Due Diligence Found a Problem: Should the Buyer Reduce the Price, Demand an Indemnity, Use Escrow or Walk Away?

When due diligence finds a problem, the buyer’s next step should not be “add another warranty”.

The right response depends on what kind of problem it is.

A known tax exposure may justify a specific indemnity. A customer contract that can terminate on change of control may need consent before completion. A disputed liability with an uncertain value may justify escrow. A permanent regulatory defect may justify a lower price — or no deal at all.

The key is to turn the due-diligence finding into a transaction decision, not leave it buried in a report.

For the wider agreement this decision sits inside, see our guide to share purchase agreements in Malaysia.

Start by classifying the problem

Before choosing a contractual remedy, ask five questions.

1. How certain is the risk? Is it an actual liability, a likely exposure or merely a possibility?

2. Can the amount be estimated? Is the downside RM100,000, RM10 million or impossible to quantify?

3. When could it crystallise? Before completion, shortly after, or over several years?

4. Can the seller fix it? Some issues can be cured before closing; others cannot.

5. Does it undermine the reason for buying the company? A defect affecting the target’s key licence, major customer or core IP can be fundamentally different from a manageable historical liability.

Those questions usually point toward the right commercial tool.

If you need the investigation framework first, see our guide to due diligence in mergers, acquisitions and business transactions.

Use a price reduction when the problem permanently reduces value

A price adjustment is often appropriate where the issue does not need to be “claimed” later because its effect on value is already known.

Examples can include:

• lower sustainable earnings than represented;

• a customer loss that has already occurred;

• required capital expenditure that the buyer will definitely have to incur;

• an asset shown in the valuation that is not actually available to the company; or

• a structural weakness that permanently changes expected cash flow.

The buyer should not pay full value and then rely on a future claim for a problem it already knows is embedded in the economics.

A price reduction is clean, but it also transfers the future upside and downside to the buyer. If the eventual loss could be much larger than the amount priced in, a price adjustment alone may not be enough.

Use a specific indemnity for an identified liability

A specific indemnity is often suited to a known risk where the buyer agrees to proceed but wants the seller to bear the financial consequence if that identified exposure crystallises.

Examples can include:

• an existing tax audit;

• identified litigation;

• a known regulatory breach;

• unpaid employee entitlements;

• a specific environmental remediation issue; or

• a pre-completion contractual claim.

The indemnity should identify the risk precisely enough that the parties know what loss it covers, who controls any third-party claim, what mitigation obligations apply and whether any financial or time limits apply.

For the broader distinction between warranties and indemnities, see our guide to warranties in a share purchase agreement.

Use retention or escrow when recourse security matters

A perfect indemnity is not much use if the seller has distributed the sale proceeds and cannot satisfy a later claim.

Retention or escrow can solve a different problem: not whether the buyer has a claim, but whether money will be available if the claim succeeds.

This can be useful where:

• the risk is significant but uncertain;

• the seller is an individual or special-purpose vehicle that may not retain assets;

• the parties expect the issue to resolve within a defined period; or

• there is a gap between the seller’s promised liability and its post-completion financial capacity.

The SPA should define the amount, holder, permitted claims, release schedule, dispute procedure and whether the escrow is exclusive security or merely one source of recovery.

Use a condition precedent when the problem should be fixed before you become owner

Some risks are not suitable for compensation after completion.

If the buyer needs a key licence, landlord consent, financing consent, release of security or third-party approval to operate the business as intended, the better answer may be: do not complete until the issue is resolved.

A condition precedent is particularly important where money cannot realistically compensate for failure.

For example, if the target’s largest customer can terminate on change of control and that customer represents most of the target’s revenue, the buyer may prefer consent before completion rather than a later damages claim against the seller.

Use a pre-completion covenant when the seller can cure the issue

A due-diligence finding may be real but fixable.

