Five Due Diligence Pitfalls and How to Avoid Them

For many middle-market businesses and private equity firms, buying or selling a company can be the deal of a lifetime — one that carries significant emotional and financial risks as well as rewards. Comprehensive, well-executed due diligence can make the difference between success and failure.

Here are five common mistakes made in due diligence and suggestions on how to guard against them.

1. Missed opportunities

Too often buyers rely on standardized due diligence requests without considering the complexities of a specific deal or nuances of an industry seller. For example, if a company sells highly customizable equipment that takes months or years to build (and to bill), you must make working capital adjustments to account for both customer deposits and costs in excess of billings. Or, a product manufacturer may face new regulations that could have a significant impact on shipping and inventory down the road. Not understanding the cyclical nature of a target company’s sales and related inventory needs could also directly affect the negotiation of the purchase price and working capital adjustment. As a buyer, an “off-the-rack” approach may lead you to overlook important business and legal information and miss an opportunity to negotiate the purchase price.

2. Pointless provisions

Buyers and sellers can waste an extraordinary amount of time during a deal on items that don’t really matter. A basic understanding of the target company’s industry can prevent this waste. For example, Much Shelist recently acted as counsel in the sale of a consulting company, whereby the negotiation process was considerably hampered by unnecessary provisions related to environmental claims and workplace contaminants — none of which should have concerned the buyer, since our client was not a manufacturer and was housed in leased high-rise space. Another example involved the sale of an early-stage technology company, whereby the sale was severely delayed negotiating representations regarding customers and accounts receivable. These are both normal provisions in some transactions, but because the target company was early stage, it had no revenues or customers.

While buyers should take care to closely examine the real risks in any deal, spinning wheels on pointless provisions costs all parties valuable time and money.

3. Red flags at the 11th hour

Nobody likes surprises. It’s crucial to identify and address material risks to the transaction as early as possible in the due diligence process. Waiting until the 11th hour to send up a flare can seriously endanger — or even kill — a deal, especially the trust factor between the parties.  It can also unduly influence decisions on other important issues if transaction costs that could have been avoided by raising the issues early on must now be taken into consideration.

For example, if trade secrets and other intellectual property are at stake, take a close look at employee confidentiality and invention assignment agreements to understand if the target company truly owns all rights in the intellectual property developed by its employees. If there’s large concentration risk with customers and/or suppliers, review such relationships early to avoid deal-breaking surprises late in the game. Share any negative findings internally with the due diligence team to assess risk and devise a course of action, then share with the other side expediently to keep the deal moving in the right direction.

4. Poor communication

This is one of the most common, and commonly overlooked, problems that plagues the due diligence process. Consider a typical deal with four different parties reviewing a lease — lawyer, accountant, real estate broker, and lender. Too often each party builds a silo around its individual concerns, neglecting to see the bigger picture. This can result in misunderstandings and even mistakes. It’s critical to establish clear channels of communication and build rapport between the buyer and seller teams early in the process.

Consider developing a master calendar of key milestones and goals for the duration of the due diligence process, including regular check-in calls with the team. Taking the time to anticipate issues and expectations, assign tasks and responsibilities, and ensure attention to detail will pay off.

5. Leaving money on the table

The process of determining a company’s value and asking price can be a nuanced one, especially if the business is subject to market conditions outside its control. It can be tricky to arrive at a fair valuation, but it essentially comes down to the strengths and weaknesses of the business, its talent, and its future revenue and profit potential. To help in assessing such value, assemble a skilled third-party team of attorneys, accountants, bankers, and other resources. In a market where good deals are hard to find and where caps on sell-side indemnification obligations are as low as 10 percent of the acquisition price (or less with an insurance policy as the sole source of relief), a comprehensive due diligence process will help assure the value being paid isn’t diminished.

Mitchell S. Roth, Managing Partner and principal at Chicago-based business law firm Much Shelist, is an accomplished attorney with more than 20 years of experience advising entrepreneurs, owners, investors, and C-suite executives at large public and privately held companies.

David M. Pilotto is a principal in the Business & Finance practice group at Chicago-based business law firm Much Shelist and concentrates his practice on mergers and acquisitions, finance transactions, and general outside corporate counsel.