Due Diligence on a Target Company’s Customer Contracts
When you acquire a business, you are not just buying its assets and brand; you are buying its future revenue streams. The single most important documents that define and secure those revenue streams are the customer contracts. For any acquirer in the UAE, conducting a deep and thorough due diligence on these contracts is not just a formality—it is a critical exercise in risk assessment and value verification.
- Due Diligence on a Target Company's Customer Contracts
- The Starting Point: Creating the Contract Universe
- The Legal Review: Scrutinizing Key Clauses
- The Financial Review: Connecting Contracts to the Numbers
- Expert Contract Due Diligence from EAS
- Frequently Asked Questions (FAQs)
- Is Your Target's Revenue as Secure as It Looks?
A company’s customer contracts are a treasure trove of information. They reveal the quality and stability of its revenue, the strength of its customer relationships, and a host of potential liabilities and risks that could dramatically impact the business post-acquisition. A cursory review is not enough. You must dissect these legal documents to understand not just what they say, but what they mean for the future financial health and operational reality of the business you are about to own.
This guide will provide a detailed checklist for conducting due diligence on a target company’s customer contracts. We will explore the key clauses to scrutinize, the financial red flags to watch for, and the strategic questions you must ask to ensure that the revenue you are paying for is real, recurring, and secure.
Key Takeaways
- Contracts Define Revenue Quality: The terms of the contracts determine whether revenue is recurring, secure, and profitable, which is a key driver of the company’s valuation.
- “Change of Control” Clauses are Critical: This is the most important clause to check. Does the contract allow the customer to terminate it simply because the company has been sold?
- Identify Revenue Concentration Risk: A heavy reliance on a small number of customers, even with strong contracts, is a significant risk that must be assessed.
- Look for Onerous Terms: Scrutinize clauses related to liability, warranties, and service levels to ensure the company is not exposed to unreasonable risks or future costs.
- Verify, Don’t Assume: The due diligence process is about verifying that the revenue reported in the financial statements is supported by legally sound and enforceable contracts.
The Starting Point: Creating the Contract Universe
The first step in the due diligence process is to get a complete picture. You should request a “contract schedule” from the target company that lists every single active customer contract. This schedule should include, at a minimum:
- Customer Name
- Contract Start Date and End Date
- Total Contract Value (TCV)
- Annual Recurring Revenue (ARR)
- Billing Frequency (e.g., monthly, quarterly, annually)
- Any upcoming renewal dates
This schedule is then used to stratify the contracts. You will want to conduct a full, detailed review of the most important contracts (e.g., the top 10-20 customers by revenue) and a sample review of the smaller contracts.
The contract schedule is your roadmap for the due diligence process. Without a complete and accurate map, you are flying blind.
The Legal Review: Scrutinizing Key Clauses
Once you have the contracts, the legal review begins. This is typically done by your legal counsel, but the CFO and business team must understand the implications of their findings. Here are the critical clauses to look for.
1. Change of Control
- The Question: Does the contract give the customer the right to terminate the agreement if the ownership of the company changes?
- Why it Matters: This is the number one deal-killer. If a significant portion of your target’s customers can legally walk away the day after you buy the company, the revenue you thought you were acquiring could vanish. If such clauses exist, you must get the customer’s consent to the acquisition *before* the deal closes.
2. Term and Termination
- The Question: What is the remaining term of the contract? What are the conditions for termination? Can the customer terminate for “convenience” (i.e., for any reason) with a short notice period?
- Why it Matters: Long-term contracts (2-3 years) with high barriers to termination are much more valuable than short-term or easily cancellable ones. This clause directly impacts the predictability of future revenue.
3. Pricing and Payment Terms
- The Question: Is the pricing fixed for the term? Are there any provisions for price increases? What are the payment terms (e.g., Net 30, Net 60)?
- Why it Matters: This determines the profitability and cash flow of the contract. Long-term, fixed-price contracts can become unprofitable if costs rise. Long payment terms can strain the company’s working capital.
4. Liability and Indemnification
- The Question: What is the company’s liability if something goes wrong? Is there a cap on the liability, or is it unlimited?
- Why it Matters: Uncapped liability clauses are a massive red flag. They expose the business to potentially catastrophic financial risk. The liability should ideally be capped at the value of the contract or the fees paid over a specific period.
5. Scope of Work and Service Level Agreements (SLAs)
- The Question: Is the scope of work clearly defined? Are there specific, measurable SLAs with financial penalties for non-performance?
- Why it Matters: A vague scope of work can lead to “scope creep,” where the customer demands more work than was originally priced for. Harsh SLA penalties can create unexpected costs and liabilities.
