Avoid private equity deal delays in UK SMEs. Learn the legal issues that derail investment and get practical steps to prepare—read the guide and protect your timetable.

Private Equity Investment in UK SMEs: Common Legal Issues that Delay or Derail Deals

Callum Ritchie February 25, 2026

Private equity investment plays a critical role in the growth of UK SMEs. It provides expansion capital, facilitates management buy-outs, supports acquisitions and, in some cases, enables founders to realise part of their investment while retaining control.

Yet despite commercial alignment between investors and business owners, many private equity transactions are delayed, restructured at the last minute, or abandoned entirely due to legal issues that emerge during the process.

Most of these problems are not dramatic or unusual. They are predictable. They arise from historic documentation gaps, informal business practices, or misunderstandings about how private equity investors approach risk allocation and governance.

This article explores the most common legal issues that delay or derail private equity investment in UK SMEs, why they matter to investors, and how business owners can address them proactively.

Misaligned Shareholder Structures and Incomplete Constitutional Documents

One of the earliest areas investors scrutinise is the company’s constitutional framework. For many SMEs, this is also where the first complications arise.

Outdated or inadequate Articles of Association
Articles of Association govern how a company is run, how shares operate and how decisions are made. In early-stage SMEs, it is common to adopt the standard model articles under the Companies Act 2006, sometimes with minor amendments. While suitable for small, closely held companies, these articles are rarely fit for purpose in a private equity-backed structure.

Private equity investors typically require:

Multiple share classes with clearly defined economic and voting rights
Robust drag-along and tag-along provisions to control exit mechanics
Compulsory transfer provisions for “bad leavers”
Reserved matters requiring investor consent
Clear dividend policies and distribution controls

Where the existing articles do not contain these provisions, they must be amended or entirely replaced. Amending articles requires shareholder approval, usually by special resolution. If minority shareholders perceive that their rights are being diluted or rebalanced, they may resist changes.

A common flashpoint involves drag-along rights. Investors will insist that, if a specified majority wishes to sell the company, minority shareholders must also sell on the same terms. This ensures a clean exit. However, where existing shareholders have never contemplated being forced to sell, introducing drag-along rights can create tension.

Similarly, compulsory transfer provisions linked to employment status can generate debate. Private equity investors expect that if a manager leaves the business in certain circumstances, they must transfer their shares, often at a discount. If the current articles are silent on this, the introduction of detailed leaver provisions can feel like a significant cultural shift.

When these constitutional revisions are identified late, the deal timetable compresses. What could have been a planned restructuring exercise becomes a reactive negotiation under commercial pressure.

Historic informal arrangements between founders
In many SMEs, the founding team operates on trust. Early contributions, sweat equity, and personal risk-taking are often understood rather than documented. While this informal approach may have supported growth in the early years, it introduces uncertainty at the point of institutional investment.

Without a comprehensive shareholders’ agreement, key issues may never have been formally agreed, including:

How profits are distributed
What happens if a founder leaves
How disputes are resolved
Whether shares can be transferred freely
The intended timing and method of exit

Over time, different founders may form different assumptions about these matters. One founder may view private equity as a stepping stone to a five-year exit. Another may see it as long-term growth capital while retaining family control. These assumptions only surface when heads of terms are negotiated.

From an investor’s perspective, internal misalignment represents risk. If founder disagreements emerge during due diligence, the investor may question whether the management team can operate cohesively post-investment.

Informal understandings also create technical issues. For example, a founder may have “promised” equity to a senior employee without documenting it. Another may have agreed verbally that a family member holds shares on trust. These arrangements, once surfaced, must be formalised or unwound before completion.

In some cases, historic informal arrangements expose deeper legal risks. A founder who contributed intellectual property before incorporation may never have formally assigned it to the company. If that founder’s ongoing role becomes uncertain during negotiations, ownership of critical assets can be questioned.

Resolving these issues often requires delicate negotiation between founders before the investor can proceed with confidence.

Unclear share ownership or missing paperwork
A clean capitalisation table, commonly referred to as a cap table, is fundamental in private equity transactions. It sets out who owns what, on what terms and subject to which rights.

In practice, SMEs frequently encounter technical deficiencies, including:

Missing or incorrectly issued share certificates
Share transfers that were agreed but never formally documented
Failure to update the register of members
Incorrect filings at Companies House
Discrepancies between statutory registers and actual ownership

These issues may have accumulated over years of growth, particularly where administrative responsibility was not centralised.

For example, if shares were purportedly transferred without proper board approval or without complying with pre-emption rights, the validity of that transfer may be questioned. Rectification may require ratification resolutions, indemnities, or in more complex cases, court applications.

Private equity investors are particularly sensitive to uncertainty over title to shares. They need assurance that they are investing into a company with clear, undisputed ownership. If historic paperwork gaps suggest otherwise, investors may widen the scope of due diligence or require additional warranties.

Missing statutory records can also signal governance weaknesses. Investors often interpret poor record-keeping as indicative of broader operational informality.

Pre-emption rights and historic allotments

Another recurring issue involves pre-emption rights on the issue of new shares. Under the Companies Act 2006, existing shareholders generally have statutory pre-emption rights, meaning they must be offered new shares before those shares are offered to third parties, unless those rights are disapplied.

