When to Walk Away: Due Diligence Red Flags That Kill Acquisition Deals

When evaluating a startup for purchase, look out for these due diligence red flags that kill acquisition deals. Companies enter into M&A transactions for several reasons, but strategic growth is always the primary objective.

You could be looking for tactical collaborations to accelerate your go-to-market strategy. Or, an acquihire to acquire an exceptional team. Another excellent reason is purchasing a startup for its intellectual property (IP) and the intangible assets it can create.

But before finalizing the deal, you’ll conduct extensive due diligence to get behind the scenes. Your goal should be to uncover undisclosed risks and any pitfalls that can derail the integration. Ensure you can extract the maximum synergies from the transaction and meet your objectives.

The first step in the right direction is appointing a due diligence team to examine and analyze the target thoroughly. You’ll look for undisclosed or overlooked issues with its financials, legal, regulatory, and taxation compliance, customer management, and human resources.

Any red flags the team uncovers will signal a decision to walk away from the deal. However, be open to negotiating solutions to resolve the issues, particularly if the deal is too good to give up. You’d give the seller time to fix the problems. Or, accept a lower price if you prefer to fix them post-acquisition.

Read ahead for in-depth information about typical due diligence red flags that kill acquisition deals.

Due Diligence Red Flags That Kill Acquisition Deals #1: Poor Financial Health

Acquirers examine the target’s financial health as one of the first aspects. Here’s how that happens:

• Your due diligence team analyzes the financial statements, profit and loss accounts, balance sheet, and the entire accounts framework. The focus here is on revenues, expenses, profits, and other reports. If the numbers don’t add up, that’s a major red flag. It indicates a lack of financial stability and control.
• Accountants also study the target’s accrued debts and liabilities. The resultant numbers will provide a clearer picture of whether it is struggling financially. A high amount of debt transfers to the acquirer, who will be responsible for paying it off. This factor poses a substantial risk.
• Certified accountants check for outdated and missing entries, inaccuracies, unexplained revenues and profits, and unclear debt and payables. Their objective is to spot errors and omissions that indicate a lack of transparency and reporting integrity. Discrepancies and misalignment between the seller’s claims and financial statement data are huge red flags.
• The target’s cash flows are under special scrutiny, particularly operating costs. The company might demonstrate profitability on paper. However, it may find it hard to keep up with payments to vendors and suppliers. A weak or diminishing cash flow typically points to operating issues.
• Accounts receivable and accounts payable are under scrutiny. A large number of accounts receivable with long collection periods means the company is experiencing unstable revenue streams. It could be relying on bridge loans and other short-term financing options to continue operating. This is not a healthy sign.
• Inconsistent revenues are another cause for concern. The target could have a concentrated customer base, which means its sales depend on just one or two major buyers. Or, the revenues could be project-based and inconsistent since they are sourced from one-off deals.

Conclusions from Financial Due Diligence

As your expert M&A advisor will recommend, you should allow due diligence to progress per the team’s discretion. Expect that a meticulous analysis can take anywhere between 30 and 90 days. This time frame can be longer depending on the complexity of the deal and the regulatory issues involved.

Speeding up the process is never advisable, since you could end up buying a company with major financial pitfalls. If the financial statements don’t align across different reports, that could signal account manipulation. You’ll know that the target is misrepresenting its performance.

Here’s another example. A sudden spike in accounts payable could mean the company has been unable to cover vendor payments. You’ll dig deeper into this issue and the reasons behind it. Is it because of cash flow problems? How did the target intend to resolve this problem?

Conversely, a sudden and unexplained revenue spike is also a red flag. Your due diligence team must analyse customer payments to authenticate the revenue. Be wary of companies inflating revenues ahead of an acquisition deal to present a positive picture to the buyer.

Get your team to analyze the cash flow projections in detail, including the historical collection cycles. The results will explain how the target has managed its working capital. This information will help you estimate the liquidity the target will bring after the acquisition. It could influence your decision.

Examining tax returns is a crucial step in the analysis. Any discrepancies in the finanical statements and tax returns are one of the due diligence red flags that kill acquisition deals.

You will need expert financial auditors to conduct audits and forensic accounting to verify the data. Ensuring accuracy and authenticity is crucial at this point.

Red Flag #2: Non-Compliance with Taxation Regulations

Non-compliance with taxation regulations is a sticky issue that an acquirer will not want to inherit with the purchase. This is why you should have an expert tax consultant on the due diligence team. This professional will examine the tax records to confirm that all taxation payments are up-to-date.

Companies must routinely comply with federal, state, local, and industry-specific taxation laws. Failure to comply with regulations can lead to hefty fines, legal action, and the risk of IRS audits. The tax consultant will review the tax returns and check for any action the IRS may have taken.

For instance, the IRS may have levied penalties for unpaid taxes, unfiled returns, and schemes to avoid paying taxes. In that case, you must evaluate the potential liabilities and how they can transfer to your company after the purchase. Financial risks like these are crucial due diligence red flags that kill acquisition deals.

