As a prospective buyer, it’s crucial to be aware of potential red flags when buying a business.
No existing business is perfect, but it’s worth taking your time here to avoid being one of the 70-90% of acquisitions that fail. The instant you sign on the dotted line, you inherit all the skeletons in the closet of the previous owner.
In this post, I’ll highlight 16 warning signs to look out for when making a business acquisition, so you can sidestep any costly mistakes.
Red Flags When Buying a Business
1. History of financial problems
A history of late payments, unpaid taxes, or outstanding business expenses could indicate that the company has cash flow problems, which could be a major impediment to future growth.
Any financial difficulties could be a sign that the business is not financially stable and is a risky investment.
2. Inaccurate financial statements
Obtaining accurate financial information is essential when buying a business, but many business owners may try to manipulate their financials to make the business look more attractive.
Don’t take things at face value, you want to do your own research and unpack everything from profit and loss statements to owner’s discretionary income.
A good starting point is to look at the company’s financial statements, including income statements, balance sheets, and cash flow statements. My advice is to invest heavily in experts to conduct financial due diligence.
3. Major fluctuations in financial results
Keep an eye out for strange or irregular financial results, such as a sudden drop in revenue or profit. These fluctuations could be a sign that something’s not quite right. It could mean that the business is trying to hide something, or even worse, that the business is in trouble.
4. Not owning the race course
Make sure the business you’re looking at isn’t single source dependent. A lot of businesses rely on someone else’s “race course” – such as exclusively using Google’s platform for their marketing.
This scenario is incredibly dangerous: Google could change their algorithm overnight and you could lose everything.
You should have a diversified marketing mix that includes various channels and platforms (i.e. content marketing, email marketing, and social media).
Amazon FBA businesses have the same risk: you don’t own the relationship with the customer, Amazon does. The last thing you want is the entire business depending on a third party platform or single source of paid traffic.
The takeaway: make sure the business is an asset that you own and control.
5. Legal troubles
This could include things like lawsuits, judgments, or regulatory issues.
Lawsuits or judgments can be costly and time-consuming to resolve, and could be a deal-breaker for any potential buyer. It’s important to understand the reasons for these lawsuits and whether or not they are likely to be resolved in the near future.
Any of these issues could be a sign that the business is not operating in a compliant or ethical manner, and that could be a major concern for you as a potential buyer.
6. Regulatory violations or non-compliance with industry standards
These issues can indicate that the company is not operating in a compliant or ethical manner, which could lead to legal and financial troubles down the road.
Not only that, it can also damage the reputation and credibility of the company, which could affect its future growth and profitability. It could also be a sign of poor management practices and lack of attention to detail, which can be indicative of deeper issues within the company.
7. Intellectual property issues or disputes over trademarks or patents
These issues could be a sign that the business is not properly protected and could potentially lead to costly litigation down the road.
Properly evaluating the company’s intellectual property portfolio is crucial in ensuring that the company is protected from any potential competitors in the market. This includes reviewing the company’s patents, trademarks, copyrights and trade secrets and making sure that they are properly registered and legally protected.
8. Unreasonable seller
Most owners paint their business in a positive light and likely have an unrealistic view of what their business is worth. They may have poured their heart and soul into the business, or maybe they just need to get a certain price to retire.
Whatever the reason, don’t get caught up in their emotions. It’s important to stay focused on the facts and base your offer on the business’s true value. Otherwise, you may find yourself overpaying or getting into a situation where the seller is unwilling to negotiate on price.
This is one reason why working with high quality M&A advisors can be helpful – they can help you stay steady and establish a fair price for the business.
If the asking price for the business seems too good to be true, it could be a sign that the owner is desperate to sell and may not have fully disclosed all of their financials or legal issues.
9. Lack of clear processes or procedures in place
Without clear processes and procedures, it’s harder for the business to run smoothly and for employees to do their jobs effectively.
Not having well-defined systems can often lead to inefficiencies, confusion, and mistakes – not to mention creating a chaotic working environment.
A ack of processes can quickly lead to key person dependency risk. When a business relies heavily on a single individual or a small group of people, it can create a bottleneck or a single point of failure. This can be a major risk for the business if that person or group leaves the company or is unable to perform their duties.
10. Lack of paperwork and documentation
If the seller doesn’t have all of the required paperwork in order, such as contracts, tax records, or other legal documents, this could either be a sign of disorganization or a dishonest owner trying to hide something.