In fast-growing SMEs, shares are sometimes issued without properly disapplying these rights or without complying with procedural requirements. If such historic allotments are defective, investors may question the validity of issued share capital.

Regularising past allotments can require shareholder resolutions which can cause delay, particularly where multiple funding rounds occurred informally.

Due Diligence Red Flags

Legal due diligence is not designed to find perfection. It is designed to identify risk. However, certain findings consistently create disproportionate delays.

Undocumented related-party transactions

SMEs frequently enter into arrangements with connected individuals or entities. These might include:

Directors leasing property to the company
Family members providing consultancy services
Sister companies sharing staff or resources
Founders receiving loans or advances
Informal cost-sharing between group entities

In many cases, these arrangements began when the business was small and trust-based. Formal contracts were seen as unnecessary. However, from an investor’s perspective, related-party transactions raise two key concerns: transparency and fairness.

First, investors need to understand whether the company’s reported financial performance reflects genuine third-party trading or includes transactions that could be altered or withdrawn post-investment. If, for example, the company pays below-market rent to a director’s property company, profitability may be overstated.

Second, there is a governance dimension. The Companies Act 2006 imposes duties on directors to avoid conflicts of interest and to promote the success of the company. If related-party arrangements have not been formally approved or documented, investors may question whether those duties have been properly considered.

Regularising these arrangements often involves:

Preparing formal written contracts on arm’s length terms
Benchmarking pricing to market standards
Ensuring conflicts are declared and recorded in board minutes
In some cases, terminating or restructuring the arrangement entirely

This process can disrupt financial modelling. If historic arrangements are adjusted to reflect market pricing, EBITDA may change. That, in turn, affects valuation discussions and debt structuring.

Where related-party transactions are extensive or poorly documented, investors may widen the scope of warranties or seek specific indemnities. That can shift risk back onto founders and delay agreement on the final share purchase agreement.

Unresolved litigation or regulatory exposure

Disputes and regulatory issues are among the most commercially sensitive findings in due diligence. The issue is not simply whether a claim exists, but whether its financial and reputational impact can be reliably assessed.

Examples commonly encountered in SME transactions include:

Ongoing employment tribunal claims
Contractual disputes with key customers or suppliers
Intellectual property infringement allegations
HMRC enquiries
Regulatory investigations in licensed sectors

From an investor’s perspective, unresolved disputes present three distinct risks:

Financial uncertainty. If damages or settlement values cannot be quantified, valuation discussions become complicated.
Management distraction. Ongoing litigation can divert leadership attention at a time when growth plans require focus.
Reputational risk. Regulatory findings or adverse publicity may affect future fundraising or exit prospects.

Where exposure is relatively minor and quantifiable, the issue is usually managed through warranties and indemnities. For example, sellers may provide a specific indemnity covering losses arising from a known claim.

In more material cases, investors may require:

A price reduction reflecting estimated liability
An escrow arrangement, where part of the purchase price is held back pending resolution
A deferred consideration structure
Completion conditional upon settlement of the dispute

If the exposure is both material and uncertain, the deal may pause. Investors are unlikely to proceed if they cannot assess downside risk within acceptable parameters.

Regulatory exposure can be particularly complex. In regulated sectors such as financial services or healthcare, an investigation may trigger mandatory disclosure obligations or affect licence status. Where regulatory approval is required for a change of control, any ongoing investigation may lengthen approval timelines.

The key factor is predictability. Investors can work with risk that is identified and quantified. They struggle with risk that is opaque or poorly documented.

Data Protection and Commercial Contract Weaknesses

Another common red flag involves weaknesses in commercial contracts and data protection compliance.

In many SMEs, key customer or supplier relationships may be governed by:

Expired contracts
Unsigned heads of terms
Rolling arrangements without formal notice provisions
Terms heavily weighted in favour of the counterparty

If a significant portion of revenue is derived from contracts that are terminable at short notice or lack enforceability, investors may view revenue as less secure.

Similarly, weaknesses in data protection compliance, such as absence of data processing agreements with suppliers or incomplete privacy notices, create regulatory risk. Under the UK GDPR regime, fines can be substantial, even if enforcement against SMEs is proportionate.

During due diligence, investors will often request:

Copies of top customer and supplier contracts
Confirmation of termination rights
Details of data processing arrangements
Evidence of cyber security policies

If documentation is incomplete or inconsistent, management may need to renegotiate or formalise arrangements before completion.

Employment Law and Management Incentives

Management quality is often the primary driver of private equity investment. Unsurprisingly, employment and incentive arrangements receive close scrutiny.

Inadequate service agreements for key individuals

In many SMEs, directors and senior managers operate under outdated contracts or informal arrangements agreed when the business was significantly smaller. These contracts may lack robust protections, or in some cases may not exist at all.

From an investor’s perspective, this creates immediate risk. Private equity houses are investing significant capital on the assumption that key individuals will remain committed and that the company’s assets and relationships are protected if they leave.

