Red flag due diligence is a short, focused review before the LOI. In two to three weeks it establishes whether there are commercial deal breakers and whether a full review is worth paying for. The warning sign most often missed is not in the market but in the gap between customer contracts and actual revenue.
What red flag due diligence is for
Before the LOI, buyers have little time, little data and a lot of hope. A full commercial due diligence takes four to six weeks. Red flag due diligence answers one question first: is there anything that kills the deal or moves the price materially?
It does not give you the full picture. It tells you whether the full picture is worth paying for.
| Red flag review | Full commercial due diligence | |
|---|---|---|
| Timing | before the LOI | confirmatory phase |
| Duration | 2 to 3 weeks | 4 to 6 weeks |
| Guiding question | Are there deal breakers? | Does the business plan hold? |
| Depth | the five to ten assumptions the price depends on | market, customers, competition and every core assumption |
| Output | verdict, red flag list, questions for the next round | report, adjusted business plan, scenarios |
The warning sign most often missed: contracts and actuals do not match
Most buyers look at the market. Very few compare customer contracts with actual revenue before the LOI. That is where we have seen most of the gaps.
The data room holds the contracts, the ledger holds the revenue. Only side by side do they show what the business plan really assumes. Three patterns come up again and again:
- Minimum commitments nobody draws. The contract guarantees a minimum volume, the customer has been taking far less for months, and the seller does not invoice the difference. The plan shows the minimum, reality shows half.
- Prices on the invoice that are not in the contract. Discounts, special terms and verbal side agreements push the actual price below the contract price. The plan uses the contract.
- Customer behaviour that shifts quietly. Order frequency drops, customers move to cheaper products, renewals happen because of notice periods, not satisfaction. The contracts continue, the relationship does not.
How to spot it: take the top 20 customers. For each, put the contract next to monthly actual revenue for the last 24 to 36 months. Check minimum commitments, prices, terms, notice periods and change of control clauses. Every gap between contract and actuals is a question for the seller before you name a price.
Three weeks, one plan
| Week | Focus | Output |
|---|---|---|
| 1 | Data room: top customers, contracts against actuals, revenue quality, customer concentration | list of gaps and open questions |
| 2 | Market and competition: expert calls, former customers, competitors; customer calls only with the seller's consent | plausibility of growth, pricing and retention |
| 3 | Business plan: the assumptions behind the price, recalculated against the findings | verdict, red flag list, recommendation on next steps |
Case example: SaaS company, exit at €40m
Constructed example. The patterns come from practice, figures and setting are invented.
A family office wants to buy a software company serving mid market clients. The seller asks for €40m, based on €6.2m ARR and net revenue retention of 115 percent. The LOI is due in four weeks.
The red flag review puts the contracts of the largest customers next to the invoices. Three findings:
- €0.6m of the ARR is one off implementation and consulting revenue. It does not recur.
- Two large customers have minimum commitments of €0.5m a year combined but use only about half. Both contracts expire in nine months. Renewal on the old terms is unlikely.
- The invoice data shows net revenue retention of around 101 percent, not 115.
Reliable recurring revenue is therefore around €5.1m ARR. At the same multiple that is roughly €33m. The deal still happens: €34m fixed plus an earn out of up to €4m tied to the renewal of the two large customers. The review took three weeks. Without it, the family office would have paid for the full risk.
When a red flag review is not worth it
A red flag review is not mandatory. In two situations we advise against it:
- The red flags are already on the table. Then the question is no longer whether there is a risk, but how big it is. Only a full review answers that.
- The deal is so small that the review is a noticeable share of the price. If you know the market from your own operations, talk to the key customers yourself.
Constructed example: a professional services firm with €35m revenue and around 200 consultants. The three largest clients account for almost half of revenue, under framework agreements without minimum volumes. The two founders who personally manage these clients are the sellers. Customer concentration and key person dependency are already in the teaser. A red flag review would only confirm what everyone can see. The real question is whether clients and the second management layer stay after the sale. Only confidential conversations with exactly those clients and employees answer that. Here you go straight to full commercial due diligence, with the seller's consent.
Who calls and what is on the table after three weeks
Requests come from private equity, family offices, strategic buyers in the Mittelstand, buyers in succession deals and lenders. The time pressure is nearly always the same: the LOI has to be signed before another bidder moves faster.
After three weeks they do not need a thick report. They need four things:
- A verdict: deal viable, viable with conditions or not viable.
- The red flag list, ranked by impact on value.
- The questions for the next round: for management, for the warranties in the purchase agreement, for the price negotiation.
- A recommendation on whether a full review is worth it and where it must focus.
IWCI works without success fees and has no stake in the deal. You pay for the review, not for the closing. That is what makes a “not viable” credible.
FAQ
What is red flag due diligence?
A short, focused review before the LOI. It looks specifically for deal breakers in market, customers, competition and business plan, and establishes whether a full commercial due diligence is worth it.
How long does a red flag review take?
Two to three weeks. A full commercial due diligence takes four to six weeks.
What is a red flag report?
The output of the review: a verdict on the deal, the list of warning signs ranked by impact on value, the open questions for the next round and a recommendation on next steps.
Does a red flag review require customer interviews?
Not necessarily. Before the LOI, sellers often do not allow customer contact. We then work with the data room, expert calls, former customers and competitors.