Experts weigh in on red flags that often pop up during due diligence.
How often does your M&A team walk away from a deal? It’s not uncommon for executive leadership to become enamored of a deal. Once that emotion takes over, it can be tough to evaluate the deal objectively and realize that it’s time to move on. One way to overcome that “urge to merge” is to approach each deal with a clear list of “deal breakers” for your organization. Below, our expert presenters share their insights on red flags to look for during due diligence.
Anthony Enlow
Director, Transaction Advisory Services, BDO
"Insurmountable financial issues often emerge when you start looking behind the numbers. For example, if the due dilgence process produces a number of downward adjustments in EBITDA because the target does not report on a US GAAP basis, this can be a major issue. We also frequently see deals fall through because management cannot support their proposed add-backs with invoices, payroll records, settlement documents, etc. When that happens, we cannot simply accept them as add-backs, which can drastically change the valuation of the business."
Maurice Liddell
Consulting Managing Director, BDO
“More and more frequently, due diligence turns up evidence of a prior data breach. Although it’s not always a deal breaker, we have seen a prior data breach reduce the Target company’s valuation by as much as 20%. Data breaches can also negatively affect stock price and may result in a potent loss of a company’s IP.
“Meanwhile, hidden or buried IT costs may result in a higher operating model. These may include upgrading older infrastructure or systems; additional software licensing; etc. This is another reason it’s critical to address IT early in the due diligence process.”
Mark Herndon
President, M&A Partners
"There should always be a 'walk-away price,' that is, a price that's simply too high for the target business. Too often, organizations approach due diligence as a way to justify a deal, rather than to evaluate the target objectively. The result? Senior leadership gets caught up in the process and ends up paying too much for the acquisition. Go into every deal with a firm price in mind. That number might decrease as you uncover additional costs. It could also even increase if you discover unpredicted synergies."
Kelly Karger
Director, Mergers and Acquisitions Consultant, Willis Towers Watson
"People-related deal breakers tend to be deal- or buyer-specific. Incompatible culture is one of the leading causes of deal value erosion, but it often gets overlooked or discounted in the due diligence process. Will the critical talent of the acquired company remain post-close to achieve the deal and ongoing business objectives?
“Bring your HR team into the deal as early as possible to evaluate organizational culture—which will also impact employee retention and productivity post-announcement. A classic example is a start-up acquired by a larger corporation: employees of the start-up may not be enthusiastic about a more corporate environment where they must count their vacation days, wear a tie to the office and get approval before making decisions. Will these employees stay? And if key employees leave, how will that impact the deal value? The answers to these questions are critical in strategic integration planning during due diligence.”
Melissa Panagides-Busch
Senior Manager, Management Advisory Services, BDO
"Some deal breakers are not actually apparent until long after the deal is done. These are usually the result of not communicating the deal rationale effectively--which means your due diligence team isn't going to look for the right things. So first and foremost, if you cannot articulate a solid deal rationale that fits with your organization's overall strategy, you should walk away from the deal."
Duncan Smithson
Director, Mergers and Acquisitions Consultant, Willis Towers Watson
"Among the most commonly reviewed potential people-related deal breakers are un- and under-reported employment obligations such as retirement liabilities, change in control and top-ups in executive contracts.
“But let’s not forget about talent assessment. Watch out for target companies that have unusually high rates of turnover or low rates of upward mobility. If you observe that few employees move up in the company, and most leave after only a few years of employment, that usually means that the organization isn’t committed to building talent internally. This immature approach to employee development can be a significant issue if the target’s value lies in its human capital.”
Michael Williams
Managing Director, Transaction Advisory Services, BDO
“Tax issues aren’t frequently deal breakers in larger deals, but they can be problematic in middle-market deals. For example, an entity being treated as an S corporation may be at risk of not meeting the multiple and complex requirements needed to be recognized as a valid S corporation. This can lead to two key risks of exposure: (1) a substantial corporate-level tax inherited in an equity acquisition; or (2) the disqualification of an election made to treat an equity transaction as a deemed asset deal for income tax purposes, which can lead to a loss of significant tax benefits for the acquirer.
Another example would be a multinational enterprise with commonly owned entities in different countries that have failed to implement and maintain the necessary safeguards to have fair and transparent arm’s-length transfer pricing among the related entities. This is especially an issue in cases in which there are numerous material cross-border transactions. This may lead to significant penalties, multi-jurisdictional tax exposures, and other burdensome costs for the acquirer to rectify the target’s prior disregard for these requirements.”
For more expert insights on due diligence, please join us for The Art of M&A Due Diligence in San Diego. This one-of-a-kind M&A executive training includes real-world case studies, breakout sessions and panel discussions, along with plenty of networking opportunities.