Top 5 Legal Due Diligence Findings In Dutch M&A Transactions | #3 Employment Legal Red Flags

About This Series: Top 5 Legal Due Diligence Findings in Dutch M&A Transactions
In the dynamic landscape of mergers and acquisitions (M&A) in the Netherlands, the legal due diligence investigation remains one of the most critical phases of any transaction. During this stage, information from the seller is thoroughly validated, potential risks are identified, and the deal value is ascertained or sometimes fundamentally reassessed. A comprehensive due diligence process not only safeguards the purchaser by identifying risks and shaping negotiation strategies, but it also benefits the seller and the target company by clarifying obligations, identifying operational improvements and aligning expectations.

This article marks the third in a five-part series on the Top 5 Legal Due Diligence Findings in Dutch M&A Transactions. For this series, we performed an in-depth analysis of the due diligence reports of our recent Dutch M&A transactions and identified the Top 5 Legal Due Diligence Findings. Each article in the series explores one of these findings as well as related topics in detail.

Summary of the article: Employment Legal Red Flags in Dutch M&A Transactions
In this third article, we explore some of the most common issues that arise during employment law due diligence and their potential impact on a Dutch M&A transaction. We highlight the risks associated with:

• requalification of service agreements into employment agreements;
• engaging management through informal or undocumented arrangements;
• gaps in contractual protections, including missing restrictive covenants, confidentiality clauses and intellectual property (IP) provisions; and
• the critical role of works councils (ondernemingsraden) in M&A transactions.

As always, we conclude with our top 5 tips for your next due diligence review.

Requalification of service and freelance agreements
Dutch companies frequently engage individuals (often senior executives, consultants or other specialized professionals) through service or freelance agreements or employment agreements. Companies may prefer service agreements for a variety of reasons, as this structure e.g. provides greater flexibility in defining the scope of services and compensation.

Under Dutch law, however, the formal label of a “service agreement” does not determine the legal nature of the relationship. A working relationship must be assessed holistically, taking into account both the contractual arrangements and the actual conduct of the parties – “substance over form”. If the working relationship exhibits characteristics of employment rather than genuine independent contractor status, the agreement may be requalified as an employment relationship, regardless of the parties’ intentions. Key factors to be examined in this regard include the provision of work, payment of remuneration and the existence of a hierarchical relationship or degree of control.

Requalification of a service agreement as an employment relationship has significant consequences for both the company and the individual:

• The individual may acquire full employment rights under Dutch law, such as protection against dismissal, continued remuneration during illness, statutory vacation entitlement, holiday allowance and severance pay.
• Reclassified employees may also gain access to the company’s pension scheme, potentially giving rise to claims by the pension fund or insurer.
• The Dutch Tax Authority (Belastingdienst) may hold the company responsible for unpaid payroll taxes and social security contributions, potentially increased by interest and fines for late payment.
• In certain situations, requalification can have retroactive effect. A court may rule that the engagement was in fact an employment relationship from the start, giving rise to claims for back pay, vacation pay and other employment benefits for the entire preceding period.

In the due diligence phase, a purchaser must thus carefully review all service agreements to assess the likelihood of requalification, as potential claims may create significant contingent liabilities for the target company. Given the “substance over form” assessment, a thorough due diligence investigation requires not only a review of the agreements themselves, but also Q&As and management interviews.

Absence of written employment or service agreements
A surprisingly frequent finding in Dutch employment law due diligence is the complete absence of a written employment or service agreement between the target company and one or more of its directors or the existence of an agreement at a different level (such as between the shareholder of the target company and the director).

While Dutch law does not require employment or service agreements to be concluded in writing (oral agreements are generally valid), the absence of formal documentation creates significant uncertainty regarding the terms and conditions governing the relationship. Under Article 7:655 of the Dutch Civil Code (Burgerlijk Wetboek) (DCC), employers are obliged to provide employees with written particulars of the main employment conditions within one month of commencement. In practice, however, particularly in cases involving founder-managers or long-tenured executives who transitioned into formal management roles over time, companies may operate for years without formalizing these arrangements in comprehensive written agreements.

