Due Diligence Red Flags in India: What SME Buyers Miss

When reported revenue doesn't reconcile with GST filings, or tax paid doesn't align with reported profit, or bank statement deposits don't match declared turnover — that divergence is the most important signal in financial diligence. It may reflect poor bookkeeping. It may reflect deliberate misrepresentation. In either case it should be treated as a priority finding that requires a specific, documented explanation before you proceed. A credible explanation looks like a specific timing difference, a documented one-off item, or a change in accounting policy noted in the audited accounts. A vague reference to the CA "handling all of that" is not a credible explanation.

Seller-presented normalised EBITDA is almost always higher than reported EBITDA. Some of the difference is legitimate — a promoter drawing well above a market-rate salary is a real add-back; a genuine one-off legal cost is a reasonable adjustment. The signal to watch for is a list of add-backs that, taken together, restate the profitability of the business so substantially that you are essentially being asked to pay a multiple of a number that bears little relationship to what the business actually earns. Each add-back should be individually justified with evidence. If they cannot be, the normalised EBITDA figure itself is unreliable as a valuation basis.

Sellers sometimes manage working capital aggressively in the months before a sale — accelerating receivable collections, stretching supplier payments, drawing down inventory — to maximise cash on the balance sheet at closing. The effect is that a buyer pays a price reflecting a healthy balance sheet but inherits a business that immediately requires additional cash to operate at normal levels. The signal: working capital at the diligence date is materially below what the business's revenue and operating cycle would normally require. Address this through a working capital peg in the SPA rather than accepting it at face value.

A business can show three strong historical years while quietly losing ground in the current period. Revenue may be declining month on month. Margins may be compressing. Key customers may have reduced their order volumes. None of this necessarily appears if you only look at annual audited accounts. Always request monthly revenue and margin data for the most recent 12 to 18 months alongside the annual accounts. A business whose most recent six months of monthly data show consistent deterioration is a materially different acquisition from one whose historical trend line suggests stability.

Revenue from entities controlled by the promoter or their family — sales to group companies, management fees from associated businesses, service income from related parties — should be treated as potentially non-recurring unless there is a clear commercial rationale for why it will continue under new ownership. The signal is not that related-party transactions exist, but that they are material, the pricing is not demonstrably arm's-length, and the seller presents them as part of the recurring earnings base.

A business where two or three customers generate the majority of revenue is not inherently problematic — the question is whether those relationships are documented in formal contracts that survive a change of ownership, or whether they are personal to the founder. The combination of high customer concentration, no formal contracts, and relationships that appear personal to the promoter is a structural risk that should be reflected in deal structure — not just noted and moved on from.

One of the most common legal findings in Indian SME acquisitions is that trademarks, domain names, or key regulatory licences sit in the promoter's personal name rather than the company's. Check the Indian Trade Marks Registry for trademark registrations — and specifically verify whether any Form TM-P assignment has been filed transferring trademarks from the promoter to the company. In a share sale the company continues to exist, but IP or licences that are not in the company's name do not automatically transfer. Moving them requires explicit action, takes time, has tax and stamp duty implications, and is not always straightforward. Finding this early allows it to be addressed as a pre-closing condition rather than a post-closing problem.

Some contracts — particularly government contracts, franchise agreements, technology licences, and distribution agreements — give the counterparty the right to terminate or renegotiate if the ownership of the contracting entity changes. Identifying these provisions early and assessing whether consent needs to be obtained before closing is a non-negotiable step. The risk is particularly acute when the contract in question represents a significant proportion of revenue.

Sellers are contractually required to disclose pending legal proceedings in their warranty representations. In practice, some proceedings are omitted — characterised as immaterial, in early stages, or simply overlooked. Run independent searches across the e-Courts National Judicial Data Grid (NJDG), the National Company Law Tribunal (NCLT), the Debt Recovery Tribunal (DRT) where applicable, and High Court dockets. If proceedings surface through independent search that were not in the seller's disclosure, that omission is itself significant — it tells you something about how the seller interprets their disclosure obligations, which is relevant to how you assess their other representations.

