1. Why Red Flags Matter More Than Headline Numbers
When evaluating an acquisition target or an investment opportunity, it's natural to focus on the headline financials — revenue, EBITDA, growth rate, valuation multiple. But the deals that go wrong post-completion almost always trace back to something that was visible during due diligence but either wasn't investigated thoroughly enough, or was identified but not properly addressed in the transaction structure.
A "red flag" in due diligence doesn't automatically mean walk away from the deal. It means: this issue needs to be quantified, and then either priced into the valuation, covered by an indemnity, structured as a condition precedent, or in extreme cases, used as a basis to renegotiate or exit the transaction. The goal of this article is to help buyers, investors, and their advisors systematically identify these issues before they become post-completion disputes.
2. Financial Red Flags
Revenue recognition irregularities. Look for revenue spikes concentrated in the final weeks of a quarter or financial year ("channel stuffing"), unusual increases in receivables that outpace revenue growth, or revenue recognised on contracts with side letters granting unusual return rights or extended payment terms. These often indicate revenue being pulled forward to hit targets.
Related-party transactions. Transactions with promoter-owned entities, family members, or affiliated companies — for services, rent, loans, or sales — need careful scrutiny. The key questions: are these at arm's length? Is there proper documentation (agreements, invoices, TDS compliance)? Related-party loans that have been outstanding for years without interest, or management fees paid to promoter entities with no clear service justification, are common ways value is extracted from a company before a sale.
Working capital anomalies. A sudden improvement in working capital metrics (days receivable, days payable, inventory turns) shortly before a transaction process begins often indicates one-time actions taken to improve the balance sheet for sale purposes — aggressive collection drives, stretched payables, or inventory liquidation — that will reverse post-acquisition.
EBITDA addbacks. Sellers commonly present an "adjusted EBITDA" with addbacks for one-time expenses, owner compensation normalization, and non-recurring items. Each addback should be independently verified — a common red flag is "one-time" expenses that recur every year, or owner compensation addbacks that don't account for the cost of hiring a replacement professional manager.
3. Legal and Regulatory Red Flags
Pending litigation and disputes. Beyond simply listing pending cases, diligence should assess the realistic exposure — amount claimed, likelihood of an adverse outcome based on legal opinion, and whether adequate provisions have been made in the financial statements. Litigation that appears minor on the surface (a small consumer complaint, an employment dispute) can sometimes indicate a pattern — multiple similar disputes may signal a systemic compliance issue.
Regulatory notices and show-cause notices. Any notices from tax authorities, ROC, labour department, environmental regulators, or sector-specific regulators (RBI, SEBI, FSSAI, etc.) should be reviewed for both the specific issue raised and what it indicates about the company's broader compliance culture.
Corporate structure and title issues. Verify that shares have been validly issued and transferred (proper board/shareholder resolutions, stamp duty paid, share certificates issued), that the company's registered office and key properties have clear title or valid lease documentation, and that all charges/liens on company assets are accurately reflected in ROC records.
Licenses and approvals. Confirm that all sector-specific licenses, registrations, and approvals (factory license, pollution control board consents, FSSAI license, drug license, NBFC registration, etc., as applicable) are current, in the company's name (not a promoter's individual name), and not subject to pending renewal issues.
4. Tax Red Flags
Open tax assessments and disputed demands. Income tax, GST, and other tax assessments that are open, under appeal, or where demands have been raised but not paid, represent contingent liabilities that transfer to the buyer in an asset/business transfer or remain with the company in a share acquisition. The amount at stake, the stage of appeal, and the strength of the company's position (based on a tax opinion) should all be assessed.
TDS and withholding tax compliance. Gaps in TDS deduction or deposit — on salaries, contractor payments, rent, professional fees — can result in disallowance of the expense (increasing tax liability) plus interest and penalty. This is one of the most common and easily-overlooked sources of unexpected liability in Indian targets.
GST input tax credit (ITC) issues. Verify that ITC claimed is supported by valid invoices from compliant vendors (vendors who have filed their returns and paid their GST), as ITC can be reversed if the vendor is non-compliant — a risk that has increased significantly under the current GST framework's matching mechanisms.
