Due diligence exists for one reason: the seller knows things about the business that you do not. Most problems diligence uncovers are fixable — priced into the deal, escrowed against, or resolved before closing. But some findings should make a buyer slow down, restructure, or walk away. Here are the red flags that matter most when buying a California business, and what each one is really telling you.
Ownership and authority problems
Before anything else, confirm the seller actually owns what it is selling and has the power to sell it:
- A cap table that does not reconcile. Missing stock certificates, undocumented transfers, verbal equity promises to early employees, or SAFEs and notes that were never tracked. You cannot buy clean title to a company whose ownership is disputed.
- Missing consents. Shareholder approval requirements, rights of first refusal, spousal community-property interests in California, or lender consents. A closing that skips a required consent invites a challenge later.
- Suspended or forfeited status. A California entity suspended by the Secretary of State or Franchise Tax Board generally cannot exercise its powers, rights, and privileges, and contracts made during certain tax suspensions may be voidable. Check standing early — it is a two-minute search that occasionally reveals a serious problem.
Financial statements that do not hold up
Watch for revenue recognized aggressively, personal expenses run through the business, related-party transactions at off-market terms, and cash sales that appear in the seller's story but not the books. A seller who says "the real earnings are higher than the tax returns show" is telling you the records are unreliable — and the same records will underlie the financial reps in the purchase agreement. Customer concentration is its own flag: if one customer is thirty or forty percent of revenue, you are partly buying a relationship that may not survive the sale, especially if that customer's contract has a change-of-control clause.
Contracts with traps inside
The target's key contracts deserve a clause-by-clause read:
- Anti-assignment and change-of-control provisions. In an asset purchase, contracts generally require consent to assign if they say so — and in either structure, a change-of-control clause can hand a key customer, supplier, or landlord leverage to renegotiate or exit.
- Expired or unsigned agreements. Revenue running on handshake terms is revenue you may not keep on the same terms.
- Exclusivity, most-favored-customer, and long-term pricing commitments. These quietly cap the upside you are paying for.
People problems: classification and wage-and-hour exposure
For California targets, employment exposure is routinely the largest hidden liability. The ABC test under Labor Code § 2775 makes many "contractors" employees as a matter of law, and misclassification carries back wages, penalties, and tax exposure that a buyer can inherit — outright in a stock deal, and sometimes under successor-liability theories even in an asset deal. Add meal-and-rest-break practices, overtime, expense reimbursement, and wage statement compliance to the checklist. If the target's workforce model depends on classification the ABC test will not support, that is not a schedule item; it is a valuation item.
IP the seller does not actually own
Ask a simple question about every important asset: where is the signed paper? Code written by contractors without written assignments may still belong to the contractors. Founders who developed the product before incorporating may never have assigned it to the company. Trademarks may be unregistered or registered to the wrong entity. Open-source components may carry license terms incompatible with the business model. If the company's value is its technology or brand, gaps here go to the heart of the deal.
Sellers who behave like sellers with secrets
Process flags matter as much as document flags: data rooms that trickle out documents, answers that shift between calls, pressure to close on an artificial deadline, resistance to ordinary reps, or a sudden push to convert the deal to "as-is." None of these proves a problem, but experienced buyers treat them as a signal to slow down and dig — precisely when the seller wants speed. Diligence findings feed directly into the purchase agreement's reps, baskets, and indemnification terms, which is why diligence and drafting should run as one coordinated effort by your M&A counsel, with contract review at its core rather than bolted on at the end.
Talk to a California business attorney
If you are evaluating an acquisition, a structured diligence review before the purchase agreement is signed costs far less than discovering these problems after closing. Schedule a free consultation or call (949) 418-2113.
This article is attorney advertising and provides general information only. It is not legal advice and does not create an attorney–client relationship. Facts matter; consult a lawyer about your specific situation.
