Small Business Acquisitions: Avoiding Hidden Pitfalls in Due Diligence
If you are on the hunt for a small business to acquire, you’ve probably been advised to go through “due diligence.” But what is due diligence in the context of a small business acquisition, and why does it matter? In short, the due diligence process is your chance to verify that everything is as advertised and uncover any hidden problems before you fully commit to the purchase. And as you can imagine, skipping or rushing due diligence can lead to unpleasant surprises after takeover.
In this article, we'll highlight three areas where red flags often hide during a small business acquisition—financial statements, customer contracts, and key employees—and illustrate each with a hypothetical small manufacturing company.
Red Flags in Financial Statements
Imagine you're reviewing the financial statements of "Precision Parts Co.," a small manufacturer of specialty components that you are interested in acquiring. At first glance everything looks solid—revenue has been growing and profits seem healthy. But then you spot an odd spike in sales in the last quarter of the most recent year. After pressing for details, you learn it came from a one-time bulk order that isn't likely to happen again. In other words, that record profit might not be sustainable once you own the business.
Financial statements can hide several pitfalls if you don't dig deep:
One-time or Unusual Revenue: A single large order or non-recurring event can inflate revenue and profit. If it won’t recur, future earnings will likely be lower than they appear in the statement.
Messy or Inconsistent Records: Many small businesses have imperfect accounting. Watch for bookkeeping red flags like inventory that never gets written down, or old accounts receivable still sitting on the books. Outdated or inaccurate figures can overstate the company's true value.
Questionable Add-backs: Sellers might present "adjusted" earnings, adding back expenses they claim are personal or one-time. Scrutinize these. Are they legitimate adjustments or attempts to dress up the profit? Insist on documentation for any add-backs.
Always verify the quality of earnings behind the numbers. If you spot unexplained inconsistencies, missing documentation, or anything that doesn't add up, treat it as a major warning sign. You may need to pause and get a professional to help review the finances. Once you're comfortable that the numbers reflect reality, it's time to move on to the customer contracts.
Red Flags in Customer Contracts
The strength of a business's revenue stream depends on its customer relationships and contracts. Now, suppose our Precision Parts Co. gets 50% of its sales from one large customer under a contract that expires in six months. There’s no automatic renewal, and you've heard this customer is considering other suppliers. That dependency, and the uncertainty around it, is a glaring red flag.
Here are contract-related issues to watch for:
Customer Concentration: If one or two customers make up a large portion of revenue, the business is vulnerable. What if a major client leaves right after you buy? Check how much revenue the top clients represent and how secure those relationships are.
Unfavorable Terms or Transfer Risk: Read key contracts. Can customers cancel on short notice? When do the agreements end? Also, look for assignment clauses—will the contract transfer to you as the new owner, or do you need the client's consent? A sale isn’t very valuable if the clients can walk away or refuse to work with a new owner.
Renewals and Obligations: Note any contracts up for renewal soon, or any onerous obligations. A deal might look great until you realize a lucrative customer contract is ending next quarter, or that you must fulfill tough conditions to keep it.
In our example, the heavy reliance on one client means you should tread carefully. You could adjust the deal terms or price to account for this risk—for instance, making part of the payment contingent on that contract being renewed. The key point is that if a company's revenue rests on a few contracts, you want to know of any instability before you buy, not after.
With the financials checked and customer contracts reviewed, the last area to investigate is perhaps the most human factor: the employees who keep the business running.
Red Flags Around Key Employees
A small business’s success often hinges on a few key people. Continuing with our example, let’s imagine that Precision Parts Co. relies heavily on a veteran shop supervisor, Maria, who has been with the company for 20 years and practically runs the day-to-day operations. During due diligence, you learn Maria has hinted she might retire when the current owner leaves. If she walks, a huge amount of know-how would walk out the door with her. This is a classic key employee risk.
Keep an eye out for people-related red flags such as:
Over-Reliance on Individuals: Ask, "What would happen if this person left?" If the answer is "the business would struggle (or even fail) without them," that's a serious concern. Common examples are an owner who is also the top salesperson, or a technician who knows a unique process by heart with no one else trained.
No Backup or Succession Plan: If crucial knowledge or customer relationships live in one person's head, transitioning the business will be tricky. Maybe only Maria knows how to fix certain machines or manage a key client relationship. If there's no documentation or second-in-command, you'll want that person to stay for a while or ensure there's a thorough handover.
Low Morale or Exit Plans: Try to gauge whether key employees intend to stay after the sale. Sometimes you can get a sense of this by talking to the owner about the team or even meeting some employees (if the process allows). If you detect that important players are anxious or planning their exits, you could be inheriting a talent drain.
How can you address these risks? Consider negotiating incentives for critical employees to stay (such as stay bonuses or a post-sale leadership role), and have the seller assist with training their replacements or be available for consultation during the transition. If those measures aren't possible, factor in the cost and time of recruiting and training new staff when valuing the business.
Closing Thoughts
Performing due diligence is about peeling back the shiny exterior of a business to make sure no unwelcome surprises are lurking beneath. The areas we discussed—the numbers, the customer base, and the people—are common spots for hidden pitfalls in small business deals. The overarching lesson is to stay curious and skeptical: if something seems a little off, dig deeper and ask questions. It's far better to discover a problem before the purchase (when you can still negotiate or walk away) than after it's yours.
In practice, that means scrutinizing the financials for anomalies, reading every important contract, and understanding who the key team members are. Unsurprisingly, we would recommend bringing in lawyers and accountants to help with this. By being diligent and spotting red flags early, you can either negotiate solutions as part of the deal or walk away from a bad one.
In the end, avoiding these hidden pitfalls sets you up for a smoother transition into ownership. You'll thank yourself later when your new business runs without any unpleasant surprises—and you can focus on growing it rather than fixing avoidable problems.