Common deficiencies include:

Absence of enforceable restrictive covenants
Weak or missing confidentiality clauses
No clear intellectual property assignment provisions
Unclear notice periods or termination rights
No garden leave provisions

Restrictive covenants, which limit a departing employee’s ability to compete or solicit clients and staff, must be carefully drafted to be enforceable under English law. They must go no further than reasonably necessary to protect legitimate business interests. Overly broad clauses may be struck down by a court, leaving the business exposed.

Investors will typically require updated service agreements that:

Include tailored non-compete, non-solicitation and non-dealing restrictions
Clarify ownership of intellectual property
Define bonus and incentive structures clearly
Provide appropriate notice periods and garden leave rights

Negotiating these agreements can become sensitive. Senior managers may perceive new restrictions as onerous or view extended non-compete periods as limiting future career flexibility. If discussions over employment terms run in parallel with share subscription negotiations, tensions can escalate quickly.

In some cases, management may seek improved remuneration or enhanced equity participation in exchange for accepting tighter covenants. These negotiations can delay completion.

Unclear ownership of intellectual property created by employees or contractors

Intellectual property is often a core asset in SME transactions, particularly in technology, creative, engineering and life sciences sectors. Yet ownership is frequently assumed rather than verified.

Under UK law, intellectual property created by an employee in the course of employment generally belongs to the employer. However, the position is very different for contractors and consultants. Unless there is a written assignment, ownership will usually remain with the individual or their personal service company.

Common problem areas include:

Software developed by freelance developers without formal IP assignment agreements
Branding and design work created by marketing consultants
Databases compiled by contractors without express ownership clauses
Founders contributing code or proprietary know-how before incorporation without formal transfer

If the company cannot demonstrate clear legal title to its core IP, investors will treat this as a fundamental risk. Without ownership, the company may lack the right to exploit or license the asset. Worse still, a disgruntled former contractor could assert rights or demand payment.

Resolving IP ownership issues typically involves obtaining retrospective assignment agreements. While many former contractors will cooperate, this is not guaranteed. Individuals may:

Request additional payment
Be difficult to locate
Refuse to sign due to personal disputes

Where the IP in question is critical, such as proprietary software forming the backbone of the business model, unresolved ownership issues can halt a transaction entirely.

In addition to ownership, investors will examine whether the company has:

Registered trade marks where appropriate
Adequate protection of confidential information
Clear processes for safeguarding source code and sensitive data

Demonstrating a structured approach to IP protection significantly increases investor confidence.

Poorly structured or undocumented share option arrangements

Equity incentives are central to private equity transactions. Investors expect management to have meaningful “skin in the game.” However, historic equity arrangements in SMEs are often informal, tax-inefficient or inconsistently documented.

Common issues include:

Verbal promises of future equity participation
Unapproved option grants
Failure to agree vesting schedules or performance conditions
Options granted without proper valuation
Uncertainty over whether shares are employment-related securities

Under UK tax law, employment-related securities are subject to specific rules. If options or shares are granted without appropriate planning, unexpected income tax or National Insurance liabilities can arise for both the company and the individual.

For example, if shares are issued at undervalue without proper structuring, the discount may be treated as taxable income. This can create a liability at a time when the shares are illiquid.

Private equity investors will frequently require the implementation of a formal management incentive plan, often structured as:

An EMI scheme, if the company qualifies
Growth shares
Ratchet arrangements linked to exit value
Sweet equity structures

An Enterprise Management Incentive, or EMI scheme, is a tax-advantaged share option plan designed for smaller, higher-risk trading companies. When properly structured, EMI options can provide favourable capital gains tax treatment rather than income tax on growth in value.

However, to qualify, strict eligibility criteria must be met, including limits on company size, trading activities, and individual working hours. If a company has previously granted informal options, these may need to be unwound or regularised before a compliant EMI scheme can be introduced.

Cleaning up historic equity arrangements can involve:

Documenting past promises and agreeing whether they remain valid
Cancelling informal or defective options
Agreeing compensation or alternative participation rights
Undertaking formal share valuations for HMRC purposes

This process can become emotionally charged. Management may feel that promised equity is being diluted or restructured under investor pressure. Clear communication is critical to avoid loss of goodwill.

For further insight into structuring management incentives effectively, see our related guidance on our employee share incentive schemes page here.

Tax Structuring and Historic Tax Risk

Tax risk can significantly affect valuation and deal certainty. Private equity investors will usually commission specialist tax due diligence alongside legal review.

Uncertain R&D tax credit claims

Research and Development tax relief is a valuable incentive for innovative UK companies. For qualifying businesses, it can generate significant cash repayments or corporation tax reductions. In growth-stage SMEs, R&D claims often form an important part of working capital planning.

However, in recent years HMRC scrutiny of R&D claims has intensified. Aggressive interpretations of what constitutes qualifying activity, particularly in software and technology businesses, have led to increased enquiry rates and clawback risk.

From an investor’s perspective, R&D claims present three distinct risk categories.

First, eligibility risk. To qualify, the company must demonstrate that it has sought to achieve an advance in science or technology and faced genuine technical uncertainty. Routine development, cosmetic improvements, or configuration work will not qualify. Where claims have been prepared using generic templates or broad narratives without detailed technical evidence, eligibility may be questionable.

