What Most Buyers Miss in Due Diligence (And It's Not the Financials)

You found the deal, got under LOI and started you initial diligence. From there, you hired an accountant or financial professional to finish QofE and to review three years of financials. You ran the numbers through your model and they hold up. At this point you're feeling great and ready to get legal involved in the deal and are just a mere 30-45 days from close.

Here's usually the conversation that I have next with most buyers: they want to move straight to drafting a purchase agreement without finishing legal and tax due diligence. And when those reviews do happen, the issues they surface get noted in a due diligence report, in an email or in passing conversation with the client and rarely does anything get noted in the purchase agreement.

That pattern is expensive. In deals under $5 million, it's often the difference between a clean acquisition and a post-close headache that costs more to clean up than had it been caught upfront and addressed under a rep & warranty.

Financial DD Is the Start. Legal and Tax DD Is Where the Real Exposure Lives.

Most searchers understand that they need to look at the books. Where buyers get tripped up is how much more work needs to be done during legal & tax due diligence.

Here's what a proper legal due diligence review actually covers: employment agreements and worker classification, contracts with customers and vendors, lease assignments, intellectual property ownership, regulatory compliance, pending or threatened litigation, and the corporate record itself. That's not a short list, and most of it won't show up in a profit and loss statement. 

Moreover, this list barely even scratches what should be looked at on the tax side: employee misclassification problems, missing payroll, multi-state nexus exposure and more can greatly increase the potential exposure for an unassuming buyer.

When buyers rush this review, they are not saving time. They are agreeing to buy whatever is buried in those categories, sight unseen, with no mechanism to hold the seller accountable after close.

Avoid taking on unnecessary exmployment exposure

Employment is one of the most common areas where I see real exposure get transferred to a buyer who had no idea it was coming.

In my experience reviewing smaller deals, it is common to find that a target company has no written employment agreements, no meaningful offer letters, and workers classified as independent contractors without any documented basis for that classification. And this only scratches the surface, W-9's for independent contracts are almost never collected and let's not even get into tax clearance certificates that are not obtained by sellers.

Sellers often built the business this way because it was cheaper and easier. The problem is that "cheaper and easier" for the seller becomes inherited liability for the buyer.

Worker misclassification is not a technical violation that gets ignored. When a classification doesn't hold up, the buyer can face back payroll taxes, penalties, and interest going back years. Add a wage-and-hour claim from a misclassified worker and the number gets bigger fast.

The fix is not expensive. New employment agreements for key employees, updated offer letters, a classification analysis for any contractors who look like employees under the economic reality test. But these need to happen immediately after close, not six months later when the first complaint lands. The buyer who notes the issue in due diligence and does nothing about it post-close inherits that exposure in full, with no recourse to the seller.

Good Old S Corps

Another common issue that I always run into are problems with S Corporation elections. These problems can be costly and lead to nasty outcomes if not addressed early on in the transaction.

I have a client right now going through due diligence on a target structured as an S corp. When we reviewed the tax returns, the problem was visible immediately: the owner-operator has not been paying himself reasonable compensation. He has been keeping his salary artificially low and taking the rest as distributions, which reduces his payroll tax exposure but violates a core requirement of maintaining the S election.

Here is why that matters for a buyer. S corporations are required by the IRS to pay owner-employees a reasonable salary before taking distributions. In serious cases, the IRS can challenge the S election itself, which would mean the company is treated as a C corporation retroactively.

Other S corp issues worth flagging in due diligence: ineligible shareholders (S corps cannot have more than 100 shareholders, and certain entities cannot be shareholders at all), second classes of stock created inadvertently through shareholder agreements, and built-in gains tax exposure if the company was previously a C corp and converted.

None of this is obscure. All of it shows up in the tax returns and the corporate documents if you know what to look for.

The Contract and Lease Problem

One more category that routinely gets underdone: assignment of contracts.

In an asset sale, contracts do not automatically transfer from the seller to the buyer. Customer contracts, vendor agreements, software licenses, and especially real property leases all need to be reviewed for assignment clauses. Some will require landlord or counterparty consent before they can be transferred. Some will have change-of-control provisions that give the counterparty the right to terminate if ownership of the business changes.

Discovering this after the purchase agreement is signed puts the buyer in a difficult position. You may need to go back to the seller to renegotiate terms, or you may discover that a key customer contract or your primary lease cannot be assigned without consent that the landlord or counterparty is not willing to give on acceptable terms.

These issues can and do come up and can quickly turn from a small problem into a large problem if not addressed properly.

The Ordering Issue in Main Street M&A

In Main Street M&A speed if often considered to be king. As a result, buyers will often push their lawyers to handle both legal due diligence and also start working on the purchase agreement and side documents all at the same time. 

When Seller's have already slogged through QofE or the bank or a broker is pushing the buyer to close the deal this sounds like the best way to approach the issue. However, in practice, it means your attorney is drafting representations and warranties based on incomplete information, then reworking them when legal or tax diligence surfaces something material.

Finishing due diligence first gives you a clear picture of what you are actually buying. The representations and warranties in the purchase agreement can be tailored to the specific risks you found. Indemnification carveouts, earn-outs, escrow holdbacks, and post-closing covenants can be structured around actual issues rather than generic ones. The drafting goes faster and the deal is better documented because you understood the business before you started writing. 

In many ways it's like the story where a man is asked to cut down a cherry tree and is asked, "what is the first thing you are going to do if you have an hour to cut down the tree?" And the person responds, "spend the first 50 minutes sharpening the axe." Putting time in up front on diligence actually increases the speed of the deal rather than slows it down.

If you take away one thing, it is this:

Due diligence is not a box to check. It is the foundation the rest of the deal is built on.

Financial due diligence tells you if the business makes money and frankly you can't let the tax and legal take precedent over whether or not the deal actually makes sense economically. Legal and tax due diligence tells you what comes with it. When buyers skip or rush the legal and tax side, they are not just taking on unknown risk. They are giving up the information they need to negotiate a deal that actually protects them.

If you find an issue in due diligence, write down what you are going to do about it and when. Make it a condition to close. Make it a post-close covenant. Structure a holdback around it. But do something with it, because noting it and moving on is the same as ignoring it.

Until next time,

Josh