The SPA can require the seller or target to take a specific action before completion, such as:

• regularising a licence or filing;

• settling an intercompany balance;

• obtaining a release;

• renewing an important contract;

• documenting ownership of IP; or

• terminating an unauthorised related-party arrangement.

The covenant should be objective enough that completion is not followed by an argument about whether the seller “used reasonable efforts” but never delivered the intended result.

Use warranties for facts that still need contractual assurance

Not every due-diligence risk is fully knowable.

The buyer may have reviewed available documents but still need the seller to confirm facts within the seller’s knowledge or control — for example, that there are no undisclosed claims, no unrecorded related-party arrangements or no material breaches of specified contracts.

That is where warranties remain useful.

But once a specific problem is already known and priced, a generic warranty may be too indirect. The drafting should reflect what due diligence actually found.

Use a post-completion covenant when the issue can only be resolved later

Some matters cannot be completed before closing but are still capable of being managed.

A seller may need to assist with a tax audit, transition a licence, cooperate in litigation, introduce customers, obtain a historical document or finish a restructuring step after completion.

In that case, the SPA should define the post-completion obligation, deadline, cooperation standard and consequence of non-performance.

If the obligation is commercially important, the buyer may also link part of the consideration or escrow release to completion of that action.

Walk away when the problem destroys the acquisition thesis

Not every problem should be priced or insured contractually.

A buyer should seriously reconsider the deal where the finding means:

• the target cannot lawfully operate its core business;

• the key asset or IP is not owned or cannot be transferred as assumed;

• the business depends on a customer or licence likely to disappear at completion;

• the seller will not provide credible recourse for a material identified liability;

• the financial information is unreliable enough that value cannot be determined; or

• the risk exceeds the buyer’s capacity or strategic appetite even after repricing.

Due diligence is valuable partly because it gives the buyer permission to stop.

Sometimes the answer is a combination

A material issue can justify more than one protection.

For example, a tax dispute might produce:

• a price reduction for the expected liability;

• a specific indemnity for any amount above that assumption;

• escrow to secure payment; and

• a covenant giving the seller conduct rights or cooperation obligations in the audit.

That does not mean the buyer should recover twice for the same loss. The SPA needs coherent rules on overlap, mitigation, insurance, tax benefits and other recoveries.

Three worked examples

Example 1 — missing change-of-control consent: the target’s largest contract permits termination if control changes. The buyer should first assess commercial concentration and whether consent can be obtained. If the contract is deal-critical, consent may be a condition precedent rather than merely a warranty.

Example 2 — historical tax exposure: due diligence identifies an ongoing audit for a pre-completion period. The buyer may proceed with a specific tax indemnity and retain part of the purchase price until the audit is resolved.

Example 3 — overstated earnings: the target’s normalised EBITDA is lower than the figure used to agree price because one-off revenue was treated as recurring. The issue is valuation, not merely breach. The buyer may need to renegotiate price rather than rely on a future claim.

Buyer decision matrix

Frequently asked questions

Is an indemnity always better than reducing the price?

No. A price reduction may be cleaner where the problem already reduces value. An indemnity may be more suitable for a contingent liability that may or may not crystallise.

Should escrow be used for every indemnity?

No. Escrow is a security mechanism with cost and negotiation consequences. It is most useful where the buyer has a real concern about future recoverability.

Can a due-diligence issue be dealt with only by disclosure?

Disclosure tells the buyer about an exception and may qualify warranty liability. It does not by itself compensate the buyer or fix the underlying problem.

When should a buyer walk away?

When the problem makes the target unlawful, commercially non-viable, impossible to value reliably, or outside the buyer’s risk appetite even after available protections are considered.

This article is for general information only and does not constitute legal advice. Every transaction and every set of facts is different. Obtain specific advice from a qualified adviser before acting on any part of it.

Legal That Works can help a buyer convert due-diligence findings into price terms, conditions precedent, indemnities, escrow arrangements and other SPA protections through our Share Sale and Purchase Agreement service.