Second, cost allocation risk. Only specific categories of expenditure qualify, including certain staff costs, software, consumables, and subcontracted R&D. Over-claiming can occur if cost bases are not carefully analysed. If time apportionment of technical staff has been estimated loosely rather than evidenced, exposure increases.

Third, documentation risk. HMRC increasingly expects contemporaneous project documentation. This includes technical descriptions, timelines, and evidence of uncertainty. Claims prepared retrospectively without supporting records are more vulnerable to challenge.

During due diligence, investors will typically ask:

How R&D projects were identified and assessed
Who prepared the claims and on what basis
Whether any HMRC enquiries are ongoing or historic
What documentation exists to support eligibility

If there is weak documentation or a history of aggressive claims, investors may treat previously received R&D credits as a contingent liability. This can lead to:

A specific tax indemnity covering potential HMRC clawback
A reduction in enterprise value
A retention or escrow arrangement to cover potential assessments
Increased warranty coverage around tax compliance

Where an HMRC enquiry is already underway, completion may be delayed pending further clarity. Even if exposure is modest, uncertainty alone can disrupt the transaction timetable.

The key issue is not whether R&D relief has been claimed, but whether the company can demonstrate a defensible and well-documented approach.

VAT treatment inconsistencies

VAT is often viewed as an operational compliance matter rather than a strategic risk. However, historic VAT errors can accumulate quietly and crystallise into material liabilities during due diligence.

Common problem areas in SME transactions include:

Incorrect classification of supplies as zero-rated or exempt
Failure to account properly for cross-border services
Misapplication of the reverse charge mechanism
Incorrect treatment of bundled goods and services
Input tax recovery errors

In technology and digital services businesses, VAT classification can be particularly complex. For example, determining whether a supply constitutes electronically supplied services, consultancy, or licensing can affect place-of-supply rules and VAT liability.

Where a company supplies services to overseas customers, errors in assessing whether UK VAT should have been charged can lead to underpaid VAT. If discovered by HMRC, this may result in assessments covering up to four years, or longer in cases of careless or deliberate behaviour.

During due diligence, investors will often commission a targeted VAT review, especially if:

The company operates internationally
A high proportion of revenue derives from digital services
There has been rapid revenue growth
Internal finance functions are relatively inexperienced

If inconsistencies are identified, the financial impact can be significant. VAT is generally borne by the supplier if it cannot be recovered from customers retrospectively. This means historic underpayments reduce enterprise value directly.

In transaction negotiations, VAT exposure may be addressed through:

A specific indemnity covering identified VAT risks
A price reduction reflecting estimated historic liability
A retention mechanism pending HMRC clarification
Completion conditional upon voluntary disclosure and settlement

Even where the quantum of liability is manageable, the process of reconstructing historic VAT treatment can be time-consuming. Finance teams may need to review years of invoices and customer contracts to assess exposure accurately.

Importantly, VAT inconsistencies also raise questions about internal financial controls. If systemic errors are identified, investors may assume broader weaknesses in accounting governance.

Entrepreneurs’ Relief and exit structuring misunderstandings

Many founders enter private equity negotiations with a clear expectation regarding personal tax outcomes on exit. A common assumption is that Business Asset Disposal Relief, previously known as Entrepreneurs’ Relief, will apply automatically.

In reality, qualification depends on strict statutory conditions under UK tax legislation.

To qualify, broadly:

The individual must hold at least 5% of the ordinary share capital
They must hold at least 5% of voting rights
They must be entitled to at least 5% of distributable profits and net assets on a winding up
They must be an officer or employee of the company
The conditions must be met for at least two years prior to disposal

In private equity transactions, changes to share classes, dilution through new equity issuance, or introduction of growth shares can inadvertently affect eligibility.

For example, if a founder’s shareholding falls below 5% due to dilution, or if new preference shares alter economic rights in a way that affects entitlement thresholds, qualification may be lost.

Late-stage attempts to restructure shareholdings to preserve eligibility can be complex and sometimes ineffective. HMRC scrutinises arrangements that appear designed primarily to secure tax relief without substantive commercial justification.

Common misconceptions include:

Assuming that any 5% shareholding is sufficient, without analysing economic rights
Believing that holding shares through a personal company automatically qualifies
Overlooking the two-year qualifying period requirement
Assuming that option exercises shortly before exit will qualify for relief

If eligibility is uncertain, founders may face a higher capital gains tax rate than anticipated. This can materially affect their willingness to accept certain deal terms.

In some transactions, disagreements arise late in negotiations when founders realise that the proposed structure may compromise relief. At that stage, restructuring options may be limited, particularly if investors are unwilling to alter economic terms.

Regulatory and Sector-Specific Compliance

In regulated sectors such as financial services, healthcare, education, and recruitment, compliance is central to valuation.

Missing or outdated regulatory licences

In certain sectors, authorisation is not optional. It is a legal prerequisite to trading. If a business is operating without the correct licence, or outside the scope of its permissions, the issue is not technical, it is existential.

