Ten most common red flags uncovered during due diligence probes of acquisition targets
The main task of any due diligence probe of an asset or potential business partner is to uncover any potential red flags – hidden risks, liabilities and potential conflicts not clearly seen on the surface.
For the selling side in a merger & acquisition deal, for example, it is only natural, experts say, to boost the sale price by providing a rosy picture of the asset being offered. A more accurate view of the asset can reveal risks that undermine the value of the asset.
Experts involved in providing due diligence services say that much depends on the peculiarities of each specific transaction being considered. Each, they say, has a unique “bouquet” of risks depending on the industry.
But, there are trends. By polling lawyers and other firms involved in providing due diligence services, the Kyiv Post put together a list of Top 10 most common problems often uncovered.
Below is a glance at what red flags are commonly found in Ukraine.
The target’s shareholders may not have properly formalized title to their shares, or the target may not have properly formalized title or leasehold to assets critical for the target’s business. The target’s assets or shares may also be pledged or otherwise used as debt security.
A potential investor has to pay attention to whether the seller has good title to his shares, and whether the company has good title to all of its key assets. This is especially important for a country like Ukraine where even a seemingly minor defect may be used as grounds or leverage by third parties, for example corporate raiders, to cause trouble in the future.
Licenses and permits
Licenses are often improperly issued by government or transferred into contractual joint ventures. There could be a dispute over validity of the license or where the license is set to expire; and there is uncertainty as to whether the license would be renewed. There is a risk that state authorities will impose sanctions for such violations.
Land plots and real estate issues
Companies may use agricultural land for industrial purposes. This is illegal. It is also very frequent that construction of real estate assets takes place without necessary construction permits. Such risks may be enough to torpedo the transaction at hand, or could lead to serious negative consequences especially in case of politically-driven dispute.
One of the hardest issues is tax compliance. Although tightly regulated by the laws of Ukraine it is very hard to foresee potential risks and issues which may be revealed by a tax inspection. Moreover, according to the recent practice, tax authorities are likely to be over-diligent during such inspections, under pressure to boost tax receipts.
Potential investors should check completeness of company’s tax liabilities and any risks for additional tax audits and penalties especially in case of using tax optimization schemes.
Salaries in envelopes
Some international investors are shocked to discover that a Ukrainian business they wish to purchase has overestimated its level of profit through blatant tax evasion schemes. A common scheme used by businesses with many employees is to avoid paying hefty payroll taxes. Salaries are paid under the table, in envelopes through unreported cash. In adhering to higher standards of business practices, many Western investors seek to pay salaries legally. For this reason, the investor may be requested to cover the potential tax liabilities before a sale is closed. Another option is to calculate the understated tax liability into a price reduction or include a clause in the contract which requires the seller to cover tax liabilities that may arise.
Violation of environmental protection, antimonopoly law
Issues related to environmental protection obligations should be reviewed carefully. It is common that targets perform their business activities without all necessary environmental protection permissions and documentation.
These risks are manageable, however. They may involve administrative fines imposed on the company. Another risk is related to the violation of antimonopoly law, which could be serious enough to cause regulators to not approve of the transaction.
It is common knowledge that in Ukraine the only way for many companies to receive their entitled Value Added Tax refunds is to pay a substantial kickback to authorities. If a Ukrainian company cannot remain profitable without VAT refunds (this is the case with many exporters), an American investor, for instance, might be forced into practices prohibited by the American law and therefore would have to stay away to avoid sanctions in U.S. America’s famous and aggressively enforced Foreign Corrupt Practices Act (FCPA). This U.S. legislation makes it a crime under federal law for officials of American companies, or their subsidiaries abroad, to engage in such practices as bribery and kickbacks.
Unofficial arrangements with local authorities sometimes provide advantages to the target’s current owners. However they may not be available to the new owners of the business. It is also very common in Ukraine that a business’ relations are maintained by one or few top executives. The company’s standing could change noticeably when these executives leave the company.
Corruption and fraud Personal arrangements Poor quality of financial information
of many Ukrainian companies are weak and incomplete. IFRS financial reporting standards are rarely used. In contrast, many companies in Ukraine hold several accounting books: the ones they show tax authorities when evading taxes, the real picture and what they show investors. As a result of these nuances, it can be challenging to get an accurate assessment of a domestic business’s financial standing.
Sometimes, management or employees skim profits from within the company by not reporting de facto sales done on the job – pocketing the cash instead. Company owners are not always interested in showing profits in Ukraine, where taxes are relatively high. So, they transfer price profit through trading companies to their offshore companies located in tax havens. There could be unreported liabilities and commitments, undiscovered banking loans and other financial obligations.
Violation of privatization process
Many assets in Ukraine were once state-owned, but have since been privatized. Often, these tenders were not transparent, un-competitive and rigged. If the original privatization deal was not transparent enough, ownership of the asset can be challenged by the state or other interested parties, such as employees who worked at the business when it was state owned.