Transfer pricing documentation. For companies with cross-border related-party transactions (including with group entities abroad), verify that transfer pricing documentation exists and that the pricing methodology can withstand scrutiny — transfer pricing adjustments can result in substantial additional tax demands with interest spanning multiple years.
5. Sector-Specific Red Flags: Manufacturing and Asset-Heavy Businesses
For manufacturing, industrial, and other asset-heavy targets, several additional areas warrant focused attention:
Deferred maintenance. Plant and machinery that has been kept running through deferred maintenance to preserve short-term profitability can require substantial capital expenditure post-acquisition. A physical inspection by a qualified technical expert, not just a review of fixed asset registers, is often necessary to identify this.
Inventory valuation and obsolescence. Inventory that includes slow-moving, obsolete, or damaged stock carried at full value (without adequate write-down provisions) overstates both the balance sheet and effectively the purchase price if working capital is used as a completion mechanism. A physical inventory count and ageing analysis is essential.
Environmental liabilities. Manufacturing facilities can carry environmental liabilities — soil or groundwater contamination, non-compliance with pollution control norms, or pending closure/remediation obligations at older sites — that may not appear on the balance sheet at all but represent significant future costs.
Labour and contract workforce compliance. Manufacturing businesses often rely heavily on contract labour. Verify compliance with the Contract Labour (Regulation and Abolition) Act, proper PF/ESI contributions for contract workers, and assess the risk of contract workers being deemed "employees" of the principal employer — a risk that has resulted in significant retrospective liabilities for several Indian companies.
Customer and supplier concentration. In manufacturing, dependency on a small number of large customers (especially in auto-ancillary or similar B2B sectors) or on a single critical raw material supplier represents structural risk that should be reflected in the valuation, not just disclosed as a risk factor.
6. Customer Concentration — A Red Flag Across All Sectors
Customer concentration deserves specific attention regardless of sector. As a general benchmark, if a single customer accounts for more than 25-30% of revenue, this represents a structural risk that should influence both the valuation (often through a lower multiple) and the transaction structure (such as earn-outs tied to retention of the key customer relationship, or specific indemnities if the relationship is contractually at risk around the time of the transaction).
The diligence should go beyond the percentage and assess: is the relationship contractually secured (long-term contract) or relationship-based (dependent on specific individuals at the target who may not stay post-acquisition)? Has the customer been notified of or consented to a change of control, if such consent is contractually required? Are there any indications the customer relationship is under strain (declining order volumes, payment delays, recent disputes)?
7. From Red Flag to Resolution — What Happens Next
Identifying a red flag is the first step — what matters commercially is how it gets addressed in the transaction. The typical resolution paths are:
Price adjustment. If the issue represents a quantifiable, known cost (e.g., a tax demand that is likely to be upheld, or inventory that needs to be written down), the purchase price can be reduced by that amount, or the amount can be placed in escrow pending resolution.
Indemnity. For contingent liabilities where the outcome is uncertain (pending litigation, open tax assessments with reasonable chance of success), a specific indemnity from the seller — often with a defined cap and time period — allocates the risk to the seller if the contingency materialises, without reducing the price upfront.
Conditions precedent. Some issues (missing licenses, unresolved title issues, pending regulatory approvals) can be made conditions that must be resolved before the transaction completes — shifting the burden and timeline pressure onto the seller to fix before closing.
Structural changes. In some cases, the transaction structure itself can be adjusted — for example, structuring as an asset purchase rather than a share purchase to avoid inheriting certain legacy liabilities (though this brings its own tax and stamp duty considerations), or carving out a problematic subsidiary or business line before the transaction.
The common thread across all of these is that red flags identified early — ideally before commercial terms are finalised — give both parties far more flexibility to find a workable solution than issues discovered after signing, when leverage shifts and renegotiation becomes adversarial.
This article is for informational purposes only and does not constitute legal, tax, or financial advice. Please consult with a qualified professional for advice specific to your situation. Maroon Advisors would be delighted to assist — get in touch.