Common examples include:

Financial services firms requiring FCA authorisation
Consumer credit businesses operating under specific permissions
Healthcare providers regulated by the Care Quality Commission
Recruitment businesses subject to sector-specific regulations
Gambling operators requiring Gambling Commission licences

In fast-growing SMEs, regulatory permissions sometimes fail to keep pace with expansion. A company may broaden its services or geographic footprint without reviewing whether its existing authorisation covers the new activity. In other cases, licences may technically remain in place but be subject to conditions that are not being fully complied with.

From an investor’s perspective, there are three primary risks.

First, trading validity. If a company has been operating outside the scope of its licence, certain contracts may be unenforceable. In regulated financial services, this can be particularly serious.

Second, regulatory enforcement risk. Regulators have powers to impose fines, vary permissions, or suspend authorisation. Even where enforcement action is unlikely, the existence of non-compliance raises concern.

Third, reputational and exit risk. Future buyers or public markets will scrutinise regulatory history. A poor compliance record may depress exit value.

In addition, many regulated sectors require formal approval for a change of control. For example, under the UK financial services regime, an acquirer of a regulated firm may need prior approval from the Financial Conduct Authority. This process is not instantaneous. It involves submission of detailed information about the investor, its controllers, and its business plan.

Where change-of-control approval is required:

The transaction timetable must build in regulatory review periods
Completion may be conditional on formal consent
Disclosure obligations may be triggered early in the process

Failure to anticipate these requirements can cause significant delay. In some cases, investors will not incur substantial due diligence costs until they are confident that regulatory approval is likely to be granted.

Even minor technical non-compliance, such as late regulatory filings or outdated compliance manuals, can trigger enhanced scrutiny. Investors may require:

A regulatory gap analysis
Updated compliance policies
Confirmation of historic filings
Direct engagement with regulatory advisers

Addressing these issues proactively is considerably easier than resolving them under time pressure during exclusivity.

Data protection weaknesses

Data protection has become a central area of risk in SME transactions. The UK GDPR and Data Protection Act 2018 impose clear obligations on businesses that process personal data. These obligations apply regardless of company size.

Many SMEs assume that because they are not large consumer brands, their exposure is limited. In reality, even modest businesses may process:

Employee data
Customer contact information
Financial records
Health data
Marketing databases
Supplier personal data

Under the UK GDPR framework, businesses must demonstrate lawful processing, transparency, security, and accountability. During private equity due diligence, investors will typically examine whether the company can evidence compliance, not simply assert it.

Common weaknesses include:

Outdated or generic privacy notices
No clear record of processing activities
Absence of data processing agreements with third-party suppliers
Inadequate cyber security policies
No documented data retention schedule
Informal handling of subject access requests

One particularly sensitive area involves special category data, such as health information, biometric data, or data relating to criminal convictions. If a company processes such data without clear lawful basis and safeguards, regulatory exposure increases.

Private equity investors are acutely aware of reputational risk linked to data breaches. A significant breach can result in regulatory investigation, financial penalties, and long-term brand damage. Even smaller breaches can attract negative publicity.

During due diligence, investors may request:

Copies of data protection policies
Details of historic data breaches
Evidence of staff training
Contracts with key data processors
Confirmation of cyber security measures

If governance appears underdeveloped, investors may insist on remedial steps prior to completion. These might include:

Conducting a formal data protection audit
Updating privacy documentation
Implementing robust data processing agreements
Introducing enhanced security controls
Providing staff training

In some cases, particularly where the business model is data-driven, completion may be conditional upon implementation of specified compliance measures.

Importantly, investors are not expecting SME-level perfection. They are looking for structured awareness and demonstrable effort. A business that understands its data flows and has taken reasonable compliance steps is far less likely to face friction than one that has treated data protection as an afterthought.

Anti-bribery and anti-money laundering controls

Private equity funds operate within a heavily regulated environment. They are subject to their own compliance obligations, including anti-money laundering regulations and internal governance standards. As a result, they must ensure that portfolio companies do not create compliance exposure.

Under the UK Bribery Act 2010, companies can be criminally liable for failing to prevent bribery unless they can demonstrate that they had “adequate procedures” in place. Similarly, anti-money laundering regulations require certain businesses to maintain robust customer due diligence and monitoring processes.

In SMEs, formal anti-bribery and AML frameworks are sometimes minimal or entirely absent. This is particularly common in businesses that:

Operate internationally
Use third-party agents or intermediaries
Work with public sector contracts
Handle significant cash flows
Operate in higher-risk jurisdictions

Investors will typically assess whether the company has:

A written anti-bribery and corruption policy
Clear procedures for gifts and hospitality
Due diligence processes for third-party agents
AML policies where relevant
Whistleblowing mechanisms
Documented staff training

The absence of formal policies does not automatically indicate misconduct. However, it does increase risk. If an issue were to arise post-completion, the investor’s exposure could be significant.

Where compliance frameworks are weak, investors may require:

Immediate implementation of written policies
Formal risk assessments
Training programmes for management and staff
Enhanced due diligence on third-party relationships
Post-completion compliance monitoring

In certain sectors, such as financial services or regulated professional services, AML compliance is not discretionary. Failure to implement appropriate procedures may expose the business to regulatory sanction.

