3 Red Flags in Due Diligence & The Dangers of Falling in Love With a Deal

When you’re buying a business, it takes a lot of time and effort to truly understand what you are getting. We’ve heard too many stories of buyers who get the short end of the stick (even swindled!) because they didn’t do what they needed to do in order to find out everything that they are getting. Buyers have to pay attention and undergo a thorough due diligence process from the very beginning to make sure you know everything you should before closing the deal. The Doida Law Group team ensures certain protections are included in our clients’ agreements, but most red flags will come from the due diligence process. The key is understanding the risks related to issues (even red flags) found in diligence.?

“Due diligence” is the concept of doing in-depth research on your own or with the help of an experienced business lawyer guiding you on what issues (including red flags) to look out for. This includes online research, reviewing public records and/or lien judgments, analyzing the sellers’ track record, network, and more. Unfortunately, some sellers don’t disclose everything that they should or fear it may devalue their business, so buyers must look high and low to learn everything they can. Even then, they’re unlikely to uncover everything.

If you’re considering buying a business and going through due diligence, here are three red flags to be aware of:

1. The seller questions the need for more information. A good buyer will propose a diligence request list. This list asks the seller for all of the things that they want to see before closing the deal. This should include financial, legal, and operational items. It might include things like operating agreements, contracts, employment arrangements, vendor relations, customer agreements, financial statements, bank statements, tax returns, etc.. It’s surprising how unorganized people can be, but persistence is key to getting what you need. If they really want to sell their business, they should be doing their best to be proactive to show you don’t have anything to hide. As counsel to many business owners, we make sure clients are aware of all of the unsightly warts to make sure there are no red flags, such as:

– When sellers unduly delay in responding to the diligence request list
– When sellers refuse to respond altogether
– When sellers question the need for more information

2. Any incidents, data, or agreements discovered during the process that contradict the story the seller has given or the written representations being made. We recently had a client who was buying a business and the seller presented a fantastic track record and spotless service. However, a quick Google search found negative reviews, that formal complaints were filed with regulatory agencies, and even found some questionable consumer protection decisions. Some of this information is easy to spot, but, in other instances, it takes a well-trained and experienced person to spot the issues.

The purchase agreement should contain a laundry list of written representations and warranties that the Seller is making with respect to the business or assets that are being purchased. Depending on how the transaction is structured, a Buyer could be assuming some obligations of the Company or otherwise exposing itself to risks related to the business operation prior to closing. Overlooking a red flag in diligence could end up costing a Buyer a lot of money in the long run. In another case, a seller disclosed material information that contradicted the written representations and warranties that were being made in writing as a “by the way” at the closing table. We did not support closing the deal and advised against it. Don’t get caught in a surprise situation with money on the table.

3. Refusing to sign or over-complicating a non-competition or a non-solicitation agreement. If this comes up, you have to wonder, “Why are they avoiding this? Is there something they’re planning on doing that would infringe on my success?” Maybe, maybe not. But what if there is? In general, if you’re paying a fair price for the business, that price usually includes the payment to keep the previous owners of the business clearly away from the business. Our team helps mitigate risks and assess how to structure these important agreements or otherwise smoke out planned intentions of the seller after closing.

“Falling in love” with a deal can be dangerous
Sometimes buyers will “fall in love” with a deal and it’s our job to steer the project in the right direction. The ‘rose-tinted glasses’ can cause buyers to make emotional and irrational buying decisions. It will also cause buyers to excuse discovered red flags. Making a mistake of that nature could be costly, if not disastrous to a buyer’s financial condition. If your due diligence process has raised suspicions or you wonder what else you don’t know, sometimes it’s best to trust your gut and take the time to understand why that is. Don’t ignore the red flags.

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Call Doida Law Group at 720-306-1001 today or contact us here to find out how we can help with your next business transaction.

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