Hidden Liabilities to Watch for in Due Diligence That Many Overlook

Due diligence is supposed to catch problems before you sign the deal, but even experienced buyers and sellers miss hidden liabilities that surface after closing in M&A transactions. This guide reveals the financial and legal risks that slip through standard due diligence and how to uncover them before closing.

Why Hidden Liabilities Derail Otherwise Solid Deals

Hidden liabilities don’t announce themselves. They’re the commitments nobody wrote down, the expenses nobody tracked properly, or the risks everyone assumed someone else would handle. By the time they surface, you’re often past the point where backing out is easy.

For buyers, discovering a significant liability after closing means inheriting a problem you didn’t price into your offer. For sellers, failing to disclose something you didn’t realize was an issue can trigger indemnification claims and legal disputes. Either way, the financial and legal consequences can be severe.

The challenge is that traditional due diligence focuses on what’s documented. Balance sheets, tax returns, contracts, and financial statements get scrutinized. But many significant liabilities exist outside formal records. A business advisor who understands M&A transactions knows to dig deeper than the paperwork.

Financial Liabilities That Don’t Show Up on Balance Sheets

Some of the most damaging financial liabilities never appear in standard financial statements. These obligations are fundamental, they’re expensive, and they’re often completely overlooked until they become urgent.

Underfunded Retirement Plans and Pension Obligations

Many main-street businesses for sale have retirement plans that look fine on paper but are actually underfunded. Defined benefit plans, in particular, can carry obligations that exceed what’s shown on financial statements. If the business has older employees with significant accrued benefits, the actual liability might be far larger than the seller disclosed.

Buyers need to request:

• Actuarial reports for any pension plans
• Current funding levels compared to obligations
• Projected contributions required over the next 5-10 years
• Any missed contributions or compliance issues

Even 401(k) plans can hide problems. Unpaid employer matches, delayed contributions, or compliance failures can trigger IRS penalties and participant lawsuits. A business broker experienced in M&A knows to request plan audits and compliance documentation, not just trust the seller’s assurance that everything is current.

Personal Guarantees and Off-Book Debt

Personal guarantees create hidden exposure that isn’t reflected in a business’s financial statements. The owner may have personally guaranteed equipment leases, facility loans, supplier credit terms, or vendor contracts. After closing, these guarantees might not transfer cleanly, leaving the buyer without critical financing or forcing renegotiation under unfavorable terms.

Common scenarios a business advisor sees:

During due diligence, request:

• Complete list of any guarantees (even expired ones)
• Copies of guarantee agreements
• Confirmation of what transfers vs. requires renegotiation
• Lender/lessor approval for transfer or release

Deferred Maintenance and Equipment Replacement Costs

Sellers often defer major maintenance and capital expenditures for a year or two before listing. The equipment works today, but it won’t last much longer. The facility needs a new roof, but it can wait another year. The fleet is aging, but you can squeeze another 50,000 miles out of it.

These aren’t liabilities in the traditional accounting sense, but they’re real expenses the buyer will face immediately after closing. A business broker who understands the industry can spot these issues during site visits and equipment inspections.

Red flags that indicate deferred maintenance:

• The equipment is older than the typical replacement age in the industry
• Repair expenses are increasing year-over-year
• No capital expenditure budget for the upcoming years
• Seller’s casual mentions of “you’ll probably want to upgrade” without adjusting the price

Get third-party equipment inspections, facility assessments, and maintenance records. Don’t rely on the seller’s verbal assurance that everything is in good shape. Your business advisor should push for documentation and professional evaluations.

Legal and Compliance Risks Sellers Often Underestimate

Legal liabilities can be even more damaging than financial ones because they’re harder to quantify and resolve. Many sellers genuinely don’t realize they’re exposing buyers to serious risk.

Unresolved Employment Issues and Potential Claims

Employment-related liabilities are among the most commonly overlooked issues in M&A transactions. These include:

• Verbal promises to employees: Promises about future compensation, ownership stakes, or severance that were never formalized. After closing, these employees may claim the buyer must honor these commitments.
• Misclassification of workers: Independent contractors who should have been employees, creating potential tax liabilities and penalties. The IRS and state agencies can pursue the buyer for past violations, even if they occurred under prior ownership.
• Unpaid overtime or wage issues: Businesses that haven’t properly tracked hours, paid overtime, or complied with wage laws face exposure to claims going back several years. These claims often surface after ownership changes when employees feel less loyal.
• Discrimination or harassment complaints: Unresolved complaints or patterns of behavior that could trigger lawsuits. Even if no formal complaint was filed, a business broker experienced in due diligence will ask about any workplace issues, investigations, or settlements.