You’ll want to make sure that all of the paperwork is in order before you make an offer, so that you understand exactly what you’re buying.
11. Poor customer reviews, retention and a bad reputation
If a business has a history of bad reviews, high churn and few repeat clients, it’s a sign that there are underlying issues that need to be addressed.
It could be a poor customer experience, low-quality products, or just bad management. Any business without loyal customers will likely have a hard time growing and making money in the long run.
As a potential buyer, it’s important to check out the reviews and reputation, both online and offline. Look for patterns and common complaints, and try to understand the root causes of any issues. If you can, talk to former and current customers to get a better understanding of their experiences.
12. High employee turnover
High levels of employee turnover can indicate a problem with the business, either in terms of management or work environment.
High turnover rate is often a sign of a toxic work environment or poor management. This could indicate deeper issues within the business that may be difficult to fix. As you’d imagine, poor company culture can make it difficult to attract and retain quality employees, which could have a major impact on the success of the business.
13. Dependency risk on key customers or suppliers
What would happen if your largest customer left tomorrow?
A business that’s overly dependent on one or two customers is a big risk. A good rule of thumb is to ensure no single client makes up more than 10 percent of your revenue. The same goes for suppliers – the business could be massively disrupted if that supplier were to suddenly go out of business or raise prices significantly.
Make sure you understand the customer and supplier landscape before you buy the business.
A large percentage of revenue from just a few customers or suppliers is a red flag. Both of these items are critical value drivers worth paying attention to when you eventually look to exit the business.
14. No clear growth strategy
If the seller doesn’t have a clear vision for how they plan to expand the business, it could indicate that they don’t have a handle on the market, the competition, or the industry. It could also mean that they don’t understand the business’s strengths and weaknesses, and how to leverage them for growth.
As a potential buyer, it’s important to ask about the seller’s growth plans and to evaluate them critically. Look for a clear vision, realistic goals, and a comprehensive plan to achieve them.
Without a clear growth strategy, the business may struggle to maintain its position in the market and may not be able to capitalize on new opportunities.
15. Unsustainable competitive advantage
Unsustainable competitive advantage is a trap. If a business has had success because of a one-of-a-kind product or patent, it’s crucial to make sure that it’s not a flash in the pan.
Otherwise, a competing business may be able to replicate or surpass your advantage in the future, leaving the business vulnerable to market changes and competition.
Ask the business owner about the company’s competitive advantages, target market, and the trends in the industry. Also, try to understand how the company plans to innovate, adapt and evolve to stay ahead of the game.
16. Signs of declining market share
If the business is losing market share, it could be a sign that something is wrong. This could be indicative of larger issues such as changes in technology or customer preferences that need to be addressed.
It’s worth spending some time doing your own market research before you make an offer on a business, to make sure that you’re getting a good deal.
If you’re not prepared for this, you could find yourself in a situation where you’re constantly throwing good money after bad.
Before you buy a declining business, make sure you have a plan in place for turning things around. This should include an analysis of why the business is declining and a detailed strategy for how you’re going to turn it around.
What questions to ask when buying a business?
To help uncover potential red flags, it’s important to ask the right questions to fully understand the company’s company’s financial health, market position, and growth potential.
Some important questions to ask include:
- What is the company’s revenue and profit history?
- How does the company generate revenue and what are its major expenses?
- What is the company’s market position and growth potential?
- Who is the company’s target market and how does it reach them?
- How do the company’s KPIs and key metrics compare to the industry average?
- What is the competitive landscape within the industry?
- How will market trends and technological advances impact the business?
- Are there any legal or regulatory issues the company is currently facing?
- What is the company’s current financial situation?
- What is the company’s current and future debt situation?
- Are there any outstanding liabilities that the company is currently facing?
As mentioned above, be sure to do your due diligence and make sure that you understand the true value of the company before making an offer.
Conclusion
Buying a business is a big decision and it’s important to get visibility into the red flags we covered.
Keep in mind that not all red flags are deal-breakers, and a few red flags can be mitigated with proper due diligence and negotiation. With that said, it is important to be aware of these potential issues and to thoroughly investigate any red flags that are identified before making a decision to purchase a business.
By doing your due diligence and researching the company thoroughly, you can help ensure that you make an informed decision and avoid any potential problems down the road.
If you have any questions, feel free to drop me a note in the comments.
Good luck!
