Red flags in potential M&As

searcher profile

November 18, 2024

by a searcher from Instituto Tecnológico de Buenos Aires in United States

What are the key red flags (both financial and operational) you look for during due diligence in a potential acquisition? I’m curious about your insights and experience about the critical aspects to focus on, beyond just the financials. Do you have any best practices for identifying risks early on?

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commentor profile
Reply by a professional
from Allegheny College in Philadelphia, PA, USA
Thanks for the tag Luke!

There are various levels of risk, and this list is certainly not inclusive (every deal is different), but some that immediately come to mind are:

1. Employer payroll taxes being properly withheld and paid to appropriate tax authority.
2. Concentration of customers and revenue (70% of revenue from one customer can be a bad thing)
3. Key man risk
4. Pending litigation or uninsured risk exposure
5. Grossly disorganized corporate records and/or misaligned tax records

Another one is suspicious seller behavior or demands. I see someone post about a ridiculous seller demand in the small business subreddit at least once a week. The recent one was refusal to provide financials until a purchase agreement was signed (not an NDA or LOI, a purchase agreement). Now, perhaps the purchase agreement had sufficient language that allowed for the buyer to complete DD and terminate the agreement if needed, but WHY WOULD WE WASTE TIME NEGOTIATING A PSA IN THIS CONTEXT? Often times there are financial issues that need to be addressed in the PSA (indemnification for unpaid tax liability, representations about customer activity, and many others). It is ridiculous to accept demands like this, and it is important for buyers to realize they can, and should, walk away from people like this.

A seller concerned about confidentiality can always redact sensitive information. Refusing to give any information is simply not acceptable and a good reason to stop the conversation.
commentor profile
Reply by a professional
from University of Massachusetts at Lowell in Chicago, IL, USA
During due diligence, I focus on both financial and operational red flags to assess potential risks comprehensively. Financially, I look for inconsistent revenue recognition, declining margins, and aggressive accounting practices, which often signal deeper structural issues. Operationally, customer concentration, high employee turnover, and regulatory compliance gaps are critical areas of concern, as they can disrupt future performance. Beyond the financials, understanding the target company’s culture and leadership dynamics is essential to anticipate potential integration or changeover challenges. To identify risks early, you should establish a network of service providers you trust and can rely on to spot anomalies to ensure a holistic view of the acquisition's viability. Feel free to reach out if you'd like to discuss more at redacted
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