Importantly, anti-bribery and AML diligence often extend beyond policies into practical behaviour. Investors may ask:

How new customers are onboarded
Whether background checks are conducted
How unusual transactions are identified
How concerns are escalated internally

If management cannot clearly articulate processes, investor confidence may weaken, even in the absence of known wrongdoing.

Warranty and Indemnity Negotiations

The allocation of risk between seller and investor is one of the most sensitive areas of any private equity transaction.

Scope and disclosure of warranties
Investors typically require a comprehensive suite of warranties covering every material aspect of the business. These commonly include warranties relating to:

Title to shares and capacity to sell
Accuracy of financial statements
Absence of undisclosed liabilities
Ownership of assets and intellectual property
Material contracts
Employment matters
Litigation and disputes
Tax compliance
Regulatory compliance
Data protection and anti-bribery

From the investor’s perspective, warranties serve two purposes. First, they incentivise full disclosure before completion. Second, they provide a contractual remedy if the business is not as represented.

Founders sometimes underestimate the legal weight of warranties. They may view them as standard, particularly where no issues have been identified during due diligence. However, warranties are statements of fact. If they are untrue and cause loss, liability can arise regardless of intention.

The disclosure process is therefore critical. Sellers are typically permitted to qualify warranties by disclosing specific exceptions in a disclosure letter. For example, if there is an ongoing employment dispute, this would be disclosed against the litigation warranty.

A well-managed disclosure process requires:

Careful cross-referencing of due diligence findings
Full transparency regarding known issues
Clear and specific wording, rather than vague general statements

Problems arise where disclosure is incomplete or poorly drafted. Generic disclosures such as “all matters in the data room” are rarely sufficient. Investors expect clear identification of the issue and supporting documentation.

If due diligence reveals inconsistencies late in the process, the disclosure exercise becomes more complex. Founders may feel under pressure to respond quickly, increasing the risk of omission. Inadequate disclosure can create post-completion disputes, particularly if investors believe that information was technically available but not clearly highlighted.

In private equity transactions where management is rolling equity, meaning they are reinvesting alongside the incoming investor, warranty exposure can feel particularly uncomfortable. Founders may be both sellers and continuing shareholders, and therefore exposed to claims from a new majority investor with whom they must maintain an ongoing working relationship.

Limitations on liability
Once warranty scope is agreed, negotiations turn to limitations on liability. These provisions determine how much sellers can be required to pay and for how long.

Key elements commonly negotiated include:

The financial cap on liability
Time limits for bringing claims
De minimis and basket thresholds
Exclusions for certain categories of loss

The liability cap sets the maximum aggregate amount the seller can be required to pay. In a full exit, this may be a percentage of the purchase price. In minority investments or where management rolls equity, the cap may be structured differently to reflect continuing involvement.

Private equity investors often seek robust protection, particularly where they are relying heavily on management representations. However, founders will usually resist open-ended exposure.

Time limits are also heavily negotiated. General commercial warranties may be limited to 12 to 24 months post-completion. Tax warranties are often longer, reflecting statutory limitation periods. Investors may argue that certain risks only become apparent after a full financial cycle.

De minimis thresholds and baskets determine when claims become actionable. A de minimis threshold excludes very small claims. A basket requires that aggregate losses exceed a specified amount before a claim can be brought. Whether the basket operates on a “tipping” or “deductible” basis can significantly affect exposure.

Where expectations differ markedly from market norms, negotiations can become protracted. For example:

A founder expecting a modest liability cap may face investor demands for a higher cap due to perceived risk.
An investor may insist that certain warranties, such as title to shares or fraud, remain uncapped.
Disagreement may arise over whether consequential losses are recoverable.

These negotiations are rarely purely technical. They reflect each party’s perception of risk and trust.

In situations where due diligence has uncovered material concerns, investors may seek specific indemnities outside the general warranty regime. Indemnities provide pound-for-pound compensation and are often uncapped. Founders will typically resist broad indemnities unless the risk is clearly defined and quantifiable.

Warranty and indemnity insurance misunderstandings
Warranty and indemnity insurance, often referred to as W&I insurance, has become common in private equity transactions. It allows the investor to claim against an insurer rather than directly against the seller for certain warranty breaches.

In theory, this can reduce friction by limiting seller exposure. In practice, misunderstandings about W&I insurance frequently cause disruption.

Some founders assume that once insurance is in place, their liability disappears. However, insurers conduct their own underwriting process. They review due diligence reports, disclosure materials, and transaction documentation. They may:

Exclude specific risks identified in due diligence
Impose excess levels or retention amounts
Limit coverage for certain categories of warranty
Refuse cover for known or high-risk issues

For example, if due diligence identifies uncertainty around R&D tax claims, the insurer may exclude tax exposure linked to those claims. In that scenario, the investor may revert to seeking a specific indemnity from the seller.

Insurance also does not cover fraud or deliberate misrepresentation. Sellers remain exposed in cases of dishonest conduct.

In addition, the premium for W&I insurance is usually calculated as a percentage of the insured amount. If underwriting reveals higher perceived risk, the premium may increase or coverage may be restricted. This can alter the economics of the transaction late in the process.

