How to Spot Hidden Risks Before Your Next Acquisition

Every acquisition involves some measure of risk – yet thousands of buyers have continued closing deals in 2023 alone. Where do these buyers gain the confidence to strike six and seven-figure deals?

Due diligence, the process of inspecting a business for hidden problems or unknown risks, goes a long way toward assuaging buyers’ fears during an acquisition. 

By thoroughly analyzing every aspect of a business, you can properly assess risk and identify growth potential before signing on the dotted line. So, of course, you can’t skimp on your analysis – otherwise, you could make the wrong choice and end up losing millions, even billions, of dollars. 

Some (myself included) might say financial data is the bedrock of a strong acquisition strategy. But if your analysis is missing certain financial, legal, and compliance risk data, your findings will be both inaccurate and skewed. And with flawed findings, you could easily miss crucial information that alerts you to serious red flags in a company.  

No acquirer worth their salt wants to make life-changing decisions based on incorrect due diligence data. But what if you don’t know what types of data are red flags vs. green flags?

If you aren’t sure, that’s okay. Below, we’ll explore what data you need to know to secure the best deal and be confident acquiring your next company. 

1. Assess Financial Stability with Days Beyond Terms (DBT)

Pro Tip: Days Beyond Terms is a key indicator of financial health and is a crucial metric to measure.

After working in the credit risk industry for nearly 20 years, I know how often businesses assume credit scores and credit limits are the most important data points to determine a business’s financial stability. 

Sure, credit scores and limits can be helpful. But are they truly indicative of a company’s stability and reliability? Are they indicative of a company’s cash flow? 

Not really. Credit scores and limits just tell you how much lenders trust these businesses and whether they eventually pay back what they owe. 

Days Beyond Terms (DBT), on the other hand, is far more enlightening.

DBT refers to the number of days a company typically pays invoices past payment terms. Let’s put this into the context of a company you’re considering acquiring. 

Company X has agreed to pay invoices on Net 60 payment terms (it’s required to pay the full amount within 60 days of the invoice date). 

But when you look at Company X’s business credit report, you see it has a DBT of 30. Meaning it’ll be at least three months before the company pays that invoice. That extra 30 days beyond the original payment terms will inevitably strain the receiver and their cash flow. 

Why is DBT important to you as a buyer? This metric doesn’t just tell you that a company is paying its invoices significantly late. It also points to flaws in its internal financial management practices, which can lead to a whole host of financial problems in the long run. 

For example, it’s possible that the company isn’t managing its Accounts Receivable/Accounts Payable function effectively. It’s also possible that the company has lost revenue and doesn’t have enough incoming cash to sustain the business. If I were looking to acquire, these aren’t possibilities I’d want in a potential acquisition.  

2. Look Below the Surface for True Financial Health

Pro Tip: Making assumptions about financial health cannot substitute proper analysis and due diligence. 

Appearances can be deceiving. That’s why, with due diligence, it’s important to dig below the surface-level impressions to the foundations of a business’s financial health. Just because things look good from the outside doesn’t mean a business has strong cash flow or consistent revenue. 

One common assumption is that a strong brand implies strong financial health. Stylish branding and positive press don’t always correlate with a company’s financial strength. This might surprise you, but larger companies tend to be the worst at paying timely invoices. 

According to Creditsafe’s State of Credit Risk: 2022 report, large businesses had an average DBT of 19 in 2022. For context, a healthy DBT would be between one and five days. So, it’s crucial to perform proper due diligence and assess the brand’s actual impact on performance and customer loyalty. 

3. Benchmark Against the Industry with Peer DBT Analysis 

Pro Tip: If the business you’re investigating has an alarmingly high DBT, don’t dismiss the possibility of acquiring a different startup in the same field. You might learn about competitors with better financial health that could be a great acquisition. 

How do you know where a business stands among its competitors? How do you validate sellers’ claims that their startups are “the best in the field?” 

Peer DBT analysis shows you the DBT of the company you’re pursuing and benchmarks it against others in the same industry. No need to estimate how your potential acquisition manages finances compared to others – let the data speak for itself. 

For example, if you think a potential acquisition would yield a significant return on investment (ROI) but the peer DBT analysis shows that other businesses have a much lower DBT, that should be a red flag. 

4. Study Late Payment Frequency and Value to Uncover Cash Flow Issues 

Pro Tip: Pay attention to payment trends and behaviors. Look at how late companies pay their bills, how often they pay late, and how much they owe in past-due payments. Combined, these can paint a very telling picture of a company’s stability and future growth potential. 

If you’ve already looked at a company’s DBT, you’ll have an idea of how late their payments are. But that data point alone isn’t enough to decide whether to acquire. 

Let’s say a company has a high percentage of late payments (70 percent) amounting to $3.5 million. These two data points, coupled with a high DBT, are clear indicators that the company is in serious financial trouble and likely has been for some time. 

