Most Searchers Get Diligence Wrong, Here’s Why

I was speaking this week with a searcher I’m investing in who is under LOI and deep in diligence. Here is what they asked me: "Given your experience as both a self-funded searcher and operator in industrial and manufacturing-related businesses, it would be very valuable to get your perspective at some point on two things: • how you approached the transition from diligence into execution, particularly early priorities, and • what you would focus on pressure-testing at this stage before committing." My answer was: you’re asking the wrong question. During diligence, this is not the time to think like an entrepreneur. It is the time to think like an investor. Entrepreneurs are optimists. They want to build. They are trained to see opportunity. They look for reasons to say yes. Investors are pessimists. Their first goal is to avoid loss. They are trained to see risk before they see opportunity. They look for reasons to say no. That distinction matters. If you are under LOI, your job is not to get excited about how you will run the business. Your job is to identify the 1 to 3 things that MUST be true for the deal to work, and then try to prove they are false. If any of those fail, you should think hard if to walk or structure the deal to address them. Where most diligence goes wrong: • Too much broad analysis • Not enough focus on what can actually break the business • Too much time thinking about execution before the deal is closed ***What you should really be looking for are the single points of failure*** Small businesses often have many single points of failure. Your job is to identify them, assess their risk and see if you can reduce the risk or live with it. Usually that means things like: • Customer concentration • Product concentration • Supplier dependency • Key employee or founder reliance • Hidden operating gaps • Fragility in the business model that is not obvious from the CIM or data room One of the biggest mistakes I see is confusing revenue concentration with profit concentration. ***You need to understand contribution margin.*** A customer that is 30% of revenue might be 50% of profit. A product line that looks secondary might drive most of the economics. *** This is counterintuitive, but it is very common in search fund businesses for a customer or product to represent a HIGHER % of gross profit than % of revenue*** If that piece disappears, does the business still work? That is the question. Also, the most important diligence insights often do not come from spreadsheets. They come from conversations, inconsistencies, and following a thread far enough until you find what really drives the business. So no, I would not focus on the transition into execution yet. Until the deal closes, stay in investor mode. Stay skeptical. Pressure-test the downside. Find the reasons to say no. Only after closing is it time to become the entrepreneur again. If you do diligence well, you are not trying to learn everything. You are trying to find the few things that matter most, and determine whether they hold. Examples from real deals under LOI 1. Sales team dysfunction Through conversations with the seller, it became clear that successful salespeople were repeatedly let go due to a bias against paying commissions. EBITDA looked fine on paper, but the business was effectively running without a stable sales function. The real issue was an underbuilt go-to-market engine and EBITDA that did not capture the true cost of running the business. 2. Misunderstood revenue mix A business marketed as diversified across multiple services turned out to generate most of its profit from one seasonal line. The rest of the year was near breakeven. The insight was not to kill the deal, but to rethink risk, seasonality, and deal structure. 3. Hidden profit concentration One searcher bought a drug delivery business where , a single product represented a the vast majority of profit. A change in pricing dynamics wiped out margins and ultimately caused the business to go bankrupt. This is a classic failure to understand contribution margin. 4. Customer concentration beneath the surface A “large but manageable” customer turned out to drive a disproportionate share of contribution margin. Going one layer deeper, the risk was tied to specific products and their lifecycle, not just the customer itself. The entire deal hinged on validating the durability of that revenue stream. In other words, we had to look at “product vintage” tied to that customer and understand where we the customer was in the product lifecyle. 5. Supplier dependency with hidden economics In one deal, the sales of products from a single supplier represented ~50% of revenue. I was a hard-to-replace product. If we lost that supplier or pricing changed, it would cascade into customer issues immediately. The added complexity was a legacy preferred pricing structure that was not visible in the financials. It showed up as rebates and bill-backs paid quarterly or annually, not in COGS or purchase orders. The real risk was not just supplier concentration, but whether those economics would survive a change of ownership. We ultimately did the deal. But we had to first get comfortable with this.