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This article will answer the following questions:
- What is needed to prepare a red flag due diligence report?
- What types of risks does the due diligence analysis in the form of a red flag report reveal?
- How is a red flag report different from other due diligence analyses?
Conducting due diligence before making a decision to acquire a company is becoming a standard in today's business environment, and the wide range of services offered by auditors and transaction advisors – including tax, legal and financial due diligence – allows investors to gain reliable knowledge about specific factors affecting the value and condition of the entity being examined. However, precise selection of the area of analysis is only the first step – regardless of what exactly will be the subject of the study, due diligence results are summarised in the form of reports, which differ from each other primarily in terms of their scope and purpose.
Depending on the size of the M&A transaction target, the amount of time available for analysis, and the agreed scope of work, the form of the final due diligence report may vary significantly.
Unlike, for example, an audit, due diligence does not have a specific form. The way in which transaction advisory experts present their findings depends mainly on the level of development of the entity being acquired and the needs of the potential investor. The main goal of due diligence is, after all, to provide the investor with the best possible support in the transaction, which professional advisors achieve primarily by identifying risk areas and helping to make an informed business decision by valuing the entity being acquired.
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Types of Due Diligence Summary Report
A red flag report mainly involves identifying threats that may prevent a transaction from being successfully completed and providing a structured quantification of these risks.
The Red Flag report is more condensed than other due diligence reports, which include a full scope of the assessment of the condition of the company being acquired. The risk assessment performed by transaction advisors in the Red Flag report is most often presented as low, medium or high risk, although it is also possible to present the results of such an examination graphically, in the form of a flag: green (low risk), yellow (medium risk) and red (high risk).
Entities interested in acquiring a company must take into account that some risks discovered during the due diligence process may constitute a threat to the success of the entire transaction (deal breaker).
Any major risk that is marked with a red flag by M&A experts should be properly analysed by the potential investor already at the red flag report stage or – at the latest – at the stage of the full due diligence report.
The reasons for the occurrence of any situation that threatens the finalisation of the transaction should be clarified as soon as possible, at the same time determining whether the entity being acquired (the "target") and its management are aware of the existence of the problem and whether they are taking or planning to take appropriate actions to enable the smooth signing of the sales agreement.
It is possible to combine work on the red flag report with work on the full due diligence report – especially if the investor is very cautious or wants to avoid incurring the full cost of due diligence if contraindications to the transaction are identified. In such a situation, the role of the red flag report is to quickly identify risks, thanks to which, in the absence of "deal breakers", work on the broader version of the report, with more in-depth analyses, continues without further disruption.
A due diligence report prepared in the form of a draft is a more extensive and comprehensive type of analysis summary than a red flag report, and is the most common type of due diligence report on an acquired company.
The draft is prepared as the first full report on the analysis of the entity and is provided to the client when a significant part (or all) of the acquisition target's documents have already been analysed. Open or not fully analysed issues that may appear in the draft report most often require additional explanations (which must be obtained from the party selling the company), or reaching additional agreements between the target and the investor.
Typically, the areas that require additional discussion are estimates that are the subject of agreements during the negotiation of price and transaction terms.
Often, the information included in the draft due diligence report has an impact on the final price paid for the target, the method of settling the transaction or the wording of the investment agreement. The main reason for preparing the due diligence report in the form of a draft is therefore to allow the buyer to familiarise themselves with the target's situation sufficiently early and to structure the negotiation process as quickly as possible.
The final report is prepared after explaining the issues that remained to be analysed after preparing the report in the form of a draft and includes the full scope of actions taken as part of the due diligence of the acquired entity.
A list of documents and data provided during the due diligence process may be attached to the final version of the report.
A confirmatory report is a specific, less common type of due diligence report. It is prepared if the original due diligence was conducted without access to sensitive data or, for example, using anonymised names of clients or contractors.