Red Flag #3: Non-Compliance with Federal and Legal Regulations

Businesses must comply with federal, state, and industry laws and regulations, and non-compliance can translate into expensive liabilities. From the time the startup is established, its owners need to register it with the relevant authorities. It must also acquire the mandatory licenses and permits.

Companies are also subject to several laws, including labor, ESG, family and medical leave, OSHA, and antitrust. Non-compliance can lead to fines and penalties, or worse, lawsuits. Post-acquisition, your company could be exposed to these risks and liabilities, so ensure the target’s licenses are in order.

If your target is a tech startup, make sure it has clear ownership and usage rights on the intellectual property. Any encumbrances in the title or usage rights can create issues down the line, not to mention the risk of lawsuits.

Your legal team must examine the trademarks, patents, copyrights, and titles on the IP. If needed, you might need to get ownership formally transferred to eliminate any liens. Don’t overlook the risk of reputational damage to your company’s brand.

While on the subject of lawsuits, your team should look into any ongoing litigation the target has been or is currently involved in. Also, examine all the contracts it has entered into with vendors, suppliers, clients, distributors, or other entities. Check for any violations that could create problems for you.

Pay special attention to the contracts employees have signed with the target. You’ll look into the wages, option pools, compensation packages,  benefits, and pension plans it offers. Ensure that it has kept up with all payments and there are no outstanding dues.

Lease agreements that the target may have entered into for premises, equipment, or other operating resources are also under scrutiny.

Red Flag #4: Poor Relationships with Customers and Other Stakeholders

A startup’s survival and credibility depend on its relationships with customers and operating partners, such as vendors, suppliers, and distributors. The company will be sustainable and profitable if these working relationships are stable.

When evaluating the target as a good candidate for an acquisition, you’ll analyze its brand value and market reach. Low customer acquisition costs (CAC) and churn rates are positive signs and indicate brand loyalty. However, you should also examine customer contracts and their terms and conditions.

Check if the company relies entirely on one or two customers for its sales. Or on one or two vendors to source the inventory. Also, check the company’s distribution channels. Does it depend on a small number of partners to manage delivery?

A stable company should have a diverse customer base and operating partners. A lack of these aspects does not necessarily need to be a dealbreaker. You would want to focus on the merits the target brings to the table and if they can balance out the negatives.

A sell-out could be the target’s strategy to remain in business by leveraging the opportunities your established organization can provide. Work with the due diligence team to evaluate the target’s assets and potential synergies before making the decision to continue or walk away.

At the same time, ensure that your company can honor ongoing contracts. You can either end them before the acquisition or renegotiate the terms and pricing structure. Focus on retaining high-value and high-profile customers who can be long-term partners with the new company.

Knowing how to navigate the due diligence process is crucial for all business owners when fundraising or negotiating an M&A deal. Check out this video in which I have explained how it’s done.

Red Flag #5: Disgruntled Team and Lack of Cultural Fit

The team is the most crucial aspect of the entire M&A transaction. Due diligence red flags that kill acquisition deals center around how the target manages its human resources. Check for the worker turnover and attrition rates, which indicate the number of employees quitting the company.

Next, explore the reasons for a poor workplace culture, including issues like a toxic work environment and conflict situations. If management has been dealing with complaints, that could indicate low morale and a lack of job satisfaction.

Other reasons people quit could include a workplace environment that is not conducive to growth and productivity. Don’t overlook the salary and compensation packages the target offers. If it is facing issues with employee retention, maintaining operations can be a significant challenge.

Why is this crucial? You could be integrating a disgruntled workforce and a toxic culture into your own company. Not only will the integration be extremely challenging to execute, but the issues could also percolate into the newly formed company. That’s something you would want to avoid.

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Red Flag #6: Strategic Misalignment

Operators in the business ecosystem understand that the success of a startup is ultimately about the founder and their expertise. This is why investors back entrepreneurs and their ideas, and not the companies they build, per se. Similarly, when acquiring a company, you’re partnering with its owner.

Before finalizing the deal, make sure the target’s mission statement aligns with your company’s. The owner’s vision and operational strategies should result in synergies that translate into profitability. If you anticipate issues with integration, it could be wiser to walk away from the deal at this point.

Many acquirers prefer to bring the target’s founder on board after the acquisition concludes. As part of the terms and conditions, the founder continues working with the management and contributes their expertise.

Before you include these terms, ensure that the owner has adequate experience and a successful track record with similar companies. These factors can influence your purchase decision because this expertise is key to laying a robust foundation for the company.

Without it, the target may not be a viable acquisition candidate.

Don’t Walk Away Just Yet!

Due diligence red flags that kill acquisition deals need not necessarily be dealbreakers. But knowing what you’re getting into before purchasing the target is a huge advantage. As mentioned earlier, you’ll need to work with your legal and M&A team to arrive at solutions.

Identifying the red flags helps you isolate the risks and prepare to deal with them. You can consider renegotiating the terms and pricing, or give the seller time to resolve the issues before the sale. Requesting provisions like warranties and representations in the agreement is also an option.

Ultimately, it comes down to the merits of the deal and if it guarantees adequate value that balances out the downsides.

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