The Financial Review: Connecting Contracts to the Numbers
The financial due diligence team works in parallel with the legal team to ensure the contract terms are accurately reflected in the company’s financial statements.
1. Revenue Recognition
- The Question: Is the company recognizing revenue in line with IFRS 15 and the terms of the contract?
- Why it Matters: Aggressive revenue recognition (e.g., booking a full year’s revenue upfront for a 12-month service contract) can inflate short-term profits. The due diligence team must ensure that revenue is being recognized correctly as the service is delivered over time.
2. Revenue Concentration
- The Question: How much of the company’s total revenue comes from its top 5 or 10 customers?
- Why it Matters: If the top 10 customers account for 80% of the revenue, the business is extremely risky, even if the contracts are solid. The loss of just one or two of those customers could be devastating. This is a key red flag.
3. Billing vs. Revenue
- The Question: Does the company’s billing schedule match its revenue recognition policy? Are there any large, unbilled receivables?
- Why it Matters: This is a key indicator of financial health and operational discipline. A large amount of unbilled work can signal problems in the company’s billing process and can be a drag on cash flow.
Expert Contract Due Diligence from EAS
A thorough review of customer contracts requires a coordinated effort between legal and financial experts. At Excellence Accounting Services (EAS), we provide the critical financial component of this process.
How We Support Your Contract Review:
- Financial Due Diligence: We trace the revenue from the contracts to the financial statements, verifying revenue recognition policies and identifying concentration risks.
- Working Capital Analysis: We analyze the payment terms within the contracts and assess their impact on the target company’s accounts receivable and overall cash flow health.
- Valuation Impact: We work with you to quantify the financial impact of the risks and opportunities identified in the contracts, helping you to make a more accurate business valuation and negotiate better terms.
Frequently Asked Questions (FAQs)
This is a major red flag. Business conducted on the basis of emails or verbal agreements is extremely risky. The revenue is not secure, and the terms are open to dispute. A condition of the acquisition should be to get all material customer relationships documented in formal, signed contracts.
This is part of commercial due diligence. You should analyze the customer’s history with the company (how long have they been a customer?), their usage of the product or service, and any records of their satisfaction (e.g., support tickets, surveys). You may also request to speak with a few key customers as part of the due diligence process.
An assignment clause specifies whether the rights and obligations under the contract can be transferred (“assigned”) to another party. A “no-assignment” clause without the customer’s consent can function like a change of control clause, potentially blocking the transfer of the contract to you as the new owner.
It can be, as it provides long-term, stable revenue. However, it also represents a significant concentration risk. You must conduct specific due diligence on the government’s satisfaction with the service and the likelihood of renewal, as the loss of such a contract would be a major blow.
In this case, you don’t review individual contracts. Instead, you review the standard “Terms and Conditions” that every customer agrees to upon purchase. The legal due diligence will focus on ensuring these terms are legally sound and protect the business from undue liability.
You must have it professionally translated by a certified legal translator. You cannot rely on an informal translation for a document that forms the basis of your acquisition.
As part of the due diligence request list, you should ask for all correspondence related to any customer disputes, claims, or warranty issues for the past several years. This can reveal underlying problems with the company’s product or service quality.
This is a liability on the balance sheet that represents payments received from customers for services that have not yet been delivered. For example, a customer pays for a full year of a software subscription upfront. You must ensure that this liability is correctly recorded, as you, the new owner, will be responsible for providing the service after the acquisition.
Yes, this is a classic “key person” risk. The value of the contracts may be tied to the personal relationship with the founder. This risk needs to be mitigated through a detailed transition plan and potentially an earn-out structure to ensure the founder is motivated to transfer those relationships to your team.
The CFO, whether full-time or fractional, is the project manager for the entire due diligence process. They coordinate between the legal, financial, and operational teams. They are responsible for interpreting the findings from the contract review and assessing their financial impact on the valuation and the overall risk profile of the deal.
Conclusion: The Bedrock of Your Investment Thesis
Your decision to acquire a business is based on an investment thesis—a story about how that company will generate future profits. The customer contracts are the bedrock upon which that story is built. If the foundation is weak, the entire structure is at risk.
A deep, meticulous, and coordinated due diligence review of a target company’s customer contracts is the only way to ensure that the revenue you are paying a premium for is secure, profitable, and sustainable. It is a critical exercise that separates a successful, value-creating acquisition from a costly mistake.
Is Your Target's Revenue as Secure as It Looks?
Our expert due diligence services provide the deep-dive financial analysis of customer contracts you need to invest with confidence.