The absence of a written agreement with management creates multiple layers of risk for a purchaser of the target company. Without written agreements, there is no comprehensive record of the agreed salary, bonus entitlements, pension arrangements, notice periods or other employment benefits. This may give rise to disputes or claims post-closing, potentially increasing the target’s liabilities. Furthermore, without written agreements, there are no enforceable non-competition, non-solicitation or confidentiality obligations. This becomes particularly problematic if key managers leave the target company post-closing, as they may be free to compete with the purchaser’s group (which as of closing shall contain the target company) or solicit employees, clients and/or other contacts of the target company immediately after closing, which could materially and negatively affect the business value of the target company.

Missing covenants
When reviewing (template) employment or services agreements, we often find that these agreements lack standard protective provisions that would typically appear in well-drafted documentation. This is particularly common with agreements that were drafted years ago and never updated, outdated precedents and documentation for employees who transitioned from other roles and standardized templates sourced online. We also anticipate that a similar trend will arise with AI-drafted documentation in future due diligence investigations.
The most commonly missing provisions include:

• restrictive covenants, i.e. provisions prohibiting employees and contractors from engaging in competing activities and/or soliciting customers, suppliers and/or employees of the target company;
• confidentiality clauses, i.e. provisions obligating employees and contractors to maintain confidentiality of inter alia trade secrets and business information of the target company; and
• intellectual property clauses, i.e. provisions governing the assignment of intellectual property rights created during employment or engagement.

The absence of these protective provisions creates significant vulnerabilities for the target company and for any potential purchaser thereof. Without enforceable restrictive covenants, former employees and contractors can immediately compete or solicit customers, suppliers and/or employees of the target company. This is particularly problematic in situations where it concerns a key contact of the target company. Important to note is that under Dutch law, restrictive covenants are only enforceable if they meet specific requirements: they must be in writing, cannot exceed a certain period, must be reasonably necessary to protect legitimate business interests, and must be sufficiently specific regarding scope and geography.

The absence of clear IP assignment provisions can create significant uncertainty regarding the ownership of inventions, software or other creative works developed by employees or contractors for the target company. Under Dutch law, IP rights in principle vest in the employer where the nature of the employment entails that the employee uses their special knowledge to make inventions or copyrightable works. However, to prevent uncertainty, it is preferable to agree clear provisions on the ownership of IP with employees involved in generating inventions or other IP protected works. Ownership of contractor-created IP must generally be established by contract; in the absence of an explicit agreement, such rights in principle vest in the contractor. Even where contractual clauses exist, the scope of the employer’s ownership may depend on whether the creation of the invention or work falls within the employee’s actual job responsibilities. Inventions not related to the employment that the employee makes in his or her private time without using resources of the employer normally vest in the employee.

A possible scenario is that the founders of the target company, working on the basis of a management agreement, developed software or made designs essential for the target company’s business. If the founders did not transfer their IP rights to the target company by written deed, the company is likely using the IP rights on the basis of an implied license, which may be terminated by the relevant founders. Ensuring that IP ownership is properly documented and, if necessary, that the relevant IP transfer deeds are executed prior to closing, is essential. Addressing these issues can impact transaction timing, as it may take considerable effort to identify all relevant IP, confirm ownership, and obtain cooperation from the relevant individuals. If the target company does not own the necessary IP, and in the worst-case scenario cannot continue its business without it, this may result in a reduction of the enterprise value of the target company or significant remedial measures might be required prior to closing of the transaction.

A lack of an explicit confidentiality clause in an employment agreement may materially weaken the protection of sensitive business information of the target company. Although the Dutch Trade Secrets Act (Wet bescherming bedrijfsgeheimen) provides statutory protection for information qualifying as a trade secret (provided it is secret, has commercial value and is subject to reasonable protective measures), reliance on this framework alone places a relatively high evidentiary burden on the employer. Moreover, while employees are subject to implied duties of confidentiality under Dutch law, the scope and duration of those duties may be disputed in the absence of specific contractual arrangements, particularly following termination of employment. Well-drafted confidentiality clauses help to clearly identify confidential information and offer more predictable and enforceable protection.

Works council codetermination
Under article 2 of the Dutch Works Council Act (Wet op de ondernemingsraden) (WOR), companies that regularly employ at least 50 employees in the Netherlands are obligated to establish a works council (WC). Once established, the WC is vested with extensive statutory rights, including rights to information, consultation and consent in relation to a broad range of corporate and organisational decisions, including with respect to an M&A transaction. Common findings during employment law due diligence include:

• failure to comply with statutory procedures for informing or consulting the WC;
• failure to obtain the WC’s advice or consent where required; and
• in some cases, the complete absence of a WC despite the statutory obligation to have one.