Timing is another factor. Underwriting requires detailed information and often direct engagement between the insurer and the transaction advisers. If insurance is introduced late, it can delay completion.

If acceptable insurance terms cannot be secured, the parties may need to renegotiate liability allocation directly. This can be destabilising if one side assumed insurance would resolve exposure concerns.

Funding Structure and Security Arrangements

Private equity investment frequently involves a combination of equity and debt. The intercreditor arrangements between lenders and investors must be carefully coordinated.

Existing banking facilities with restrictive covenants
Most SMEs operate with some form of external debt, whether overdrafts, term loans, revolving credit facilities, asset-based lending or invoice discounting. These facilities are governed by detailed loan agreements containing covenants and undertakings.

During a private equity transaction, the following provisions are particularly relevant:

Change-of-control clauses
Restrictions on issuing new shares
Negative pledge clauses
Financial covenant tests
Restrictions on additional borrowing

A change-of-control clause typically provides that if ownership of the company changes beyond a specified threshold, the lender has the right to demand immediate repayment. From a lender’s perspective, this is logical. They extend credit based on an assessment of the existing ownership and management profile.

However, in a private equity transaction, change of control is often central to the deal. If lender consent is required but not obtained in advance, the company may technically be in default at completion.

Similarly, some loan agreements restrict the issue of new shares, particularly if doing so affects ownership percentages or control rights. Others may prohibit structural changes without prior consent.

If these provisions are identified late in the process, management may need to approach lenders at short notice to request waivers or consents. This can introduce several complications.

First, lenders may require detailed information about the proposed transaction, including business plans, investor identity and revised financial projections. This increases the flow of sensitive information and may raise confidentiality concerns.

Second, lenders may use the opportunity to renegotiate pricing, security or covenants. If the company’s financial performance has improved significantly since the facility was put in place, refinancing may be attractive. However, if performance has been volatile, lenders may seek tighter controls.

Third, if refinancing is contemplated alongside the private equity investment, timelines must align. New lenders will conduct their own due diligence and may require revised security packages. Coordinating equity documentation and debt documentation simultaneously requires careful project management.

Where existing lenders are supportive and the business is performing well, obtaining consent may be straightforward. In more complex or stressed situations, lender engagement can delay completion.

Early review of all financing documents is therefore essential. Identifying consent requirements and potential covenant breaches before exclusivity is granted avoids unnecessary pressure later.

Intercreditor arrangements and priority of claims

When private equity investment involves new debt, particularly in leveraged buy-outs or growth financings, intercreditor arrangements become central.

An intercreditor agreement governs how different lenders rank in relation to each other and how enforcement proceeds are distributed if the company defaults.

Key issues typically addressed include:

Priority of repayment
Enforcement standstill periods
Voting rights among lenders
Turnover provisions
Release mechanics on exit

Equity investors will want clarity that senior debt is structured appropriately and that enforcement rights are predictable. Lenders will want assurance that their priority is protected.

Negotiating these arrangements can be technical and time-consuming, particularly where multiple tranches of debt exist. If not properly coordinated, inconsistencies between loan documentation and equity documents can create conflict.

For example, equity documentation may assume that investor consent is required for certain actions, while loan documentation may grant lenders parallel rights. Aligning these frameworks is essential to avoid governance friction post-completion.

Inadequate security documentation
Security is a critical component of lending arrangements. Lenders typically take security over company assets, including:

Fixed and floating charges
Share charges
Debentures
Assignments of receivables
Charges over intellectual property

Under UK law, most company charges must be registered at Companies House within 21 days of creation. Failure to register within this period can render the security void against a liquidator or administrator and other creditors.

In SME transactions, security defects are more common than many directors realise. Examples include:

Charges granted but never registered
Incorrectly described secured assets
Security granted by the wrong group entity
Missing board approvals authorising the grant of security
Outdated security not formally released after repayment

These defects create priority issues. If security is not validly perfected, a lender may not rank as expected in an insolvency scenario. For incoming investors or lenders, uncertainty over existing security ranking is unacceptable.

Rectifying security defects is not always straightforward. If a charge was never registered and the statutory deadline has passed, court application may be required to permit late registration. This process takes time and may not always succeed.

Where refinancing is planned, existing security must be released before new security can be granted. Release documentation must be carefully coordinated to ensure that security is not unintentionally discharged before replacement security is in place.

In group structures, complexity increases further. Cross-guarantees and cross-charges between subsidiaries must be mapped carefully to understand exposure and priority.

If security documentation is incomplete or inconsistent, investors may insist on:

A comprehensive security review
Fresh security packages
Confirmation of ranking positions from lenders
Legal opinions on enforceability

This can extend transaction timelines, particularly where multiple jurisdictions are involved.

Cultural and Governance Tensions

Not all deal failures stem from technical legal defects. Some arise from mismatched expectations about governance and control.

Board representation and reserved matters

Private equity investors will almost always require board representation. This typically includes the right to appoint one or more directors and, in some cases, an observer. They will also require a list of reserved matters, meaning decisions that cannot be taken without investor consent.

