What is due diligence?
Due diligence is the investigation a buyer does after signing a letter of intent and before committing to the purchase. It checks the financials, contracts, staff, assets, legal position and operations against what the seller has told you.
A red flag is anything that suggests the business is worth less, or carries more risk, than presented. Finding one is the point of due diligence. Ignoring one is how buyers end up overpaying.
What are the biggest financial red flags?
- Earnings that don’t reconcile. Profit and loss figures that don’t match bank deposits or tax returns. Always rebuild revenue from the bank statements.
- Add-backs without evidence. An add-back is a cost the seller says won’t continue, added back to profit. Every one needs a receipt, an invoice, or a clear reason. Be wary of add-backs that are really ongoing costs.
- An underpaid owner. If the owner works 60 hours a week for a small salary, you’ll need to pay someone a market rate to replace them. That comes straight off the earnings.
- Revenue spikes before sale. A sudden lift in the final year can mean pulled-forward sales or delayed costs.
- Working capital games. Receivables collected early, suppliers paid late, or stock run down just before settlement.
- Deferred capital spending. Equipment, vehicles or software that are overdue for replacement. That bill becomes yours.
- Unrecorded liabilities. Tax arrears, staff entitlements, supplier disputes, or loans not on the balance sheet.
Each one changes your debt service coverage ratio (DSCR): the cash available to repay debt divided by annual repayments. See DSCR explained.
What are the customer and revenue red flags?
- Customer concentration. One customer, or a handful, making up a large share of revenue. If they leave, so does the profit.
- Contracts that can’t be transferred. Customer agreements with change-of-control clauses, meaning the customer can walk away when ownership changes.
- Rising churn. Customers leaving at a faster rate recently.
- Relationships held by the owner. Customers who buy from the person, not the business.
- Pricing well above or below the market that you can’t explain.
What are the people red flags?
- Key-person dependence. One person, often the owner, holds the know-how, the licence or the relationships.
- Staff who don’t know about a sale and may leave when they find out.
- Staff paid off the books, misclassified as contractors, or owed entitlements.
- High turnover that the seller can’t explain.
What are the legal and operational red flags?
- Leases close to expiry, with no renewal option, or that need landlord consent the landlord may refuse.
- Licences and registrations held personally by the seller, which may not transfer. Check the rules in your state or country for your industry.
- Current or threatened disputes, claims, complaints or regulator inquiries.
- Intellectual property (the brand, website, software) owned by the seller personally, not the business.
- Compliance gaps: safety, privacy, industry rules.
Red flags at a glance
| Red flag | What it usually means | Typical response |
|---|---|---|
| Earnings don’t match bank | Earnings are overstated | Re-price on verified earnings |
| Unproven add-backs | Real profit is lower | Exclude them from the valuation |
| One customer is a large share | Revenue is fragile | Earn-out or bigger seller note |
| Owner holds relationships | Goodwill may not transfer | Longer handover and seller rollover |
| Change-of-control clauses | Contracts may end | Get consents before settlement |
| Deferred capex | Hidden future cost | Reduce price or fund it in the deal |
| Undisclosed liabilities | Debts become yours | Indemnity, retention or walk away |
What should you do when you find a red flag?
A red flag isn’t automatically a deal-killer. You have five options:
- Ask. Many issues have a reasonable explanation. Get it in writing, with evidence.
- Re-price. Adjust the price to the verified numbers.
- Restructure. Move more of the price into seller finance (paid over time) or seller rollover (a stake the seller keeps). If the earnings don’t hold up, the seller shares the downside instead of you carrying it alone. See seller finance explained and seller rollover explained.
- Protect. Use warranties (promises in the contract), indemnities (the seller covers specific losses) or a retention (part of the price held back for a period).
- Walk away. If the issue goes to the heart of the business, or the seller hid it, this is often the right call.
Restructuring is the most underused option. A senior debt, seller finance and seller rollover mix lets you keep a good business with a fixable problem, at a structure that still pays for itself.
How do you run due diligence? Step by step
- Start before the LOI. Good questions to ask a business seller surface most issues early.
- Make the LOI conditional on satisfactory due diligence and financing. See letter of intent for buying a business.
- Rebuild the financials from bank statements and tax returns.
- Review every material contract: customers, suppliers, leases, staff, licences.
- Meet key staff and, where the seller agrees, key customers.
- Inspect the assets and get a view on equipment age and condition.
- Get professional help: an accountant for the numbers, a lawyer for the contracts.
- Write down every finding and decide: accept, re-price, restructure, protect or walk.
What red flags kill deals?
In the deals we work on, the issue that most often ends things isn’t a bad number. It’s a seller who hid it. A problem disclosed early is a negotiation. A problem discovered late is a trust issue, and trust is what seller finance runs on. If you’re buying a competitor, you know the business well enough to spot most of these yourself; see how to buy your competitor.
Want help structuring around what due diligence finds?
On an acquisition strategy call we look at your target and how the deal could be structured so it still pays for itself. See if you qualify.