Red Flags
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What are the biggest red flags you look for during due diligence? And when is a red flag a showstopper or just a challenge?
One of the biggest red flags I run into is changes in accounting structure relatively prior to the close. I’ve seen far too many companies, albeit smaller in size (<$10MM rev), change their structure with the aim of increasing EBITDA.
One of the red flags we pay attention to is the ownership of assets we’re buying. Many times with software companies we find that their solutions are partly owned by one of their clients/minority investors.
A red flag is something that contradict with your corporate objectives. Financial, strategic and control are key part of those red flags. A multi disciplined team shall be able to identify those red flags.
From my experience with few M&A transactions I have been involved in during my work is the contractual complexities of the target company. examples are the consents required for shareholders agreements and change of control of existing joint venture that the target is part of which could lead to a breach of agreement clauses the bidder was not aware of and therefore could be really a show stopper.
I think it’s the information that is not clearly disclosed to deal participants such as patent/IP ownership, business secret, potential tax lawsuit liabilities, change of company structure, or compensation policies prior to the deal closure.
Biggest red flag is lack of organization and documentation in key metrics. Sometime its not the actual result, but an attempt to document it.
Biggest have been legal issues that could be hiding/past or current litigations. Also, leadership not being aligned and additional HR/people issues (making sure proper screening is completed on current and future employees)
One of the most critical DDs is the Financial one: the findings will be very crucial in constructing a view of the target’s financial performance & growth. This will certainly enable reaching a valuation that my seem fair & appropriate.
For manufacturing industries, rad flags can be the actual status of inventory (real value vs book value) and supply chain resilience or lack thereof. For instance, how many of the key components are single sourced and how reliable are the suppliers.
one major deal breaker from my HR experience was a result of huge amounts of future liabilities and employee relations issues. The target company being assessed had major flaws in its compensation and benefits packages, and overpaid above 200% of the market in specific jobs. The total headcount was too large to not consider future costs pertaining medical liabilities. further-more, it was clear that the NewCo would have a big challenge internal pay equity and the resistance expected from the target company employees would be too large. Other possible acquisition however did not have these HR issues, which automatically made them more viable targets.
In my experience either a major legal issue (breach of labor agreements, contracts, regulatory requirements), tax issues (reporting, credits, payments) and accounting treatment for financials are the major areas which can cause red flags. Keeping emotions out and focusing on the problem, impact, (cost/time/risk) and weighing options is critical in the end.
One of the red flag while my team are doing due the DD process, we (together with the advisors) have identified certain key area of inconsistency, including certain financial information were unclear, etc. This has cause my company to drop off this deal.
Some of the practices and observations that could trigger a red flag:
1. Requests to involve individuals in transactions normally between government entities
2. Requests for unusual or excessive confidentiality about the terms of, or the parties to, the transaction
3. Unexplained urgency or last-minute requests for changes to the transaction
4. A trust or private investment company involved in the transaction is unable or unwilling to provide information on controlling parties or beneficiaries
5. Inquiries made outside of normal business channels
6. Requests for unusual labelling or packing for shipment of goods
7. Requests for specifically stated values on customs documents
8. Requests to subvert normal or required recordkeeping procedures
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