In many cases where companies have filed for bankruptcy, the DBT, late payment frequency, and total value have all been considerably high. Or, they’ve risen drastically and stayed high for several months until bankruptcy was the final option.

These issues likely arose for several reasons. For one, revenue may have declined due to rising inflation, the cost-of-living crisis, and declining consumer spending. Financial issues could also have occurred due to strained liquidity or mismanagement of working capital. 

Whatever the underlying causes, you need to know this information before you acquire the company. 

5. Weigh the Amount and Severity of Legal Filings 

Pro Tip: Don’t assume legal filings have nothing to do with a company’s financial health. Settlements and court judgments can cost millions, even billions, of dollars on top of legal fees and other related costs. That can be a huge drain on cash flow. 

The reality is that most companies have to deal with legal issues. But as an acquirer, the amount and severity of those legal issues tell you if a business is too risky to buy. 

If you see that a company has hundreds of lawsuits, over 20 court judgments, and dozens of tax liens, you know acquiring that business will be more trouble than it’s worth. Not only is your reputation at risk, but you could also lose customers, sales, and revenue. And, of course, you’ll pay thousands out of pocket for attorneys, court judgments, and tax liens. 

That money will have to come from somewhere – and it will eat into the company’s cash flow sooner than later. If you don’t think legal troubles can create cash flow problems, remember that legal filings cost American businesses over $54 billion in 2022. 

Of course, not all legal filings are deal breakers. For example, tax liens and uniform commercial code (UCC) filings drain less cash flow than lawsuits and court judgments. 

The key takeaway here is that you shouldn’t ignore the relevance and impact of legal filings on a company’s financial health – they’re linked. You must study the right data points together, whether it’s attorney fees and DBT or late payment frequency and tax liens. 

 If you don’t study both, you could invest in a company that costs you more than it yields in ROI. 

6. Safeguard Your Reputation By Reviewing Compliance Alerts

Pro Tip: Compliance should never be an afterthought during due diligence. The implications of compliance violations are far-reaching and touch every part of a business, from customer acquisition and loyalty to sales, brand reputation, and more. 

Industry laws and regulations exist for a reason. If a business doesn’t comply with those rules, it risks potential damage legally and financially – otherwise known as compliance risk. 

Compliance can have a domino effect on the bottom line. We live in a world where environmental, social, and governance principles (ESG) and corporate social responsibility (CSR) aren’t just nice-to-haves – they’re a vital factor in people’s buying decisions. 

Research from OpenText shows that nearly 90% of global consumers would choose to buy from companies with ethical sourcing structures in place over ones that did not. The research also found that 83% of global consumers are willing to spend more on a product if they can be certain it’s ethically sourced. 

When companies ethically source, they ensure their products and raw materials come from businesses that comply with sustainable practices and legal requirements. As consumer demand for ethical sourcing increases globally, so do laws about it. 

And when businesses break these laws, they face serious legal liabilities or reputational damage. In many cases, a single violation can cost a company upwards of $250,000 (and that’s on the low side). Just imagine how high the fines could be if a company is convicted of multiple violations. 

It’s not just ethical sourcing and supply chain laws you need to analyze. You should also run searches on global sanctions and Politically Exposed Persons (PEP) lists for any companies you’re considering investing in. It could very well save you a lot of money and reputational damage down the line. 

Just look at what happened earlier this year when the US Treasury fined British American Tobacco $508 million for violating Office of Foreign Assets Control (OFAC) sanctions against North Korea and weapons of mass destruction proliferators. As a new investor, you would want to know that information before deciding to invest in the company. 

Unfortunately, many acquirers don’t apply the same rigor when evaluating compliance risks as they do with financial risks. But compliance risks can be just as dangerous and stall a company’s growth. 

Think about the amount of effort you put into your accounting. If you don’t invest similar energy into running the full array of compliance checks on companies you’re considering acquiring,  you’re done. Your reputation is tied to that company even if people discover its involvement in unethical practices. 

Not only will that turn off your loyal customers and lead to a decline in sales and revenue, but it could also become a problem with shareholders, cause the company’s stock price to plummet, and attract a slew of negative publicity. Do you really want your firm’s reputation tied to a company like that? 

Here are a few types of checks you can run to make sure you’re in compliance with local, state, and federal regulations:

• Know Your Company (KYC) / ID verification
• Anti-money laundering 
• Global sanctions and watchlists (current and previous)
• PEP (Politically Exposed Persons)
• Law enforcement

Ready to Run Due Diligence on Your Next Acquisition?

Due diligence is only as useful and reliable as the data behind it. By analyzing every part of a company – from its legal to financial to compliance aspects – you’re better equipped to make informed decisions and manage risks effectively. 

Cutting your analysis short will only hurt you. But a thorough due diligence process will shine a spotlight on hidden risks lurking beneath the surface of your next acquisition.