There are many hurdles on the way to a successful M&A transaction. But luckily, we’ve established a number of tools and processes to navigate the rough seas of deal-making.
Once a suitable target company is found and has passed the initial screening during deal sourcing the deal team will proceed into a more formal phase of the Due Diligence (DD) process.
Usually, there are four main areas every DD process has in common when buyers want to learn more about a target company: (1) Commercial, (2) Financial, (3) Legal, and (4) HR. Depending on the industry/segment the target company operates in, there could be additional diligence areas of interest, e.g. Technology.
The main goal of Due Diligence is to uncover potential risks and verify the target. In my career as Corporate M&A professional, I’ve seen many deals unfold – and identified a number of early warning signs that trigger me not to proceed with a transaction, or at least to think about additional mitigations to reduce risks.
In this article, I will share some red flags that I’ve personally encountered.
Excessive Secretive Behavior
Throughout DD a buyer and its deal team will have multiple interactions with the CEO of the target company. While it is understandable that management is somewhat reluctant to over-share information in the early stages of a transaction when certain trust levels are not established yet and it is somewhat unclear if the buyer wants to proceed with the transaction, continuing this form of hide & seek throughout the entire process could be an indication for a cover-up by the management.
It is ok not to share detailed customer names when going through the sales pipeline, especially if the buyer and the seller operate within the same market. It would not be okay if the seller is refusing to review the sales pipeline at all or only shares very high-level information about it.
I once had a case where a target tried to limit information flow to the extent that a proper diligence report could not be created. I picked up the phone and explained the situation, and told them whatever they try to achieve with this behavior it won’t make it easier for the transaction to go through. They don’t want a diligence report with statements like: “No data points provided by the target, therefore we assume XYZ”. If there are issues we need to identify and make them transparent to decision makers so they can have an unbiased opinion to move forward with the deal or not.
The main goal of commercial DD is to better understand the target’s business model and explore how the company addresses the needs of its customers, capitalizes on key industry trends, and navigates the competitive environment.
Typical issues of concern would include shrinking market size or declining market share in an overall growing market, dependence on powerful suppliers, or a concentrated customer base. If only a handful of customers are responsible for the overall revenues of the target, losing 1 or 2 of them could have a massive impact on the overall business.
One I came across personally was that a target had multiple high-caliber logos in their pitch deck. As a buyer, you think “those are all active customers, wow what a track record”, because this is what such a slide suggests, right? After digging a bit deeper by looking at the customer contracts I figured out that only a fraction of the logos are active paying customers.
The rest was either one-time projects where customers ran a proof of concept and decided against the target solution, or customers which had a contract in place some time ago, but were not active paying customers anymore.
Financial DD (FDD) includes a detailed examination of a target’s historical statements and management’s financial projections. First, you want to understand if the overall business model and commercial approach are reflected in the financial statements and compare it with peer companies and industry standards to assess the overall financial performance of the company. Are margins increasing over time? Are future projections reasonable and sound? What about working capital which is required to run the company? Does the company have enough runway to reach a certain milestone?
Look out for off-balance sheet financial instruments like unused commitments, letters of credit, etc., weakening working capital trends. Second, you look for common accounting shenanigans like cookie jar accounting that can distort the real financial performance of a company.
Finally, you bring everything you learned into your financial model, which will result in a company valuation, which will be part of the negotiations. When analyzing historical revenue data you also want to look at its quality. What are the components, and what are the revenue drivers?
If you are buying a SaaS company then the typical SaaS metrics need to be in place. Also from a scaling perspective, at the end of the day, it is all about growth and how you as a buyer can achieve synergies. As with this one case where a target claimed to have double-digit year-over-year growth of recurring revenues.
As a buyer, you are tempted by this claim and maybe you start justifying a high deal price and other deal mechanics bound to this KPI. The end of the story was, that the target had indeed those numbers, but the biggest portion of those revenues was coming from low-margin professional services. This is not exactly what you are looking for as a buyer of a SaaS business.
Legal DD is typically done by a law firm acting as an outside counsel. The scope of legal DD usually contains the review of the target’s material legal documentation and the legal status of the company’s key stakeholders.
While the list of items in an LDD could be extensive (law firms somehow need to occupy their associates 😊 ) there are common flags that need more attention and could become a real deal breaker. Examples are pending regulatory issues (e.g. biotech companies waiting for FDA approvals), corruption and bribery accusations (the company operates in sanctioned or high-risk countries), insufficient protection of intellectual property, and questionable ownership rights (IP chain of title is unclear, as the company is a spin-off from another organization).
The human factor is one of the most critical elements of a transaction. While obtaining IP could be a core driver of a transaction, the ongoing operations and value realization will always occur with the people involved. Besides more formal assessments regarding pension plans, benefits, recruitment, etc, as a buyer, you want to find out if the work culture is toxic if there is high attrition in the workforce, and if frequent changes in the board and upper management of the company happen.
After all, you want to make sure that synergies will be realized and the business case comes to life once you close out the transaction. If management wants to cash out all its equity, or customers have a strong personal loyalty to the owners this is never a good sign and needs further digging.
The Due Diligence process is an important step in a transaction. You take the target for a test drive and try out everything visible. You also look under the hood and make up your mind if the company is the right fit for you. There won’t be a target that checks all the boxes, so you will probably end up with minor issues you need to take care of. After all, you are buying a company that is out there for at least a couple of years if not dozens, just as a used car it will have things that need attention. It is important to define what issues are absolute no-goes and which risks can be mitigated once the transaction closes. But hey, if a deal is too good to be true, it probably is.