Question for the accountants, attorneys, and due diligence professionals!
October 11, 2023
by a searcher from University of Minnesota - Twin Cities Campus in Marysville, WA, USA
Hi all! I'm beginning the due diligence process for two businesses (my first two LOIs - woohoo!
For those of you who do due diligence frequently, what are some common red flags that you see pop up during due diligence? Put another way, what are some common problems with businesses that due diligence uncovers that would cause you to advise a buyer not to acquire the business?
If it helps narrow down your thought process, both of these businesses are PR firms.
Thanks in advance for your input!
from University of Cape Town in Auckland, New Zealand
Just to add to the other voices from a financial point of view. First, Kudos for front-footing the due diligence process and asking the questions. Financial due diligence findings seldom lead to walking away but rather leads to (1) an adjustment to the purchase price/multiple or (2) special protective clauses in the agreement e.g indemnities and warranties. If of course Owner is trying to hide things best way is often to walk away Below are a few problem areas often with small businesses (1) Quality of financial information – first you want to have a sense of the level of bookkeeping to gauge how much reliable is the financial information. Consider protection for things such as unaccrued expenses that need to be paid after acquisition. • Accounting package - should be satisfied if the company is using an off-the-shelf accounting package e.g Xero. • Audit or external accountant – when a CPA is involved in audit or preparing annual financials that is good • Internal controls and separation of owner & business (2) Revenue recognition and growth – this is the highest risk area in acquisitions. There are 2 things here (1) that the business is making the money it says it is making and (2) the money is coming from where they say its coming from. • In terms of 1 tax returns and a proof of cash exercise would help. • Number 2 is important, you just must be clear about what products, customers, and locations are driving sales and sales growth. Sometimes you find that a business with hundreds of products is relying on only a few for profitability, same as customers. Unfortunately red flags with customers/products etc tend to result in aborting the deal. Feel free to reach out if you have any questions – redacted
in Petaluma, CA, USA
I have a small sample size but off the top off my head, and not in any order, here are a few things. I expect several of these to be yellow flags in any deal but hopefully not rise to red.
1. Employees: If the business shrunk or flatlined headcount post Covid, then is it adequately staffed now or are things ripping at the seams?
2. Employees: Retention of any key employees, previous arrangements/conversations they might have had with sellers about the sale, any expectations that they might "get" the business or tried to buy it previously..etc
3. Finances: This is different for every business but there are a number of things sellers can do to dress up a business for sale. Any anomalous changes in key metrics such as GP%, Expenses%, CAC and other KPIs going back 3 years min should be looked into.
4. Employees: In some businesses, employee turnover can be so high that it might not be a good fit for what you want to do. I backed out of one business that had been hiring one new employee every week for the past year because of attrition.
5. Customers: How has customer acquisition "really" happen? State of (all) key relationships, as Patrick said.