You can spend months courting potential buyers, fielding multiple offers, and securing that letter of intent.
But it doesn’t matter if the deal falls apart in due diligence.
It’s more common than you might think: These days, more deals collapse during due diligence than at any other stage of the M&A process. Buyers have become extraordinarily selective about the risks they’re willing to accept, and the margin for error during due diligence has never been smaller.
With that in mind, here are the five common red flags than can derail M&A and the steps you should take to address them before going to market.
1. Poor Quality of Earnings
Nothing sends buyers running faster than discovering that the financial picture you’ve presented doesn’t hold up under scrutiny.
Nowadays, pretty much every serious acquirer conducts a quality of earnings (“QoE”) analysis. This is a deep dive into your financial statements that goes far beyond a standard review, determining how much of your reported EBITDA is actually sustainable and recurring.
Common issues include:
- Inconsistent revenue recognition practices: Buyers immediately question companies that opportunistically record revenue to inflate performance.
- Undocumented add-backs: While legitimate owner expenses can be “added back” to EBITDA, each must be thoroughly documented and justified.
- Recent dramatic changes in performance: Sudden profitability improvements without clear operational changes raise suspicion about financial engineering.
- Customer concentration: When a significant portion of revenue comes from a small number of customers, buyers tend to see it as added risk.
You can proactively address these concerns by conducting your own QoE analysis before going to market. Well-prepared sellers also maintain clean, consistent financial records with clear documentation for all significant transactions and can articulate the drivers behind any material changes in performance.
2. Hidden Liabilities
When sophisticated buyers uncover undisclosed liabilities, they’ll question everything else you’ve shown them.
These hidden liabilities commonly surface in several key areas, including:
- Underfunded employee benefits: These are pension obligations, healthcare commitments, or deferred compensation arrangements that haven’t been properly accounted for.
- Contingent legal exposure: Any pending or threatened litigation, warranty claims, or product liability issues are huge red flags.
- Tax compliance gaps: Unfiled returns, unpaid taxes, or aggressive tax positions could trigger future audits.
Similarly, you can conduct your own internal audit of these liabilities well before seeking a buyer. This way, you can identify any potential issues and develop a plan to address them.
3. Worker Misclassification
As federal enforcement reaches record levels, worker classification has become a prime focus area during due diligence.
Worker misclassification takes two primary forms:
- Independent contractor misclassification: Treating workers as contractors when they should legally be classified as employees.
- Exempt/non-exempt misclassification: Categorizing employees as exempt from overtime when they don’t meet the legal requirements.
Either scenario can saddle your buyer with the responsibility of paying unexpected back wages, unpaid benefits, taxes, and potential penalties. So make sure you review your workforce classification with experienced employment counsel at least a year before seeking a sale. This provides time to reclassify workers if necessary and establish a track record of compliance that will survive due diligence scrutiny.
4. Cybersecurity Risks
Cybersecurity has become a standard part of due diligence — and for good reason. The average cost of a data breach now exceeds $4.88 million, a figure that continues to rise annually. As a result, buyers are increasingly walking away from deals when they identify significant cybersecurity vulnerabilities that could expose them to breach risks post-acquisition.
The most common cybersecurity red flags include:
- Lack of formalized security policies and procedures: The absence of documented protocols for data protection, access controls, and incident response.
- Poor security governance: No designated security leadership or oversight of cybersecurity practices.
- Inadequate technical controls: Missing fundamental protections like multi-factor authentication, encryption, or proper network segmentation.
- History of breaches or near-misses: Previous security incidents that weren’t properly addressed or remediated.
To address these and other risks, it’s wise to invest in an independent cybersecurity assessment at least 12–18 months before seeking a sale, giving you time to implement security improvements and demonstrate a track record of responsible data protection.
5. Compliance Gaps
Businesses face a vast array of requirements at the federal, state, and local levels, and failing to meet these regulatory standards is one of the quickest ways to lose out on a deal.
Compliance issues that frequently derail deals include:
- Industry-specific regulatory violations: Failure to maintain required licenses, permits, or certifications.
- Data privacy compliance gaps: Non-compliance with GDPR, CCPA, or other applicable privacy regulations.
- Import/export violations: Particularly for businesses with international operations or supply chains.
- Health and safety violations: OSHA citations or unaddressed workplace safety issues.
Your buyer will thank you if you conduct a comprehensive compliance audit across all relevant regulatory areas before you attempt to sell.
Getting Ahead of Due Diligence Issues
Due diligence issues are far easier (and less expensive) to address before going to market than they would be during an active transaction. By identifying and addressing potential red flags early, you’ll not only increase the likelihood of a successful transaction but may also significantly enhance your company’s valuation.
The more potential issues you can identify and address before a buyer discovers them, the stronger your negotiating position will be throughout the transaction process.
Reach out today to discuss how you can get ahead of these due diligence issues.