From an M&A perspective, works council issues can materially affect both the timing and legal certainty of a transaction. Article 25 WOR contains an exhaustive list of proposed decisions in respect of which the WC has a right of consultation. These include, among others:

• decisions relating to the transfer of control over the company or part thereof;
• the acquisition or disposal of control over another company;
• material changes to the organisation of the business or the allocation of powers within the company; and
• the appointment of external advisors in connection with such decisions.

As a result, in an M&A transaction involving a purchaser, seller and target company that each have a WC, all three parties may be subject to consultation obligations. Furthermore, these obligations may arise at an early stage of the transaction process, even before transaction documentation is negotiated, as early as the moment when an M&A advisor is entrusted with providing advice in relation to the transaction.

When requesting advice, the target company must provide the WC with a detailed explanation of the rationale for the proposed decision, the anticipated consequences for employees, and any measures envisaged in response to those consequences. The advice must be requested at such a point in time that it can meaningfully influence the decision-making process. In practice, the consultation process typically takes at least four to six weeks and may take longer if the WC requests additional information or clarification.

Failure to consult the WC in accordance with the WOR, or proceeding in material deviation from a negative WC opinion, entitles the WC to initiate proceedings before the Enterprise Chamber of the Amsterdam Court of Appeal (Ondernemingskamer). At the request of the WC, the Enterprise Chamber may:

• order the entrepreneur to withdraw the decision in whole or in part;
• reverse the consequences of the decision; or
• prohibit acts aimed at implementing the decision.

This means that a deal can be blocked or an obligation can arise to reverse it. While successful challenges to the validity of an M&A transaction remain rare in practice, works councils can and do seek injunctive relief that may delay closing and, in some cases, leverage their position to influence transaction-related governance arrangements or employee-related safeguards.

Finally, where due diligence reveals that a target company should have established a WC but failed to do so, this presents additional risks. Under the WOR, any interested party may request the subdistrict court (kantonrechter) to order the establishment or continued existence of a WC. In practice, employees, sometimes encouraged by trade unions, may request the establishment of a WC during the transaction process, which can lead to unexpected delays and tensions. From a purchaser’s perspective, inheriting a company with a history of non-compliance with the WOR may also signal broader governance deficiencies that warrant closer attention.

Top 5 tips: assessing employment issues

1. Engage works councils as early as possible — involve works councils at the outset of the transaction process and incorporate adequate time for consultation into your deal timeline. Statutory advice and consent obligations can materially affect transaction timelines and early engagement reduces the risk of delays.
2. Identify and secure IP — identify all IP relevant to the target company’s business and confirm ownership well before closing, so that any necessary IP transfers can be executed timely and efficiently. Early planning helps prevent delays in the transaction timeline.
3. Consider conditions precedent — if the target company does not own intellectual property critical to its business, make the transfer of such IP a condition precedent to closing to safeguard the value of the business.
4. Expand your review beyond standard templates — carefully review agreements for key personnel and/or obtain confirmations via the due diligence Q&A and management interviews where necessary. Agreements for key personnel may deviate from provided templates or include deviating terms that are not immediately apparent.
5. When reviewing restrictive covenants, focus on enforceability — ensure that restrictive covenants comply with Dutch statutory requirements, as non-compliant covenants may be void and unenforceable, leaving the target company without the protection it assumed it had.

Need advice on legal employment issues under Dutch law?
Do you want to assess whether there is a requalification risk with respect to a contract under Dutch law, what rights a works council has in a particular situation or whether a works council must be installed at all – and, if so, what the legal implications could be? Please do not hesitate to contact Friederike Henke or Deniz Xinyi Bussing of our Corporate M&A department, Epke Spijkerman of our employment practice, or Philip ter Burg or Julia Mascini of our commercial and intellectual property practice, who would be pleased to advise you and provide tailored guidance on these matters.

• Stay tuned: in the next part of our Top 5 Legal Due Diligence Findings in Dutch M&A Transactions series, we will explore commonly flagged intellectual property rights issues during legal due diligence.