The M&A Process: Due Diligence the Best Way to Ferret Out Red Flags

It’s amazing to see the high degree of clickbait articles that are still floating around the internet. I’m sure most of us have succumbed to them, at one point or another, out of boredom or curiosity. But we can all see the telltale signs that indicate the poster is just fishing for clicks.

Imagine the above headline reads: “20 Outrageous Reasons Office Tech M&A Deals Fall Apart—You Won’t Believe No. 17.” Admittedly, it would be fun to learn that one seller was actually a front for a cult that is planning a trip to the moon to unite with Devana, the Slavic goddess. Fact of the matter is, the red flags most buyers encounter are fairly universal and are unearthed through routine due diligence procedures.

Regardless, we don’t need to manufacture headlines that draw attention to M&A these days. Last week, our roundup featured an unprecedented six deals in one week, and we narrowly missed a seventh when Flex Technology Group announced a major deal just after the newsletter had been mailed (read about it here). So, we’ll spare you from tales that are salacious, outrageous and bizarre, because reality has been far more interesting of late. This leads us to this week’s M&A subtopic of red flags that can put the kibosh on negotiations…and you will believe them.

A.J. Baggott, RJ Young

One of the more common and earlier-detectable signs that a deal may not be imminent is when seller owners or their brokers are liberal with the adjustments made to their EBITDA calculations, which RJ Young President AJ Baggott believes is an early indicator for the Nashville, Tennessee, dealer heading into the financial due diligence and review. At a more micro level during the due diligence process, an organization’s ability to provide clear and well-documented support for the requested documentation says a lot about the organization and the likelihood of the provided detail’s accuracy.

“Missing support or unclear backup is a red flag that the financials may or may not be accurately represented,” Baggott said. “Further, when variances do occur over time periods under review and no clear explanation can be provided for the change in financial trend, that tends to be a red flag that either something could be off or there is no clear line of sight in the operational performance to financial outcome.”

Contracted Woes

Aric Manion, Kelley Connect

It’s important to take a deep dive into the recurring revenue that a seller is gleaning from its contractual agreements, notes Aric Manion, CEO of Kelley Connect in Kent, Washington. Careful analysis might yield a significant issue, such as the lack of minimum bases within contracts.

“There have been a lot of sellers that didn’t have bases in their contracts when we looked at their invoicing system,” he said. “You really need to review the contracts, because you’re really buying the recurring revenue. The same goes for ensuring they don’t have a concentration of customers that may be at risk of going away.”

Jim Sheffield, UBEO

That lack of contracted bases in service pacts and inconsistent profit margins equate “noise in the financial statement,” notes Jim Sheffield, CEO of UBEO Business Services in Austin, Texas. Recurring revenue, as Manion alluded to (and Sheffield concurs) is everything.

“It’s the recurring revenue aspect that makes our business so great,” he said. “Not that we can’t fix that (lack of bases), but it’s definitely an issue. We can work through a lot of problems as long as their people run a tight, solid financial department. That’s beneficial for the seller to have.”


Dan Ruhl, Oval Partners

During the pandemic, many U.S. businesses took advantage of paycheck protection program funds that enabled them to meet payroll obligations and keep workers gainfully employed. The drawback, notes Dan Ruhl, a partner with Oval Partners—the private equity firm behind Flex Technology Group—is that some businesses maintained a headcount that couldn’t be justified by their revenue and profits.

“The businesses that didn’t make the decision to right-size during the pandemic period and are still at a lower revenue with a higher cost base make it harder for us to look at them [for a possible acquisition] today,” Ruhl said.

Joe Dellaposta, Doing Better Business

Most dealers agree that a lack of transparency can indicate underlying or unspoken problems. Joe Dellaposta, COO of Doing Better Business in Altoona, Pennsylvania, believes that when a seller is not completely open with him from the start, issues will gradually be unearthed, making the entire process a waste of time.

A deeper look into a company’s payroll can also yield inconvenient truths, such as huge turnover in key positions, which could speak to the corporate culture. “If a company has five salespeople, and all five have been there for less than six months, that’s probably a huge red flag,” Dellaposta said.

Erik Cagle
About the Author
Erik Cagle is the editorial director of ENX Magazine. He is an author, writer and editor who spent 18 years covering the commercial printing industry.