Lower middle market businesses ($1M-$10M EBITDA) are often the most attractive because they’re underoptimized. The issue with this underoptimization, however, also means under-documented, owner-dependent, and financially unverified. 

Because of this, the seller’s numbers are just a starting point. Additional due diligence is then required to uncover the true financial and operational challenges the business faces, and it may even be something the seller doesn’t know. 

The Risks a Seller’s Numbers Won’t Show You

There are five hidden risks that a standard P&L will never show you: 

1. Customer Concentration
2. Key-Person Dependency
3. Financial Discrepancies
4. Operational Diligence
5. Deferred Capital Expenditure

• Customer Concentration 

  

Customer concentration means a large share of revenue depends on a very small number of clients.

Allianz, one of the largest credit insurers worldwide, defines high customer concentration as any single customer above 20% of revenue. 

Now, the danger itself isn’t the percentage. It can work, to some degree. The real problem is what sits behind this 20%. 

Often, with LMM businesses, this deal is held together by a handshake or a 20-year relationship. 

If there isn’t a contract in place with transparent agreements, then this relationship often belongs to the owner who’s leaving, not the company you’re buying. 

Solution 

Develop a revenue map by customer for the last five (or more) years, and then check every major account for three things: 

• A written contract 
• Assignability on change of control 
• Whether the relationship survives without the current owner

When concentration is high, however, it shouldn’t be an immediate “no” to the deal, there can always be a workaround. 

You just need to price this risk into the deal structure. An escrow or earnout tied to retention of key accounts is the most used solution. 

• Key-Person Dependency

  

Key-person risk is the amount a business relies on a certain individual. Sometimes, you’ll find that a lot of the business only 

exists in the founder’s head, like the pricing logic, vendor terms, customer history, and informal procedures that keep operations running. 

None of these procedures are written down. The reason is that they never needed to be. It operated fine, so the owner never felt the need to. When they leave, however, all that information goes along with them. 

The Exit Planning Institute’s 2025 research found that roughly 70% of businesses put on sale never find a buyer, and the main reason is owner dependence. Therefore, it’s a serious due diligence issue that needs research. 

Solution 

List every decision only the owner makes, every relationship they hold, and every process that nobody has documented. 

Afterward, negotiate the risk into the deal via a transition period, a consulting agreement, retention terms for second-tier managers, and documentation as a condition of closing. 

De-risking keyman dependency should start before the signature, not after. By doing so, you’re able to move the business from founder-led to process-driven safely. 

• Financial Discrepancies 

  

The financials of an LMM business are rarely audited; they’re usually just compiled or reviewed. 

Often, that leaves three places for problems to hide: 

• Hidden Liabilities: Pending litigation, warranty claims, unfunded obligations. 
• Misclassified Expenses: Personal spending through the business, generous add-backs, owner compensation.
• Unrecorded Obligations: Off-balance-sheet leases and verbal commitments to staff, vendors, or customers, etc. 

The result is a large gap between reported EBITDA and real, transferable EBITDA. And since the purchase price is a multiple of that number, any dollar overstated is multiplied into the price you pay. 

Solution 

A proper financial audit of the deal, in the form of a Quality of Earnings analysis. A QoE goes beyond a standard P&L to test whether the earnings are real, recurring, and transferable. 

Simply put, performing such an audit ensures that you buy a business for what it’s worth, not what the sellers, often with wrong figures at an LMM level, suggest. 

• Operational Diligence

  

Operational diligence asks whether the business can actually survive, not just now, but after the transaction.

It helps answer questions like: 

• Is it scalable? 
• Is it already running at the ceiling of its current systems? 
• Will the best team stay? 
• Will the best technician still be satisfied? 
• Do the systems transfer? 
• Does the entire operation rely on one person’s memory? 

A business can pass a financial audit, but fail miserably here. The reported revenue only tells you what the old owner could make; it doesn’t tell you whether the operations can make you the same returns. 

Solution 

Even before the LOI, walk the floor. Get a feel for the business, interview second-tier staff, review systems and software, check employment contracts, and test whether the entire process works without the owner interfering. 

By performing the above, you get a good feeling for how the business operates. It’s unlikely that you can do a full dive into the business, but you want to develop a strategy to push the boundaries and to reveal information on operational excellence or operational mediocrity. 

Anything of concern should be addressed in the buying contract. One method of doing this is tying the findings to an NWC peg, which is an agreed level of working capital the business must hold at closing, which can help with some of the potential costs. 

• Deferred Capital Expenditure 

An owner planning an exit will naturally stop reinvesting, resulting in maintenance getting deferred, equipment starting to age, and replacement cycles starting to stretch.

Because of this, margins start to improve, EBITDA climbs, and the business’s margins look better. However, the only reason the business is looking leaner is that it’s being starved. 

You, as the buyer, then pay a multiple on those inflated earnings. Then, once you’ve purchased the business, you quickly come to the realization that equipment needs changing, maintenance needs to come in, and more. 

This is actually one of the best hidden flags of the five, as it makes the business look more attractive and cleaner. Something that gets investors excited and willing to pay more. 

Solution 

Build an independent cap-ex schedule. Get the equipment inspected, age every major asset against its useful life, and compare historical maintenance spend against industry averages. 

Whatever your findings are should be mentioned in the contract and used to lower the price. At the end of the day, you’ll be paying for this later on, which shouldn’t be the case. 

The Pre-LOI Due Diligence Checklist 

Knowing these red flags is only the start. To ensure proper risk mitigation, you need to follow a checklist to ensure you don’t miss these issues. 

Customer Concentration

• Request revenue by customer for the last five years. 
• Flag any single account above 10% of revenue and investigate anything above 20%. 
• Confirm every major contract is written, current, and assignable on change of control. 
• Ask who owns each key relationship and what happens if the seller leaves. 

Key-Person Dependency

• List every decision only the owner makes and every relationship only the owner holds. 
• Check which processes are documented and which exist only in someone’s head. 
• Review employment agreements, especially for second-tier managers. 
• Negotiate the transition period and consulting agreement before signing. 

Financial Discrepancies

• Commission a QoE analysis before building the offer for the seller. 
• Challenge every add-back individually rather than just accepting it. 
• Cross-check the P&L against tax returns and bank statements. 
• Ask directly about pending litigation, warranty exposure, and verbal commitments. 

Operational Diligence

• Walk the floor and interview staff, not just the owner. 
• Test whether the operations run without the owner ever interfering. 
• Review systems, like what transfers, what expires, and what lives in someone’s memory.
• Compare staff compensation against the industry’s market. 

Deferred Capital Expenditure

• Request the full equipment schedule with purchase dates and life expectancies. 
• Compare cap-ex and maintenance spend against revenue after five years. 
• Have all major assets independently inspected before any price is agreed. 
• Deduct catch-up spend from the offer and hold it back in an escrow if needed. 

Where OCX Advisors Comes In

Investing in an LMM can be lucrative if done correctly. The issue is that doing it right is difficult and requires professional analysis and due diligence to get the purchase price and agreement right. 

That’s exactly what we can help with at OCX Advisors. We can perform due diligence, audit, and develop a purchase agreement that’s fair based on real data. For more information about how we can help, contact us today.