5 Red Flags when Buying a Business | The Firm Exchange Blog

5 Red Flags when Buying a Business

Post written by Firm Exchange on June 29, 2018

Buying a business is often an exciting time for a buyer. However, it can be a road with a lot of financial peril if you don’t proceed carefully and intelligently. When you find a business for sale that meets your initial criteria, it can often be tempting to rush the process and start the next chapter of your career. Before you jump on a deal, though, it is important to look out for red flags and make sure that you are getting what you expect.

Sellers will often position the business in the best possible light and may gloss over any defects in the business to achieve the best price possible. As a buyer, it is important to approach any deal with a dose of skepticism and conduct a thorough due diligence process to minimize negative surprises after you close. To help you avoid common pitfalls, here are five red flags to look for when buying a business.

#1: Unusual Liabilities

Look out for unusual business liabilities that may threaten the financial viability of your new business. These might include lawsuits, the threat of litigation, unpaid wages, secured debts and labor code violations. Ideally, you unearth and discuss any potential issues of this nature during the due diligence process. However, you may consider asking your attorney to include a full liability disclosure indemnity clause in the sales contract. These clauses require the seller to provide information on any such liabilities and cover potential costs should they arise after you close on the purchase.

Depending on the situation, it may make sense to buy only the business’s assets and not its liabilities. Some liabilities could appear years later, so this is a more proactive approach. You should consult an attorney, but one common strategy is to form a new Limited Liability Corporation, or LLC, to buy the business and hire the employees. Rehiring employees in the new LLC may reduce or even eliminate any employee claims that arose during their previous work.

#2: Dishonesty

Owners who are dishonest about even small things may be hiding bigger issues. Some aggressive business owners might suggest or imply that their businesses earn more money than the books show. This is a red flag that should concern you. There’s no way to verify such a statement, and an owner who suggests hidden income might be breaking the law. The owner could even be suggesting that you become complicit in the crime by continuing to underreport earnings.

Many owners might stretch the truth or prefer not to say why they’re selling to protect their privacy. Others, however, might evade a critical truth such as a changing neighborhood that can no longer support the company’s products or services. Demographic changes can erode your customer base and may make it difficult to find new customers. Ways to uncover dishonest sellers include:

  • Matching financial records with tax filings and other government reports
  • Interviewing employees, customers, suppliers, and even nearby businesses
  • Insisting on an inspection of the property

You may need professional assistance in analyzing complex financial records and conducting property evaluations, so consider hiring an accountant and an inspection team to get a more accurate assessment.

#3: Recent Business Developments

Business developments in your industry or the city where the business is located are worthy of special attention and may present big red flags. Any major construction or development project could change the nature of business such as restricting access to the building. If you’re buying a retail store, for example, a new big-box retailer may undercut prices and challenge your ability to compete.

New developments can be a red flag to look for when buying a business
New commercial developments can be a red flag when buying a business.

A small restaurant might face a flood of competition because a new office park is in the planning stages. The competition might even come from within the business, such as a talented employee who plans to start a competing business. The owner might look to start a business nearby, so inserting a non-compete clause in the contract is often a good strategy.

Industry developments can also pose risks. Emerging technology could render the business outdated or obsolete in its current form. If you must replace or update your equipment, the sale might not be the bargain it seems.

#4: Demand for a Quick Deal

After deciding to buy a business, your due diligence is only getting started. It often takes months to analyze the business and finalize the details of the transaction. Sellers have a strong incentive to keep the process moving along, but undue pressure to hurry up the deal can be a sign of something more serious. If the seller insists on a fast sale – and the reasons seem legitimate – you might consider asking for financial breaks or other perks to mitigate any increased risk.

#5: Frequent Turnover

Frequent turnover in ownership may indicate that other buyers haven’t been able to succeed, or the work required is unexpectedly difficult. The same holds true for frequent changes in management and perhaps even staff. If you discover multiple sales or outsized staff turnover within the recent past, you should investigate further.

Some Red Flags Can Be Opportunities

Red flags can sometimes become opportunities. A major development might slow business for a year or two but create greater opportunities once completed. Long-term construction projects can be a big benefit to neighborhoods. They can expand markets and bring new customers to the area.

Regardless of red flags, you should invest some time to determine the likely consequences. Researching the business that you plan to buy and conducting a thorough due diligence process is critical. Here at Firm Exchange, we offer the tools and resources buyers and sellers need to conduct the due diligence process. Join today and see how Firm Exchange can help you buy the right business for you.

DISCLAIMER: The information contained in this article is for informational and discussion purposes only, and should not be relied upon without seeking your own professional advice. The Firm Exchange, LLC is not a law firm, accounting firm or professional services firm, and accordingly it disclaims any liability for any reliance on the contents of this article. As each situation is unique, you are encouraged to discuss your specific situation with a qualified attorney, accountant and/or other relevant professional services provider.