Due Diligence Findings That Can Threaten A Deal

December 2012       Download PDF      Print

During the due diligence stage of an M&A deal, a buyer conducts a detailed final review of a business to make sure they've uncovered any issues that may reduce the value of the company. Most of the time, business owners make accurate financial and legal representations to potential buyers when selling their companies. However, buyers sometimes uncover serious and previously undisclosed issues that threaten the value of their deal.

The following examples are just a handful of the red flags a buyer may encounter during the due diligence stage of buying a business.

Losing a large customer

Some businesses have a single customer that is responsible for a large percentage of the company's sales. In such cases, a member of the buyer's deal team may wish to interview the target's main customer to assess the vendor/customer relationship and determine the likelihood of maintaining the client after a change in ownership.

Consider this scenario: a buyer is seriously evaluating the purchase of a business that has a client who represents nearly one-fourth of its revenue. During the due diligence process, a representative from the buyer's party discovers that the customer plans to withdraw its business due to a change in strategic direction. In fact, the client had informed the company of the change four months earlier. The seller hadn't disclosed this development, knowing it would have an adverse effect on the company's future profitability.

To protect themselves from similar issues, buyers will typically add a material adverse change clause to their purchase agreement. Such clauses cover events that occur between the signing of a letter of intent and closing. In situations similar to the one described above, a buyer would likely want to back out of a deal and could exercise the clause, citing dishonest behavior on the part of the seller.

Void on management team

Many buyers search for acquisitions with experienced management teams that can continue growing the business after a deal closes. In the due diligence process, some buyers may discover that a company's leadership team isn't prepared to manage the business in the previous owner's absence.

Before marketing their company for sale, a business owner may realize that there is a void in the company's top management structure. Knowing that buyers would likely be deterred from a company without management infrastructure, an owner may accidentally hire the wrong person to fill the void. A company with a weak management team may represent too much risk for a potential buyer.

Troubling legal past

Occasionally, a deeper look into a company's past will reveal evidence of pending lawsuits or a history of legal battles fought against a customer, former employee, regulatory agency, shareholder, or supplier. A key manager at the company, or even the owner, could have a hidden criminal past or have faced allegations of fraudulent behavior before joining the business.

Such findings can make a buyer question the integrity of the company and its leadership. In some transactions, an owner may plan to stay on and run the company after it is sold. However, if too many questions arise during the litigation analysis of the business, a buyer may perceive the owner's presence as too risky and could end talks.

If buyers notice some indication of fraudulent behavior, they could become worried about the integrity or accuracy of the company's financial statements and choose to hire a forensic accountant to review them. If they can verify that the seller's financial records are clean, they may choose to move forward with a deal and negotiate provisions to end the owner's association with the company once it is sold.

Labor law violations

M&A due diligence teams will spend substantial time exploring the various components related to acquiring or combining workforces. This includes reviewing the seller's employee benefit plans, as well as ensuring their current and past personnel policies are in compliance with federal and state labor laws.

Sometimes, a buyer will discover potential liabilities that are a result of employee rights violations by the seller. Certain violations can result in severe penalties that can amount to several millions of dollars. A buyer would undoubtedly want to protect themselves from assuming such a liability, especially if it came as a result of the previous owner's negligence.

Uncovering a pending liability with a stiff penalty can easily derail a transaction, especially one involving a smaller company. If a buyer suspects future complaints may be filed against the company, yet they still wish to purchase the business, they may try to negotiate indemnification provisions that would protect them from being held liable for damages in such claims.

End of the deal?

As the examples above illustrate, due diligence can uncover a wide variety of potentially damaging issues. It's important for buyers to work with their financial and legal advisors to assess each due diligence concern and evaluate how it impacts their deal's value. Ultimately, a buyer will need to determine whether the issue is either surmountable or significant enough to end the transaction.