How to Identify Material Contracts in a Data Room

Identifying which contracts are material is the single most consequential judgment call in the early stages of M&A due diligence. Every subsequent decision about where to allocate review time, which provisions to extract, and what to highlight in the diligence memo flows from this initial materiality determination. Get it right and the deal team focuses its effort on the contracts that drive deal value and risk. Get it wrong and critical issues hide in contracts that no one reviewed while attorneys spend hours on routine agreements that do not affect the transaction.

The Four Lenses of Materiality

Materiality is not a single test. It is a multi-dimensional assessment that considers financial magnitude, strategic importance, contractual terms, and regulatory requirements. A contract can be material under one lens and immaterial under another, which is why experienced deal teams evaluate each agreement through all four.

Lens 1: Financial Value Thresholds

The most straightforward materiality test is whether the contract exceeds a defined financial threshold. Common approaches include:

Percentage of revenue. Contracts representing more than 1-5% of the target's annual revenue are presumptively material. For a company with $50 million in revenue, a 3% threshold means any contract worth $1.5 million or more annually receives full review.

Absolute dollar thresholds. Some deal teams set absolute thresholds (e.g., any contract with annual value exceeding $500,000) regardless of the target's overall revenue. This approach is simpler but may be over-inclusive for large targets or under-inclusive for small ones.

Aggregate counterparty value. A single counterparty might have multiple contracts that individually fall below the threshold but collectively represent material revenue. Evaluating materiality by counterparty rather than by individual contract catches this pattern.

Liability exposure. Contracts with uncapped indemnification obligations, unlimited liability provisions, or large liquidated damages clauses may be material based on potential liability exposure even if their annual revenue contribution is modest.

Lens 2: Strategic Importance

Financial thresholds miss contracts that are material because of what they represent rather than what they are worth.

Key technology licenses. A $50,000 annual software license might be immaterial by dollar value but critical if the licensed technology is embedded in the target's product and cannot be readily replaced.

Exclusive arrangements. Exclusive distribution, exclusive supply, and exclusive licensing arrangements define the boundaries of the target's competitive position. They are material regardless of the dollar value because they constrain or enable strategic options.

Key personnel agreements. Employment agreements for the CEO, CTO, key salespeople, or other individuals whose departure would materially affect the business are material even when the compensation amounts are not individually significant.

Regulatory prerequisites. Contracts that are required to maintain regulatory licenses, certifications, or permits (such as compliance monitoring agreements, mandatory insurance policies, or required vendor relationships) are material because losing them could shut down operations.

Lens 3: Unusual or Non-Standard Terms

Contracts with terms that deviate significantly from market standard deserve attention regardless of their dollar value.

Unlimited liability. Any contract where the target has accepted unlimited liability or uncapped indemnification is potentially material because the exposure is theoretically unlimited.

Unusual change of control provisions. Contracts that give counterparties extraordinary rights upon change of control (automatic termination, acceleration, repricing) are material to the transaction specifically.

Non-standard termination rights. Contracts terminable on very short notice, terminable without cause, or subject to automatic renewal with evergreen provisions that lock the target into long-term obligations.

Cross-default provisions. Contracts where default triggers cross-default in other agreements can create cascading risks that make an otherwise modest contract systemically important.

Guarantees and sureties. Personal guarantees by founders, parent company guarantees, or surety bonds represent contingent obligations that may not appear in the target's financial statements but are material liabilities.

Lens 4: Regulatory Materiality Standards

For public companies or targets being acquired by public companies, SEC materiality standards provide an additional framework.

SEC filing requirements. Regulation S-K Item 601 requires that material contracts be filed as exhibits to registration statements and periodic reports. The categories include contracts outside the ordinary course of business, contracts upon which the business is substantially dependent, and contracts with directors, officers, or significant shareholders.

"Substantially dependent" test. The SEC standard asks whether the registrant's business is substantially dependent on the contract. This is a qualitative test that complements quantitative thresholds and captures contracts that are operationally critical regardless of their individual dollar value.

Investor standard. More broadly, a contract is material under securities law if a reasonable investor would consider it important in making an investment decision. This standard focuses on decision relevance rather than financial magnitude alone.

Practical Identification Process

Having established the four lenses, the practical process for identifying material contracts in a data room follows a structured workflow.

Step 1: Gather Baseline Information

Before reviewing contracts, request from the target:

• Customer and revenue breakdown by counterparty
• Vendor and supplier spend by counterparty
• List of all contracts the target considers material
• Any contracts previously identified as material in regulatory filings or prior transactions

This information provides the context necessary to apply financial thresholds and identify strategically important relationships before opening a single contract.

Step 2: Apply Quantitative Screens

Using the financial information, identify all contracts that exceed the dollar value threshold. This is the fastest screen and typically identifies 15-25% of the data room as presumptively material.

AI-powered contract review tools can accelerate this step by extracting contract values, payment terms, and counterparty information from every agreement in the data room simultaneously. This extraction allows deal teams to sort contracts by value and identify threshold-crossing agreements without manual review.

Step 3: Apply Qualitative Screens

Review the classified contract inventory for agreements that may be material under the strategic importance, unusual terms, or regulatory lenses. This requires understanding the target's business model, competitive position, and operational dependencies.

Industry-specific patterns. In technology, prioritize IP licenses and development agreements. In healthcare, prioritize payor contracts and compliance agreements. In manufacturing, prioritize supply chain and equipment agreements.

Step 4: Cross-Reference and Validate

Compare your materiality determinations against the target's own assessment, the deal team's understanding of the business, and any management representations about key contracts. Discrepancies between your assessment and the target's should be investigated.

Step 5: Document and Communicate

Produce a materiality matrix that lists every contract identified as material, the basis for the determination (which lens or lenses apply), and the priority level for detailed review. Share this matrix with the deal team, client, and anyone responsible for purchase agreement negotiation so that materiality determinations drive downstream work.

Common Mistakes in Materiality Determination

Setting thresholds too high. A threshold that captures only 5-10 contracts may miss important agreements. Better to err on the side of inclusion and triage during review than to miss a material contract entirely.

Ignoring aggregate exposure. Twenty contracts with the same counterparty, each individually below the threshold, may collectively represent material concentration risk.

Equating materiality with revenue. Contracts that do not generate revenue but create obligations (guarantees, indemnities, restrictive covenants) can be highly material.

Static determination. Materiality should be reassessed as diligence progresses. A contract that appeared routine may prove material once the deal team understands the target's operational dependencies.

The goal of materiality identification is not to create a perfect list on day one. It is to create a defensible, systematic framework that ensures the most important contracts receive the most thorough review, and that the framework improves as the deal team's understanding of the target deepens through clause extraction and M&A diligence.

---