Is That Deal Worth It?

Len was in growth mode. His five-year-old IT business had gained double-digit market share and he decided to purchase a competing company to add capacity. Once the deal was done, however, Len discovered undisclosed side deals with several customers. These arrangements granted these customers discounts and payment terms that were far more favourable than he would have agreed to. Furthermore, he found that the company's previously reported financial results were grossly overstated. Had Len conducted a sufficient due-diligence assessment prior to finalizing the acquisition, he would have discovered these issues.

This is not an uncommon problem; a 2011 survey of small and mid-sized businesses found that 26% had experienced at least one incident of fraud. Small, high-growth companies are especially susceptible to unethical conduct  because they often lack internal controls, run lean operations relying on only a few individuals for key financial functions (reducing segregation of duties) and focus on revenue growth at the expense of governance. To boot, certain purchase structures, such as earn- outs and pricing based on EBITDA (Earnings Before Interest, Taxes, Depreciation and Amoritization) and working capital, may also encourage financial reporting manipulation by an unscrupulous owner wanting to maximize the selling price of his or her company.

When such situations go unchecked, you may have, along with a company, unwittingly acquired costly problems such as the undisclosed deals or financial misrepresentations that Len experienced. But that's just the tip of the iceberg. You could face more serious financial and legal issues, such as misappropriated company assets or tax evasion.

A red-flag assessment

Thankfully, these pitfalls can often be avoided by conducting a fraud assessment. Here are examples of some common red flags and the problems they could signal.

1. Unusually close relationships between managers or employees and key suppliers. Potential problems: fraud, kickbacks, loss of key suppliers.

2. Significant use of cash to pay employees or vendors. Potential problems: undisclosed agreements and liabilities.

3. Inadequately supported estimates of bank balances (i.e., work in progress, reserves). Potential problems: lack of funds, concealment of financial reporting fraud

4. Extensive use of agents or consultants to conduct international business, especially with an undocumented mandate. Potential problems: inappropriate payments, violation of anti-corruption legislation

5. Large, round-dollar payments to vendors (poorly supported or delivered to bank accounts in unusual locations.) Potential problems: corrupt payments, payments to fictitious vendors

6. Lack of documented policies, such as codes of conduct and other workplace policies. Potential problems: greater likelihood of fraud

7. Lack of structured performance assessment and incentive programs. Potential problems: post-transaction performance issues, undisclosed liabilities for bonuses

8. High travel and entertainment expenses. Potential problems: improper payments, personal expenses inappropriately expensed to the business

9. Principals attach unduly high importance to lifestyle and social status. Potential problems:  personal lifestyle trumps business ethics

If any of these red flags are flying, you need to carry out a detailed review. This may include conducting information-gathering meetings or requesting background checks on employees, contractors, agents or other third parties.

If everything checks out and you decide to proceed with the transaction, preventing fraud and theft shouldn't stop once the ink dries on the purchase agreement. It's important to set the tone that dishonesty will not be tolerated. This means establishing comprehensive anti-fraud programs and controls.  These could include routine background checks on new employees in key roles; instituting codes of conduct and policies explicitly prohibiting wrongdoing; implementing confidential reporting mechanisms; and monitoring through audits and oversight by senior management.

Ryna Ferlatte  is a regional investigative and forensic services practice leader with accounting firm MNP who helps business leaders reduce, detect and mitigate fraudulent activities.