If the negotiations undertaken by the transaction parties after the initial due diligence are fruitful, the confirmatory due diligence phase may take place. In this phase, the acquired entity discloses selected (or all) data to which access was previously restricted. This additional step serves to confirm (and detail) the conclusions drawn earlier and to assure the potential investor that the M&A process is proceeding smoothly.
The confirmatory due diligence phase therefore occurs at an advanced stage of the transaction; the stages that follow it most often include preparing the purchase agreement (along with other transaction documents) and closing the transaction.
Examples of risks identified in red flag due diligence reports
There can be many threats to the success of an M&A transaction. Negative factors may depend not only on the target itself, but also on the market in which such a target operates. Additionally, red flags may result from the planned course or type of transaction (other things should be considered, e.g. in the case of the purchase of shares / stocks or the purchase of assets), but there is also nothing to prevent transaction advisors preparing the report from focusing on examining threats indicated directly by the potential investor.
What risks are worth paying special attention to and what are the most common red flags?
No possibility of selling the target
Polish regulations do not allow the transfer of ownership in some legal forms.
Transfer of ownership is not possible, for example, in the case of a sole proprietorship. In such a case, in order for the transaction to be possible, it is necessary to transform the target into a legal form that is subject to the possibility of sale, or to make a decision to change the type of transaction to an asset deal. In the case of this type of transaction, however, it may turn out that the seller is not the owner of the assets, that the assets sold are the proceeds of crime or that they are pledged.
Lack of ownership of the business being run
The threat resulting from lack of ownership may be caused by registering the business in the name of another person (e.g. the wife or husband of the individual who is a party to the transaction) or may be the result of the entity failing to secure the intellectual property being used – e.g. a trademark.
Another (less obvious) case of a threat in this respect may be the acquisition by the entity targeted by the transaction of generic goods that do not have a registered trademark. In this situation, even marking the goods with the target's trademark does not guarantee their uniqueness or automatically give such a target exclusivity for the goods in question.
Unfulfilled or breached contractual and legal requirements
Often, the potential buyer is convinced that the target entity can be more efficient after being incorporated into another company or undergoing restructuring. In other cases, the buyer may want to acquire de facto market share through such a transaction, as its plan is to close the acquired entity and increase its own production.
In the case of such plans, requirements or indicators related to subsidies or external financing received by the target may become a red flag. In the case where the condition of receiving the subsidy was to maintain the level of employment for a specified period of time, closing the acquired entity may prove impossible or very expensive.
A similar problem occurs if, as a result of the transaction, the target loses the basis for the subsidy it was previously granted. This can happen, for example, when the subsidy was granted to a small or medium-sized entity, but as a result of the investor's takeover, the target is incorporated into the structures of the entity taking it over and thus becomes a large enterprise.
For acquirers with significant budgets, the contractual requirements related to potential fines may not be an issue, but for most potential investors this could be a deal breaker.
Problems related to the target's use of external financing
The use of external financing by the acquired entity may be associated with certain requirements that will have to be met in the event of signing the sales agreement.
In the case of bank financing, a red flag may be a clause of immediate repayment in the event of a change of the beneficial owner of the company. A change in indicators (or the target owner) may in this situation involve the need to immediately return the financing, which will significantly affect the price of such an M&A transaction.
Conducting proper analyses and good due diligence report remain key to success in M&A transactions
As we can see, reports prepared as part of due diligence can reveal many unusual problems, the existence of which may not be known to either the buyer or the seller (for this reason, when deciding to sell a company, it is a good idea to use vendor due diligence).
Investors deciding to conduct a transaction should be aware of how useful this tool is and decide to use the appropriate type of due diligence report depending on the target and the phase of the investment process.
Red flag and draft reports contain less information or assume that certain issues will remain open, so they are a good solution at the initial stage of M&A. On the other hand, the final or confirmatory report is based on the broadest set of data, and the conclusions drawn from it are the most complete – so they are ideal at the negotiation stage.
