From Red Flag to Resolution: How Due Diligence Issues Get Negotiated Away
A red flag in due diligence is rarely a deal-breaker on its own; what matters is how buyers and sellers negotiate it into the contract.
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The flag is only the start of the conversation
When due diligence turns up a problem, whether it is an unassigned lease, a missing consent, a dormant employment claim or a gap in IP ownership, the discovery itself is only the opening move. Deal lawyers spend far more time deciding what to do about a red flag than they spend finding it. The report that lists the issue is a snapshot; the real work is turning that snapshot into contractual protection, a price adjustment, or a decision to walk away.
This matters because most red flags do not kill deals. Buyers who expect every finding to be pristine are usually disappointed. Almost every target has some historic untidiness: an expired licence that was quietly renewed late, a contract that technically needed a change-of-control consent that nobody sought, a director’s loan that was never properly documented. The question for the deal team is whether the issue is material, whether it is fixable before completion, and if not, how the risk should sit between buyer and seller afterwards.
Materiality and triage
Not every flag deserves the same response. Due diligence teams typically triage findings by likely financial exposure, legal risk and how easily the point can be resolved before signing. A red flag that could unwind the core commercial rationale for the deal, such as a key customer contract being terminable on change of control, gets escalated immediately to the deal principals. A flag with a small, quantifiable cost, such as an unpaid but modest historic liability, is often simply priced into the deal.
This triage process is where in-house counsel, external lawyers and the client’s finance team have to work together. Lawyers identify the legal risk and its rough shape; the finance side attaches a number to it; the commercial team decides whether that number is tolerable against the strategic case for doing the deal at all.
Disclosure: putting the seller on record
One of the main tools for dealing with a known issue is disclosure. Sellers give warranties in the sale agreement, promises about the state of the business, and disclosure is the mechanism by which they qualify those promises against known facts. If a red flag has been identified and properly disclosed against a specific warranty, the buyer generally cannot later claim damages for breach of that warranty in relation to the disclosed matter, because they went into the deal with their eyes open.
This is why disclosure letters and disclosure bundles are fought over so hard. Sellers want broad, general disclosure that captures everything uncovered in due diligence. Buyers want narrow, specific disclosure that forces the seller to flag each issue individually against the precise warranty it affects, so nothing is buried in a general data room reference. How a red flag is disclosed, generally or specifically, has a direct financial consequence if the problem later crystallises.
Warranties, indemnities and price mechanics
Where disclosure is not enough to satisfy the buyer, a red flag is usually addressed through one of three contractual tools. A specific indemnity is a pound-for-pound promise to compensate the buyer if a named risk materialises, used for well-defined, quantifiable exposures such as a known tax liability or ongoing litigation. A specific warranty with no disclosure against it shifts general risk onto the seller for an area of concern, useful where the exposure is harder to quantify. And a straightforward price adjustment, sometimes routed through a retention or escrow of part of the purchase price, deals with issues that can be estimated but not eliminated before completion.
Escrow arrangements are common precisely because they let a deal proceed without either side having to fully resolve a red flag first. A portion of the price sits with a third party for an agreed period, released to the seller if the flagged risk does not materialise, or paid out to the buyer if it does.
When a flag becomes a walk-away issue
Some findings cannot be priced or indemnified away. A target that turns out not to own the IP central to its business, or a regulatory breach that puts a licence at risk, can undermine the entire commercial logic of the transaction. In those cases the red flag report feeds directly into the decision whether to proceed at all, sometimes leading to a restructured deal, a materially reduced price, or termination of negotiations. Lawyers on both sides will usually flag these issues early and escalate them outside the normal weekly reporting cycle, because they affect whether the deal happens rather than how it is priced.
Why this process matters beyond the deal
How red flags are resolved shapes the post-completion relationship between buyer and seller, and often determines whether disputes arise later. A well-drafted disclosure letter and carefully scoped indemnities reduce the chance of expensive post-completion litigation over what was or was not known at signing. For anyone involved in a transaction, understanding that a red flag report is the beginning of a negotiation, not a verdict, helps set realistic expectations about deal timetables and pricing.
For general guidance on the legal profession’s approach to transactional work, the Law Society and the SRA both publish material aimed at helping businesses understand what solicitors do during a deal.