Red Flags When Buying a Business
Deciding to buy a business involves a lot of research, commitment, and risk.
This endeavor could involve spending your life’s savings, moving to a new location, and taking your first shot at business ownership.
Because of all these potential changes, you want to know you're making the right choice when you decide to buy a business.
While there’s no such thing as “the perfect business,” there are several red flags you can look out for when you’re deciding on the business you want to buy.
At MidStreet, we've been very selective of the businesses we've chosen to work with throughout the years. Experience has taught us what to avoid, and we want to share what we've learned with you.
To help you find the right business, we put together this list of red flags to look out for when buying a business.
The information below will be split into two categories: red flags when working with a seller, and (more generally) red flags when buying a business.
Combined, these two categories will be your go-to guide on red flags when buying a business.
To make sure you have all the information you need, we've also included a short list of misconceptions that buyers often have about sellers.
Let’s jump in!
Red Flags When Working with a Seller
As business brokers and M&A advisors, one of our favorite things to do is work with sellers. Their inspirational stories and entrepreneurial spirits are part of why we work so hard to find the best buyer for their businesses.
Unfortunately, however, not every seller is as trustworthy or knowledgeable as we'd hope.
Let's dive into some of the things to keep an eye out for when working with a seller.
1. No Reason for Selling
If someone has decided to sell their business, they should be able to tell you why. Oftentimes, a business owner is either nearing retirement, wants to spend more time with family, or doesn’t feel like they’re the best person to keep running the business once it has reached a certain size.
These are all common, understandable reasons for selling.
When a business owner can’t tell you the reason they want to sell, that should raise a red flag.
Think about it. Business owners have spent years growing their businesses. They've poured in money, sacrificed time with family, and worked several 60+ hour weeks.
They didn’t just wake up one day and decide it’s time to sell: they have a reason.
This is something you'll want to clarify before moving forward with an acquisition. One of the first questions we ask sellers is their reason for selling, and when they can't tell us, it raises a red flag.
Whether it's just their lack of commitment to sell, or they're trying to hide something, neither are good signs.
2. Inconsistent Desire to Sell
Something else to look out for is a seller who seems iffy about whether they actually want to sell or not.
This raises a red flag because of the amount of time and resources that could be wasted on someone who isn't serious about selling.
As a buyer, you will need to invest a lot of time and money in your attorney and CPA to help conduct due diligence, negotiate representations and warranties, and several other important tasks.
Wouldn’t you have some serious regrets if you spent all that money just for the owner to decide that they aren’t ready to sell after all?
If you pick up on a seller’s inconsistency on their desire to sell early on, it's best to have an honest conversation with them and their business broker about their intentions, or avoid them altogether.
3. Too Eager to Sell
Contrastingly, you also don’t want an owner who is overly eager to sell.
This can be tricky because sellers who want to offload their businesses immediately will often accept a low purchase price that may seem like a steal at first glance.
In other words, if an owner wants to dump their business as quickly as possible for a low purchase price, it’s probably not a business you want to buy.
4. Unrealistic Expectations
Possibly one of the most common issues you’ll run into when inquiring on businesses is an owner who believes their business is worth much more than it actually is.
This is a perfectly natural feeling for a business owner to have, and most can be reasonably brought back to reality by a quality business valuation.
However, there are some business owners who won’t accept the reality of what their business is worth, or will only accept the high-end of their value range.
Some business owners are also unrealistic about what terms they'll agree to. Sellers may hesitate to offer the training you think you'll require post-acquisition, or be unwilling to budge on other items that could generally be negotiated.
As you can imagine, this can create a problem if the deal requires any sort of compromise, which they often do.
This can be cause for concern, but it's important to note that this is relatively common. Sellers could have been misled into believing their business is worth more than it is, so it doesn't always mean they're incompetent or untrustworthy.
5. Understated Involvement
Something else that can be a red flag is when a business owner claims they don’t have much of a role in the business, or that the business “runs itself.”
This doesn't always mean the seller is being deceitful. Running the business has probably become second nature to them over time, so it can be easy for them to understate their involvement.
All of those responsibilities that seem like small tasks can start to add up once you start to quantify the seller's role in their company.
If you’re buying a business, you need to have a real understanding of what the previous owner’s responsibilities are. You're about to step into that role, so you need to make sure you aren't biting off more than you can chew.
This is impossible to figure out if the owner consistently understates their involvement.
It is important to remember, however, that there are cases in which the seller truly is an absentee owner.
They may be being completely honest about the efficiency of their business, but it's important for you to verify this.
6. Unsure of Their Numbers
When an owner doesn’t have an accurate understanding of their business’s numbers, this can also be a bad sign.
Owners who overstate or understate their revenues by hundreds of thousands of dollars are probably a bit disconnected from the business.
A disconnected owner could mean that a business isn’t being properly managed, and that’s not something you want to step into.
Keep in mind, not every owner is extremely involved in their accounting practices. It may take a little extra communication with the business's accountant and bookkeeper to get to the bottom of things, which isn't abnormal.
But generally speaking, the more difficult it is to get to the bottom of a business's financials, the less you can rely on them being accurate.
7. The Business Has "No Problems"
If someone claims that their business has no problems, it’s likely untrue. In fact, it’s closer to impossible.
Even the most successfully operated businesses have their problems, which is completely normal. An honest owner who truly knows their business will be willing and able to have an honest conversation about their shortcomings.
If a business owner is telling you that their business has no problems, you can probably guarantee two things: either they are being dishonest, or they are too far removed from the business as an owner.
8. They're Unrepresented
It may sound biased, but we truly believe that the best way to sell a business is to use a qualified business broker or M&A advisor. These professionals act as a guiding light during a sale as they help sellers value their businesses, work with buyers, and offer advice throughout.
