Due diligence in M&A: eight red flags investors should not ignore

Due diligence is the stage at which an investor looks inside a target business before settling on price and terms. Experience from more than 120 engagements shows that the significant issues rarely sit in the audited financial statements; they hide in the gap between reported figures and how the business actually runs. Below are eight red flags Corvane's team encounters most often.

Financial

• 1. Profits rise but cash flow does not. Early revenue recognition, lengthening receivables or unusual inventory build-up call for a close look at the quality of earnings.
• 2. Revenue concentrated in a few customers or dependent on parties related to the current owners — a risk once control changes hands.
• 3. Costs paid by the owners outside the books, such as management salaries or office rent, which make margins look better than they are.

Tax

• 4. Two sets of figures: large, unexplained differences between management accounts and tax filings.
• 5. Tax incentives currently enjoyed whose conditions may no longer be met after the transaction, or whose supporting documentation is incomplete.
• 6. Undocumented related-party transactions, or unreviewed tax years with significant transaction values.

Legal

• 7. Core assets not held by the company: land, trademarks, domain names or licences registered to individuals or other entities.
• 8. Key contracts with change-of-control clauses allowing counterparties to terminate when ownership changes; or unrecorded labour disputes and social insurance obligations.

“A red flag doesn't mean the deal has to stop. What matters is spotting it early, quantifying its impact and bringing it to the negotiating table — through price, through warranties and indemnities, or through the deal structure.” — Mr Dinh Quang Vinh, Partner, Transactions & M&A, Corvane Advisory

From findings to contract terms

Due diligence findings only add value when they are turned into specific actions. Depending on severity, an investor may adjust the price, require the seller to remedy issues before completion, hold back part of the consideration, add representations and warranties, or change the structure from a share deal to an asset deal.

Every transaction has its own context, and this list is no substitute for full due diligence. Corvane recommends that investors combine financial, tax and legal due diligence from the outset so that findings are assessed within a single picture and issues that fall between disciplines are not missed.

Allowing enough time

For a mid-sized business, combined financial, tax and legal due diligence typically takes four to eight weeks, depending on the quality of the data room and the seller's cooperation. Compressing it excessively to meet a signing date is often why important issues are missed.