Share pledges given by the promoter as security for loans, and charges created on company assets, appear on the MCA charge register via Form CHG-1 (charge creation) and Form CHG-4 (charge satisfaction). An unsatisfied Form CHG-4 for a repaid loan — where the charge was never formally satisfied — creates a cloud on the company's records. A pledge on shares means the buyer cannot receive clean title without the lender first releasing it. Both are worth identifying early — finding them one week before closing is significantly more disruptive than finding them in week two of diligence.

Complete dependence on the founder is among the most consistently underestimated operational risks in Indian SME acquisitions. Where the founder is the primary contact for every major customer and supplier, makes all non-routine decisions, and holds all institutional knowledge — the revenue that appears in the accounts may be inseparable from the person rather than the business.

Revenue that is personal to the promoter is not business value; it is relationship value that may not survive a change of ownership. This risk needs to be reflected in price or deal structure rather than addressed through optimism about the transition.

Employee departures during a sale process are not always coincidental. Senior employees who become aware of a transaction sometimes update their CVs. Sales staff who personally own customer relationships may receive approaches from competitors. If meaningful departures occur during the diligence period, investigate the reason — and assess whether the departure materially changes the value proposition of the acquisition.

Suppliers who are concerned about a customer's ability to pay tend to tighten credit terms or move to cash-on-delivery before any formal default occurs. This doesn't appear in the accounts. Ask to see supplier credit terms as agreed versus actual payment performance over the last 12 months. If major suppliers have informally tightened terms recently, find out why.

A business that operates entirely on tacit knowledge — where the how, why, and when of every operational decision exists only in people's heads — transfers poorly. Ask for documented procedures for core operational functions. Ask what would happen if three senior people were unavailable for a month. The comfort or discomfort with which these questions are answered tells you something about how genuinely transferable the business is.

A business that cannot produce accurate, timely management information — current month revenue, gross margin by product line, debtor ageing, inventory levels — has an operational blind spot that creates real risk for a new owner. Assess the accounting and ERP systems early. A business running on disconnected spreadsheets and informal records is not inherently a bad acquisition — but the systems investment required should be modelled explicitly into the acquisition cost.

Any seller with a genuine intention to complete a transaction should be willing to share three years of audited financial statements to a credible, identified buyer under a signed NDA. Resistance to this — or the substitution of management accounts or informal summaries for audited figures — is worth noting carefully. There are occasionally legitimate reasons: accounts not yet finalised, or a business at a stage where formal audit isn't yet standard practice. Both should come with a clear timeline and an alternative that gives the buyer equivalent comfort.

When some categories of documents arrive promptly and others are repeatedly deferred, the pattern tends to be informative. What a seller is comfortable sharing quickly and what they consistently defer often maps to areas of strength and areas of concern. When the deferral consistently maps to the same areas of the business across multiple requests, it warrants direct attention rather than patience.

Urgency that arrives without a specific, verifiable reason — another buyer is moving fast, the seller needs to close before year end — tends to function as a negotiating tactic rather than a genuine deal condition. Real urgency exists in transactions and when it is genuine it comes with specifics. When it is manufactured it is typically vague and consistent regardless of what questions are asked.

A seller who opens at an ambitious price is normal and expected. A seller who cannot articulate any methodology that produces their number, and whose position has not moved materially across multiple substantive conversations backed by evidence, is either genuinely uninformed about market values or committed to a number regardless of what the business warrants. Both create a difficult negotiation — and sellers who remain significantly above independently defensible value rarely close at prices that make sense for the buyer.

Representations and warranties, escrow arrangements, and specific indemnities are standard features of professionally advised Indian SME acquisitions. A seller who insists on full payment at closing with no post-closing recourse of any kind is either not well-advised or is aware of something they have not disclosed. A seller genuinely confident in their disclosures has no rational basis for refusing reasonable protections.

If your identity as a potential buyer, your indicative pricing, or your diligence findings are communicated to other parties without your consent — whether to other buyers, employees, customers, or suppliers — that tells you something important about how the rest of the process will be managed.