Seven Warning Signs Your Due Diligence Team Should Identify
Expanding your business through the acquisition of another company can be an overwhelming task. Business owners often come to us unsure where to begin—not just what questions to ask, but also what to do with the answers. No matter your industry, type of company, or familiarity with the acquisition process, we advise business owners to start by building an experienced deal team.
A skillful, accomplished deal team with a thorough understanding of the due diligence process can save you time and money by identifying potential warning signs regarding a target company’s financials; performance; customer and supplier relationships; environmental and safety record; taxes; employee retention; or legal problems. Raising these seven red flags before you decide on an acquisition can help you steer clear of larger problems down the road.
Red Flag #1: Disorganized Financial Statements
Your first step in deciding whether to acquire a company is to initiate a detailed due diligence process to determine the company’s value, and the first indication of that value is the quality of the company’s financials. A company that fails to provide organized, detailed information throughout the process is sending you an important message: Be cautious of proceeding with this acquisition.
A business owner looking to sell the company may provide any of the following three types of financials:
Audited financial statements.
Audited statements—the most accurate financials that a company can provide—carry the fewest red flags for a buyer. Verified at the most detailed level by an accounting firm, they provide reasonable assurance that the company’s financials are not misstated or missing critical pieces of information.
Verified by an independent accounting firm but to a lesser degree than fully audited financial statements, reviewed financials are often less costly and time-consuming while still helping provide reasonable assurance that the target company’s financials are correctly stated.
Offering little to no verification from a third-party accountant, compiled financials carry the most serious acquisition red flags. A party outside the company does compile an independent statement, but this accountant does not provide assurances of its accuracy. If the company you are looking to acquire does not have either reviewed or audited financials, you should see this as an immediate red flag.
As a buyer, you should require a quality of earnings report (QofE)—a comprehensive evaluation of a company’s financial performance to show how its revenues are accumulated—on any company you wish to acquire. A QofE verifies the accuracy of financial statements and helps identify performance risks within the company. This report also helps ensure that while structuring a deal, both parties are using an accurate assessment of company performance.
Red Flag #2: Financial Performance Issues
In any acquisition, determining the target company’s normalized profitability—an analysis of all income generated by its core operations—is a key part of the valuation process. Any income deemed to be nonrecurring (such as a forgiven PPP loan) is removed, as are certain expenses (called “add-backs”) that do not reflect normal company performance and are not critical to generating core revenue. Assessing addbacks and normalizing earnings allows your due diligence team to determine the company’s actual efficiency and assess its true performance.
Is poor financial performance the result of current management decisions or a fundamental problem of business operations? Your due diligence team will recognize the latter as a severe acquisition red flag. Likewise, a bloated company that requires reassessment of its entire expense structure is a very different problem from decreased margins caused by excessive personal expenses of current management—both are potential red flags, but the former points to a fundamental problem in operations that is inherently risky to the company’s future performance.
Red Flag #3: Contingent Customer and Supplier Relationships
Change is inevitable during an acquisition, and if key relationships hinge on the current owner or other key employees, any variation from the status quo may affect the company’s valuation. Imagine you purchase a company that enjoys strong cash flow and margins, with a single customer driving 50% of its historical performance. Now imagine that customer cuts ties with the company the next day—and you have just lost 50% of your value. Too much reliance on one customer can be a significant red flag during the acquisition process, so a thorough review of the company’s customer relationships is essential.
Losing a major customer relationship after the acquisition is a very real possibility that your deal team must consider, and assessing supplier relationships can be just as critical. Relying solely on one vendor to provide materials or products means any price increases could cut margins considerably—especially if you’re seeking to scale operational capacity beyond the target company’s current level of demand.
Red Flag #4: Environmental and Safety Concerns
Environmental and safety red flags are another cause for concern when you’re looking at potential acquisitions. As a buyer, you may be subject to certain liabilities if the target company has improperly maintained or contaminated the site(s) where it operates.
Completing a Phase 1 Environmental Site Assessment is a common practice among experienced due diligence teams. This report helps determine potential liabilities associated with the property you wish to acquire, so you can appropriately protect yourself and your business. The results also are considered reasonable enough due diligence for a buyer seeking to avoid the risk of inheriting certain liabilities vis-à-vis provisions in the Comprehensive Environmental Response, Compensation and Liability Act (CERCLA) of 1980.
In certain industries, the seller’s safety record is a critical indicator of how a company treats both its employees and customers. Has the company you wish to acquire adequately followed all health and safety guidelines for its operations? Checking its safety protocols and historical violations with the Occupational Safety and Health Administration (OSHA) helps ensure that you actually have taken control of operations, can keep your employees safe, and can avoid future penalties from OSHA.
Red Flag #5: Tax Liability
When performing due diligence regarding the seller’s taxes, you must first identify where the company has nexus. A company you acquire is liable for the state’s sales taxes if it meets either of two parameters: the business has a physical presence in the state (physical nexus), or its sales exceed a certain economic threshold (economic nexus). You should speak with a tax expert, though, because other factors could create nexus as well.
Keep in mind your tax exposure resulting from a transaction during the due diligence process. A company that is not compliant with the obligations that correspond with its nexus in all states is sending up an acquisition red flag. While tax concerns for the buyer typically are carved out of an acquisition, tax authorities may still choose to come after you. Also, carefully consider the nexus exposure that you will take on after the acquisition. Your newly merged business will likely have new tax considerations due to changes in size and geographic footprint.
Red Flag #6: Employee Retention Risks
A company’s most valuable asset is its employees, which means it’s vital to ensure that the target company has a culture and business model that can be integrated into your own. Operating within a single or similar culture can help keep turnover low during the transition.
A large disparity in compensation for similar positions is another significant red flag, especially if this leads to reductions in pay, which are likely to create turnover after an acquisition. Analyzing how benefits and pay structure affect key personnel will help you assess whether matching compensation and retaining employees is feasible.
Regardless of the various similarities and differences between the two companies’ business models, the organizational structure will change during an acquisition; certain positions need to be filled, whereas others will be vacated. Although many factors can affect employee retention during an acquisition, most retention issues can be mitigated with strong management oversight and workforce incentives. Due diligence will help you identify the costs and solutions needed to retain the right employees.
Red Flag #7: Legal Problems
The due diligence process allows you to assess any current or pending legal issues surrounding the company you wish to acquire, which can be a large red flag. Legal snags often point to complications in how the company has been run historically, but they can also highlight a severe problem in the business’s overall operations. Previous legal issues bring a higher likelihood of future legal difficulties.
Once your deal team completes comprehensive legal due diligence of the target company to uncover past or present legal issues with customers, suppliers, competitors, the government, or even the business owners themselves, you should try to carve these out of the acquisition to keep you and your company protected. A stock purchase can still put you in the line of responsibility in some cases, however, so count on your deal team to help you develop strong legal protections throughout the process.
Build a Strong Deal Team So You Can Proceed with Caution
As a buyer, you will need to consider numerous factors and scenarios before deciding to purchase a target company. Identifying every warning sign and gaining as much information as possible are essential as you analyze all aspects of the potential acquisition. Surrounding yourself with an experienced due diligence team will allow you to pinpoint and counteract those red flags one by one, so you can make the most informed decision possible before making that purchase.