Red Flags in Due Diligence

We were approached by a small company in the consumer goods business looking to raise capital to build inventory. 

It’s true, experience is everything, and we’re game to share. 

In our normal course of conducting due diligence, we discovered that the owner of the company previously had exited and sold another business and, rather than pay federal taxes, he had used the proceeds to improve his operations of this current company, and expedite order delivery.  

In addition, his accountant, upon learning of the owner’s decision against paying the IRS what was owed, quit the firm, and the owner was currently using a part-time bookkeeper to manage the finances. 

Consequently, despite the fact that the business was making money, had great products, was well known in the industry, and the investment structure would have been rewarding to its investors, we declined to pursue the opportunity… Making management decisions that might affect the success of the investors’ loan (being forced by the IRS to settle its claim and penalties), or the accuracy of the financial reports being generated, was a BIG Red Flag. 

If you invest in private companies over a long enough time-line, you will encounter many unique scenarios.  That’s why due diligence is key!

The following areas of concern can often give you an early warning of problems to come …

  • Management:  It starts (and ends) with the people … the owners and managers of the business to whom you are lending.  No contract or agreement with them will make up for dishonesty or incompetence.  What do you know about them, and have you conducted thorough background checks including criminal reviews, a lien and judgement screen and an analysis of their past business performance?  
  • Credit Analysis:  A debt investment is very different from an equity investment.  While most companies can issue equity to raise growth capital, most venture-stage companies (i.e., younger businesses that have not yet generated positive operating cash flow), and some more established business with recent troubles should not finance their businesses using debt.  A potential borrower must demonstrate to you, the prospective creditor, its ability to “service” the loan, which includes making regular interest and principal payments to you during the term of the loan. 

We find it can be helpful — especially to cut through what can be a deluge of information — to have a few financial ratios to use in your due diligence process:  

  • Debt/EBITDA:  Total Debt divided by the sum of Earnings before interest, taxes, depreciation and amortization — typically under (ideally, well under) 3.5x; 
  • Loan-to-value ratio:  It depends on the collateral involved, but think about what discount to the stated collateral value would be needed for you to sell the underlying collateral in a “fire sale” situation and get your investment back.  Your loan amount should be lower than the fire sale value of the collateral supporting it; 
  • Fixed Charge Coverage Ratio:  The ratio of the borrower’s operating cash flow available to meet debt service divided by the amount of principal and interest due — typically at least 1.2x, depending on the predictability of the operating cash flow.

As a lender, you will not be participating in the Issuer’s future profits, so prioritize the sources of loan repayment in your analysis.  There should be multiple sources of repayment in case the primary one doesn’t work. 

  • Business Operations:  It is important to also understand the “how’s” of the business, not just the “what’s” (typical Due Diligence).  For example:
  • How do the senior managers manage?  Weekly staff meetings?  Standard Operating Procedures?  Strong inter-personal skills?  Inviting input from all levels of employees, or is it an insular, tightly controlled process by an inexperienced owner?  
  • How is information (financial and otherwise) collected and used across the organization?  Are business decisions made with good data…or hope? 
  • Is there a seasonality to the business (particularly in agriculture)? 
  • How strong is the borrower’s finance staff?  Is this financially a well-managed company?  
  • Is there an adequate information technology infrastructure supporting the business?  If not, then financial and other data provided to investors is highly suspect.  

There are many other aspects of corporate analysis and of conducting thorough due diligence. We suggest you also read Carofin’s Seven Key Questions for Evaluating a Private Company and use our Due Diligence Guidelines for your next private debt investment. 





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