Form SS-8 test
- Compare job duties to classification
- Check time records
- Review payment methods

### 12. Employment Practices

**Document Review:**
- Employee handbook
- Hiring/firing procedures
- Discrimination policies
- Sexual harassment policies
- Safety procedures
- Wage and hour compliance

**Compliance Check:**
- I-9 forms on file (all employees)
- W-2 vs. 1099 appropriate
- Workers comp coverage
- Required posters displayed
- OSHA compliance
- ADA accommodations

### 13. Potential Claims

**Look for:**
- Recent terminations (potential claims?)
- Discrimination complaints
- Wage and hour violations
- Safety violations
- Unreported injuries
- Harassment complaints

## Intellectual Property

### 14. Trademarks & Trade Names

**Verify:**
- Business name available to use
- Trademarks properly registered
- No infringement claims
- Who owns the IP (business or individual?)

**Search:**
- USPTO trademark database
- State trademark registers
- Common law usage
- Domain name registrations

### 15. Patents & Copyrights

**For Tech or Content Businesses:**
- Patent portfolio review
- Patent validity
- Copyright registrations
- Software licenses
- Work-for-hire agreements
- Employee IP assignment agreements

### 16. Proprietary Information

**Verify Protection of:**
- Customer lists
- Supplier relationships
- Recipes/formulas
- Processes and methods
- Software and systems
- Marketing materials

**Check:**
- Non-disclosure agreements in place
- Employee confidentiality agreements
- Access controls
- Trade secret protection

## Environmental & Safety

### 17. Environmental Compliance

**If Property or Manufacturing:**
- Phase I environmental assessment
- Hazardous materials storage
- Waste disposal records
- Underground storage tanks
- Asbestos or lead paint
- Soil contamination

**Liability Risk:**
- Current owner liability
- Successor liability
- Cleanup costs
- Government enforcement

### 18. OSHA & Safety

**Review:**
- OSHA inspection history
- Citations and violations
- Safety training records
- Incident reports
- Workers comp claims history

**Warning Signs:**
- Frequent violations
- Serious or willful citations
- Repeat offender
- High injury rate

## Tax Compliance

### 19. Tax Status

**Verify:**
- All tax returns filed
- No outstanding tax liabilities
- Tax clearance certificates
- No liens or levies

**Check:**
- Federal income tax
- State income tax
- Sales tax
- Payroll taxes
- Property taxes
- Excise taxes (if applicable)

### 20. Sales Tax

**Critical for Retail/E-commerce:**
- Registered in all required states
- Nexus analysis complete
- All sales tax collected and remitted
- No outstanding audits
- Returns filed on time

## Insurance

### 21. Coverage Review

**Verify Adequate Coverage:**
- General liability
- Property insurance
- Workers compensation
- Professional liability (E&O)
- Product liability
- Cyber liability
- Business interruption
- Key person insurance

**Check:**
- Coverage amounts appropriate?
- All assets covered?
- No coverage gaps?
- Claims history

### 22. Claims History

**Request:**
- 5-year loss runs
- All insurance claims filed
- Pending claims
- Denied claims

**Analyze:**
- Frequency of claims
- Types of claims
- Resolved vs. pending
- Pattern of issues

## Your Legal Due Diligence Checklist

### Phase 1: Document Collection
- [ ] Corporate formation documents
- [ ] All contracts (customer, vendor, lease, employment)
- [ ] Litigation disclosure
- [ ] License and permit copies
- [ ] Insurance policies
- [ ] Employee handbook
- [ ] IP documentation

### Phase 2: Verification
- [ ] Public record searches
- [ ] License status checks
- [ ] Litigation searches
- [ ] Tax clearance certificates
- [ ] Insurance certificate verification
- [ ] Landlord communication

### Phase 3: Professional Review
- [ ] Attorney review of contracts
- [ ] Environmental assessment (if needed)
- [ ] IP attorney review (if significant IP)
- [ ] Employment attorney review (if complex)
- [ ] Tax attorney review (if issues found)

## Red Flags That Should Stop the Deal

**Critical Issues:**
- ✗ Seller won't disclose litigation
- ✗ Missing critical licenses/permits
- ✗ Lease cannot be assigned
- ✗ Pending government investigation
- ✗ Major environmental liability
- ✗ Fraudulent practices discovered
- ✗ Non-compete clauses affecting operations

## Protection Strategies

### In the Purchase Agreement:

**1. Representations & Warranties:**
```
Seller represents and warrants:
- No pending or threatened litigation
- All licenses current and transferable
- No violations of laws or regulations
- All contracts disclosed and assignable
- No environmental liabilities
- Compliance with employment laws
- All taxes paid and returns filed
```

**2. Indemnification:**
Seller indemnifies buyer for:
- Undisclosed liabilities
- Pre-closing legal issues
- Breach of representations
- Environmental cleanup

**3. Escrow/Holdback:**
- Hold 10-20% of purchase price
- For 12-24 months
- Covers discovered issues

### Due Diligence Contingencies:

**Make offer contingent on:**
- Satisfactory legal review
- No material issues discovered
- All licenses transferable
- Landlord consent obtained
- No undisclosed litigation

## Cost of Legal Due Diligence

**Budget Guide:**

**Basic Review:** $3,000-$5,000
- Contract review
- Public record searches
- License verification

**Standard Review:** $5,000-$10,000
- Everything in basic
- Detailed employment review
- IP assessment
- Regulatory compliance review

**Complex Review:** $10,000-$25,000
- Everything in standard
- Environmental assessment
- Detailed IP portfolio review
- Multi-state compliance
- Complex regulatory issues

**Worth It?** Legal issues can cost 10x-100x the due diligence cost.

## Working With Your Attorney

**Hire:**
- Business attorney with M&A experience
- Local attorney familiar with state laws
- Industry specialist if needed

**Provide:**
- All documents from seller
- Your concerns and questions
- Deal structure and timeline
- Budget for legal review

**Ask For:**
- Prioritized list of issues
- Risk assessment (high/medium/low)
- Recommendations for each issue
- Estimated costs to resolve

## The Bottom Line

Legal due diligence isn't just paperwork—it's protection. Hidden legal issues can:
- Shut down operations
- Trigger lawsuits
- Cost hundreds of thousands to resolve
- Make the business worthless

**Don't skip it. Don't rush it. Don't do it yourself.**

Hire professionals, invest the time and money, and verify everything before you close.

## Your Next Steps

1. **Download Our Legal Due Diligence Checklist:** Complete list of what to check
2. **Get Our Document Request Template:** Request list for seller's attorney
3. **Use Our Complete Guide:** Detailed legal due diligence procedures

Legal due diligence might seem expensive, but buying a business with hidden legal problems is far more costly.