When it comes to mergers and acquisitions, due diligence is not just a legal obligation or a formal procedure. It is a crucial step that can make or break a deal and determine the future of the merged entity. A good due diligence process can reveal the strengths and weaknesses of the target company, identify the potential risks and opportunities, and help the buyer negotiate the best terms and price. A good due diligence can also set the tone of a successful deal, by establishing trust and confidence between the parties, aligning the expectations and goals, and creating a positive momentum for the integration.

Common Red Flags

Some of the common red flags in due diligence are:

  • Inconsistent or incomplete financial records, such as missing invoices, receipts, or tax returns, or discrepancies between the audited and unaudited accounts. These may suggest poor accounting practices, lack of control and monitoring that may mean fraud, or misrepresentation. A common example that we have seen is a target company may inflating its revenue, understate its expenses, or hide its debts, to appear more profitable or solvent than it actually is.
  • Legal issues, such as pending or potential lawsuits, regulatory violations, intellectual property disputes, non-permitted activities. These may expose the target company to significant costs, damages, or penalties, or affect its reputation or goodwill.
  • Operational issues, such as low customer satisfaction, high employee turnover, poor quality control, or outdated technology. These indicate operational inefficiencies, quality issues, or competitive disadvantages. A classic example is that target company having a high rate of customer complaints, refunds, due to defective products, poor service, which erode its customer loyalty, retention, or acquisition of customers.
  • Low quality of earnings due existence of non-recurring revenue, aggressive revenue recognition, understatement of expenses, improper accounting policies and related party transactions not considering arm's length principal.
  • Market issues, such as declining sales, shrinking market share, increasing competition, or changing customer preferences. This signal market saturation, erosion, disruption, or reduced growth opportunities.
  •  Heavy reliance on a small number of customers or suppliers, which could pose a risk if these relationships are not stable or if the terms are not favorable.
  • Changes in management or loss of key personnel following the acquisition can disrupt business operations. It's important to assess the depth of the management team and the plans for key personnel post-acquisition.
  • Cultural issues, such as mismatched values, vision, or goals, or incompatible management styles or organizational structures. These may create conflicts, misunderstandings, or resistance, or hamper the post-deal integration. Therefore, a matching of wavelength is critical even before the due diligence process is initiated.

Key to a Successful Deal

  • While red flags may not necessarily be deal-breakers, they may require further investigation, negotiation, or mitigation to ensure a successful outcome. To make the deal fly through, the parties involved should: While red flags may not necessarily be deal-breakers, they may require further investigation, negotiation, or mitigation to ensure a successful outcome. To make the deal fly through, the parties involved should:
  • Conduct a thorough and objective due diligence, using reliable sources and methods, and involving experts and advisors as needed. This will help gain a comprehensive and realistic understanding of the target company, its strengths, weaknesses, opportunities, and threats, as well as its valuation and synergies.
  • Communicate clearly and transparently, disclosing any relevant information, addressing any concerns, and resolving any conflicts. This will help build trust, rapport, and credibility, and avoid any surprises, delays, or disputes.
  • Align their expectations and interests, finding common ground and mutual benefits, and agreeing on the valuation, terms, and conditions of the deal. This will help them achieve a fair and balanced deal and maximize the value and returns for both parties.
  • Prepare for the post-deal integration, planning and executing the necessary steps to combine the resources, processes, and cultures of the two entities. This will help realize the potential synergies, efficiencies, and growth of the combined entity, and minimize the risks and costs of the integration.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.