Reserved matters commonly include:

Approval of annual budgets and business plans
Acquisitions or disposals above specified thresholds
Changes to share capital
Incurring material new debt
Entering into significant contracts outside the ordinary course of business
Changes to senior management remuneration

From the investor’s perspective, these rights are fundamental safeguards. They allow oversight of strategic direction and ensure that significant decisions align with the agreed growth plan.

For founders accustomed to unilateral control, however, these provisions can feel intrusive. What was previously a quick commercial decision may now require formal board approval.

The friction often does not arise from the substance of the reserved matters, which are usually market-standard, but from the perception of lost independence. Founders may worry that entrepreneurial agility will be replaced by bureaucracy.

If these concerns are not addressed openly, negotiations over board mechanics, quorum requirements or voting thresholds can become unexpectedly contentious.

Reserved matters should be proportionate and tailored to the size and complexity of the business. A well-structured governance framework can preserve operational flexibility while ensuring appropriate oversight.

Formal reporting obligations

Private equity investors expect structured, consistent financial and operational reporting. This typically includes:

Monthly management accounts
Cash flow forecasting
Key performance indicators
Regular board packs in advance of meetings

In many SMEs, financial reporting may historically have been less formal. Management accounts may have been produced quarterly, with limited narrative analysis. Budgets may have been indicative rather than binding.

Post-investment, the reporting often intensifies. Investors rely on timely data to assess performance, manage portfolio risk, and report to their own stakeholders.

For management teams unused to this level of scrutiny, the transition can be demanding. Finance systems may need upgrading. Additional personnel may need to be recruited. Processes must become more disciplined.

The cultural challenge lies in the perceived shift from entrepreneurial freedom to structured accountability. Some founders interpret enhanced reporting as mistrust. Investors view it as standard governance.

If expectations around reporting are not discussed clearly before completion, friction may arise shortly after investment. What the investor considers routine may feel burdensome to management.

The key is preparation. Upgrading reporting systems before investment signals professionalism and reduces the shock of transition. It also demonstrates to investors that management is comfortable operating at institutional standards.

Clear exit planning and time horizon discipline

Perhaps the most fundamental cultural difference between founders and private equity investors concerns time horizon.

Private equity funds are structured with defined lifespans. They typically aim to exit investments within a set period, often three to seven years, to return capital to their own investors.

Founders, by contrast, may view the business as a long-term or even generational asset. They may see private equity as growth capital without fully internalising the expectation of a future exit.

This divergence can manifest subtly during negotiations. For example:

Investors may require drag-along rights to ensure a clean sale process.
They may insist on mechanisms that facilitate future refinancing or secondary buy-outs.
Ratchet structures may be designed to incentivise high exit valuations within a defined timeframe.

If founders are uncomfortable with the concept of a forced sale, these provisions can become contentious. The legal debate over drag rights or compulsory transfers may mask a deeper reluctance to commit to an exit strategy.

Similarly, investors often require detailed strategic plans outlining potential exit routes. Founders who view the investment as open-ended may struggle with this discipline.

When expectations about exit are not aligned early, the relationship can deteriorate later, particularly if performance pressures increase.

How to Reduce the Risk of Delay

Preparation is the most effective way to prevent transactions from stalling.

Conduct pre-investment legal health checks
A structured internal review of corporate records, employment contracts, IP ownership and compliance procedures can identify issues before investors do. Early remediation strengthens negotiating position and credibility.

Align shareholder expectations early
Founders and minority shareholders should discuss exit objectives, dilution tolerance and governance changes before formal negotiations begin. Internal alignment prevents public disagreements.

Engage specialist advisers at heads of terms stage
Experienced corporate lawyers can ensure that key commercial protections are addressed early, reducing the risk of costly renegotiation later.

Upgrade governance processes in advance
Regular board minutes, accurate statutory registers, and formalised policies demonstrate maturity. Investors are reassured by evidence of disciplined management.

For more detail on preparing for investment, see our guidance on our private equity legal services page here.

Conclusion

Private equity investment in UK SMEs is rarely derailed by a single catastrophic issue. More often, deals are delayed by a combination of historic informality, incomplete documentation, tax uncertainty or misaligned expectations.

The common thread is preparation. Businesses that invest time in strengthening governance, documenting arrangements properly, and seeking early legal input consistently experience smoother transactions.

Private equity investors expect risk to be identified and allocated transparently. They do not expect perfection. When founders approach the process proactively, with clear advice and realistic expectations, legal issues become manageable steps rather than deal-breaking obstacles.

For SME owners considering private equity investment, early strategic planning is not simply prudent, it is a commercial advantage.

We usually offer a no-cost, no-obligation 20-minute introductory call as a starting point or, in some cases, if you would just like some initial advice and guidance, we can instead offer a one-hour fixed fee appointment (charged from £250 plus VAT depending on the complexity of issues and seniority of the fee earner).

Please email wewillhelp@jonathanlea.net or call us on 01444 708640 as a first step. Following an initial discussion, we can provide a clear scope of work, a fee estimate (or fixed fee where appropriate), and confirm any information or documentation we would need to review.

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This article is intended for general information only, applies to the law at the time of publication, is not specific to the facts of your case and is not intended to be a replacement for legal advice. It is recommended that specific professional advice is sought before relying on any of the information given. © Jonathan Lea Limited.