To uncover these issues, buyers should:

• Review all employment agreements and offer letters
• Request documentation of any complaints or HR issues
• Verify worker classification (especially in states with strict rules)
• Interview key employees about any unresolved concerns
• Check for any informal bonus or commission agreements

A qualified business advisor will insist on employment practice liability insurance (EPLI) policy history and claims, which often reveal issues the seller didn’t disclose verbally.

Intellectual Property Gaps and Licensing Problems

Intellectual property problems are widespread in main-street businesses for sale, where the owner never formalized IP ownership. The business might use logos, software, or processes that were developed by contractors or employees who retained ownership rights. After closing, the original creators could demand licensing fees or assert ownership.

Common IP issues that surface post-closing:

• Software or websites built by third parties who retained source code rights
• Marketing materials using images or content without proper licensing
• Product designs or processes developed by consultants without assignment agreements
• Trade secrets or proprietary methods that key employees could take to competitors
• Domain names or social media accounts registered in the owner’s personal name

During due diligence, a business broker should help you:

• Verify ownership of all trademarks, patents, and copyrights
• Review all contractor agreements for IP assignment clauses
• Confirm software licenses transfer and aren’t tied to the seller personally
• Document any trade secrets and ensure non-compete agreements protect them
• Transfer domain names, social media accounts, and other digital assets properly

Small businesses often run on software or systems with licenses in the owner’s name, use personal email addresses, or rely on owner-specific accounts. After closing, you might discover you can’t access critical systems or that licensing requires expensive upgrades to transfer.

How to Uncover These Issues Before They Kill Your Deal

Finding hidden liabilities requires a methodical approach that goes beyond reviewing documents. Here’s how experienced M&A professionals structure due diligence to catch what others miss.

• Start with a comprehensive information request list: Don’t accept vague assurances. Your business advisor should provide the seller with a detailed list covering financial records, contracts, employee files, compliance documentation, insurance policies, and operational procedures. The list should specifically request information about guarantees, contingent liabilities, informal agreements, and potential claims.
• Conduct on-site visits and employee interviews: Many hidden liabilities only surface during site visits. Equipment condition becomes obvious when you see it firsthand. Employee concerns emerge during casual conversations. A good business broker knows how to observe operations and ask questions that reveal issues the seller didn’t think to mention.
• Review insurance claims history: Insurance claims reveal problems the seller might not disclose voluntarily. Workers’ compensation claims indicate safety or workplace issues. General liability claims show operational risks. Product liability claims suggest quality control problems. Request at least five years of loss runs and claims history.
• Verify regulatory compliance independently: Don’t rely on the seller’s statement that they comply. Check directly with regulatory agencies when possible. Review inspection reports, permit renewals, and any correspondence with authorities. Environmental compliance, in particular, can hide massive liabilities that aren’t reflected in financial statements.
• Hire industry-specific experts: Generic accountants and attorneys miss industry-specific issues. For manufacturing, get equipment appraisals and environmental assessments. For healthcare, verify licensing and HIPAA compliance. For technology, validate IP ownership and software licensing. Your business broker should help coordinate these specialists.
• Ask about “near-miss” problems: Many liabilities start as close calls that were narrowly avoided. Ask the seller about regulatory issues that were resolved, customer complaints that didn’t escalate, employee problems that were handled informally, or supplier disruptions that were barely prevented. These reveal vulnerabilities that might resurface under new ownership.

Get Expert Help With Your Due Diligence

Hidden liabilities are exactly why experienced guidance matters in business transactions. Protecting clients from unexpected liabilities requires knowing what questions to ask, where to look, and which specialists to bring in. The difference between a smooth closing and a costly mistake often comes down to catching these issues early.

Ready to ensure your transaction is protected? Call Lake Country Advisors for a FREE, confidential business valuation and consultation. Don’t let hidden liabilities turn your deal into an expensive problem.