Someone who is trying to sell their business without representation can have unrealistic expectations regarding their business’s value and the transaction timeline.
They may also be far too busy to handle document requests in a timely manner, which can prolong the deal and hurt the business's performance.
Overall, when a seller has hired someone to represent them in the sale of their business, it shows their commitment to selling, which can make the process of buying a business far less stressful.
9. They've Previously Sold In the Same Industry
If a seller has sold a business in the same industry before, that can raise a red flag.
This may not seem troublesome at first glance, but think about this from a competition perspective.
The business owner sold a business in the same industry before, and then turned around and started another one. Depending on the industry and location, this could have created some serious competition for the buyer of the first business the owner sold.
If they’re selling you a business, who’s to say they won’t do the same thing again?
In most cases, you'll require a seller to sign a non-compete in which they agree not to open a competing business within a certain time-frame. But once that non-compete term ends, everything is free game.
You don’t want competition from the previous owner to infringe on your success a few years after buying a business, so be leery of sellers who have previously sold a business in the same industry as the one you’re buying.
It's important to note that this isn't a deal breaker, and there have been several honest business owners who have sold within the same industry twice.
To give yourself peace of mind, make sure the seller didn't violate their non-compete when they sold their first business.
10. Unreported Cash
Business owners not reporting all of their cash sales isn't uncommon, but if they are trying to include unreported cash in the value of their company, that can raise a red flag.
Paying for unreported cash when you purchase a company could lead to some unfortunate surprises once you start understanding what the earnings actually are in the months after an acquisition.
Red Flags When Buying a Business
While sellers themselves present most of the red flags when buying a business, there are more general things to look out for involving the business's financials, equipment, real estate, etc.
Let's take a look at some of the more business-related red flags to look out for.
1. Inconsistent or Declining Earnings
During due diligence, you'll generally want to see the last three years of profit and loss statements (P&Ls) for the business.
If the numbers from year to year are extremely inconsistent, or appear to be declining, this could indicate a couple things that are bad news.
Inconsistent earnings make it very difficult to project a business's future earnings potential. Without a way to reasonably estimate how well the business can do after an acquisition, it's virtually impossible to determine if the business is worth your investment.
Inconsistent or declining earnings can also mean that a business's sources of revenue fluctuate greatly based on uncontrollable factors like the economy or advancements in technology.
The safest bet is to purchase a business with earnings that are as predictable as possible, so when numbers are shifting around drastically, this could be a bad sign.
It's important to keep in mind that earnings can appear to be inconsistent if a business does cash-based accounting instead of accrual accounting.
Because cash-based accounting only records profits and losses once payments are distributed or debts are paid, it can make one year look extremely inflated while the next looks dismal.
In this case, a good accountant can usually make the necessary adjustments, but it may come at a substantial cost. Who pays that cost will have to be negotiated between you and the seller, but sellers are often willing to pay an accountant to adjust their books to get the business sold.
2. Behind on Taxes
If you buy a business with tax trouble, you may expose yourself to problems with the IRS.
This may come in the form of delayed payments on income taxes, which business's sometimes neglect when going through financial difficulties.
Keep an eye out for this or other neglected taxes when your CPA combs through financials.
All the items listed above are generally things you don't want to see when inquiring on a business, although some of them can be remedied by the right professionals.
Sometimes, however, buyers can become concerned about sellers and their businesses for things that shouldn't be a concern at all.
Let's address some of the misconceptions you may have about what constitutes a red flag in a business acquisition.
1. Associating the Desire to Sell with Business Failure
Perhaps one of the biggest misconceptions people have when someone is selling their business is that the business must be failing. If the business is successful, why would the owner want to sell it, right?
This couldn't be further from the truth. In fact, the best time for a business owner to sell their company is when it's reached its peak.
This may sound odd at first, but since companies are valued based on their earnings, they'll be valued the highest when they're earning the most.
To learn more about why people sell their businesses, check out our blog "Why Do Owners Sell Their Businesses?"
2. Seller Is Concerned About Confidentiality
It may be hard to grasp the importance of confidentiality as a buyer, but rest assured, sellers have great reasons for keeping their business sale confidential.
Their concerns about confidentiality shouldn't signal any sort of secrecy or dishonesty.
3. Seller Is Cautious About Sharing Sensitive Information
A business's sensitive information can't be trusted with just anyone.
Things like customer information, trade secrets, etc. have to be kept within the organization to prevent that information from being used against the business.
While the seller will share this information with a buyer eventually, they will generally want a prospective buyer to be thoroughly vetted before they do.
Buying the Right Business
When working with a seller and their business broker or M&A advisor, the best thing you can do is be prepared with the right questions to ask. The red flags we listed are a great place to start, but here are a few additional things you'll want to keep an eye out for when working with a seller:
- They are selling the business after a short period of ownership
- They are willing to call off the deal over minor issues
- They are unusually young and still passionate about business ownership
- They are hesitant to provide requested information after you’ve sent your Letter of Intent (LOI)
It's important to remember that any of the items listed above aren't necessarily deal killers. Sometimes there are perfectly good explanations.
Slow down, spend some time with the seller, and ensure you get your questions answered to your satisfaction.
If the business broker or M&A advisor tries to shield you from spending some time with the seller in person, make it known you won't proceed without it. In the end, a big part of your decision is going to come down to a gut feel, which is hard to get without some face-to-face time.
At MidStreet, we work hard to facilitate trust and create the smoothest transaction process possible. If you have questions about our process, or are interested in one of our listings, contact us today. We’d be glad to help!