Most entrepreneurs believe that buying a business is less risky than starting a business from scratch. The risk is lower because buyers can examine the company before making the purchase decision. This article discusses 15 red flags that buyers should be aware of when acquiring an existing company.
1. Owner's reason for selling
Owners have an informational advantage over buyers since they know the company better than anyone else. The information advantage gives owners a negotiating edge. Buyers can level the playing field by determining the owner's true motivation for selling. Determining the owner's intent enables buyers to examine the company in the right context.
Most owners describe their reasons for selling in a positive light and always use generalities. Promotional materials may include statements about the owner retiring, focusing on a different venture, moving to a different state, etc. These explanations may be accurate but could also disguise ulterior motives for the sale. Buyers must scrutinize the owner's situation to determine the true reason for the sale. This is where the due diligence process comes in.
Due diligence helps buyers avoid mistakes by unearthing potential problems before buying the business. If you don't have the expertise to perform the due diligence personally, consider hiring an experienced CPA or attorney.
2. Inaccurate financial statements
Accurate financial statements are essential tools to determine if the business generates enough earnings to make the transaction worthwhile. However, obtaining accurate financial information may be difficult. Updating accounting systems is time-consuming, detail-oriented work. Small business owners don't have the time or inclination to put in the effort to keep up-to-date accounting information. This affects their ability to provide accurate reports.
Buyers cannot make an informed decision unless they have accurate financial reports. They should consider walking away from any acquisition whose finances cannot be accurately determined. Furthermore, buyers should not take financial reports at face value. Financial reports should be carefully examined and verified. This type of due diligence requires detail-oriented work, as many transactions must be verified individually. It's best to enlist the help of a CPA familiar with this type of work.
3. Not up to date in their taxes
Buying a company that has tax issues can leave buyers exposed to problems with the IRS. Pay careful attention to the company's payroll taxes. Some companies delay paying these taxes when they encounter financial problems. Tax problems are serious and could leave buyers exposed to expensive penalties. Consider having a tax expert review the company's tax filings to ensure they are accurate.
4. Obsolete or inaccurate inventory
Some acquisitions include inventory as part of the price. However, inventory can also be sold separately from the business. This may be the case if inventory was bought separately and the seller needs it to pay off debt. Inventory must be carefully examined during due diligence to avoid making an expensive mistake. Buyers must evaluate a number of issues, including:
- The historical inventory turnover ratio
- Is the inventory's quality good?
- Is the inventory obsolete?
- Do you need all or some of the inventory?
- Does the physical count match the records?
- How to determine the "fair value" of the inventory
These tasks are best performed by experts, such as your CPA, appraiser, or inventory service.
5. Unusually high Seller's Discretionary Earnings (SDE)
The company's Seller's Discretionary Earnings (SDE) are often used as a metric to determine the value of a company. This metric represents the seller's earnings before taking benefits. Obviously, sellers have an incentive to present the highest possible value. Doing this helps ensure the highest possible company valuation.
Since the SDE affects the company's valuation, it also affects everything that is tied to this value. This includes the size of your equity injection, the size of your loan, the size of your debt payments, your ability to get a loan, and so on. Ultimately, the size of the SDE determines what you pay for the business.
The Seller's Discretionary Earnings must be carefully examined to ensure they are reasonable. This review requires industry knowledge and accurate financial reports. Financial reports enable buyers to remove any components that may artificially increase the SDE.
6. Unusual add-backs
Add-backs are adjustments to the Seller's Discretionary Earnings that enable buyers to determine the profits they can expect from an acquisition. They are an important metric because of their ability to increase SDE. Consequently, sellers have an incentive to include as many add-backs as they can.
Add-backs are often heavily negotiated between buyers and sellers. Buyers must examine add-backs carefully to determine their accuracy and whether they are truly "one-time" expenses. Otherwise, they unnecessarily inflate the SDE.
7. High revenue concentration
Concentration happens when most of the company's revenues come from a few customers. Losing one or more of these customers can become a serious problem. In some extreme cases, losing a single client could threaten the company's existence. Buyers should be careful of acquisitions with highly concentrated revenues.
8. Business does not qualify for financing
Most entrepreneurs use financing to buy a company. As part of their due diligence, lenders evaluate the company to determine if the transaction meets their criteria. Transactions can be declined if the company:
- Is in a restricted industry
- Has financial problems
- Has structural problems
- Has viability problems
Lenders won't finance a transaction with a risk level above their internal guidelines. Consequently, buying a company that a lender does not want to finance should be considered inherently risky.
9. High amount of seller financing
Owners want to get paid as quickly as possible for the sale. They prefer to avoid offering seller financing to buyers whenever possible. Sellers offer to finance a transaction only when they have no other option and only if it's to their advantage.
It's common for some transactions to have a small amount of seller financing. The amount of financing varies from 5% to 20%. This financing indicates the seller is confident in the business. However, a transaction with a high level of seller financing could indicate a potential problem with the business. Buyers must scrutinize this situation.
Sellers usually offer a high amount of financing when there is a problem with the transaction. The reason can be as simple as covering a valuation difference between the asking and the appraised price of the company. A more serious issue could be that lenders are unwilling to finance the transaction, leaving no other option for the seller. In the worst-case scenario, sellers could offer generous financing because they are trying to unload a troubled business. Regardless, buyers should be cautious in these situations.
10. High employee turnover
Evaluate the company's average employee turnover against the industry average. Remember that turnover varies substantially by industry, so it's essential to look at industry averages. A company with a high employee turnover could indicate serious problems with the company or labor supply.
11. Few repeat clients
Repeat clients are important to the success of many businesses. Examine if the company's sales to repeat clients are within industry norms or your expectations. Lower-than-expected repeat sales could indicate problems with the service quality.
12. Equipment problems
Buyers must evaluate the machinery and equipment to determine their condition. Machinery that has not been adequately maintained or is old may need to be replaced. Acquisitions can include additional funds for upgrades and replacements. However, your offer needs to reflect these costs to avoid overpaying for the business.
13. Market direction
The market direction plays an important role in your acquisition's future. Buyers need to look at the market's direction from a high-level industry perspective and a local perspective. The specifics and relevance of these perspectives vary by business type. The following two examples give you an idea of how these perspectives work.
Consider a business in the retail space, such as a car wash. Buyers need to review the local market conditions, including current and future traffic volumes, weather seasonality, local competitors, and so on. These conditions have an immediate and direct impact on the business. General industry concerns are also an important factor. However, these issues only affect the general market potential.
On the other hand, consider a national wholesaler of machine parts. Local conditions such as traffic volumes or local construction projects are not a significant concern for the buyer. However, the buyer needs to examine national industry trends carefully as these will determine the demand for their products and market direction.
14. Pressure to close quickly
Buyers should be cautious if there is pressure to buy the business quickly. Rushing the due diligence process may cause you to overlook important details that could cost you later. While the process should always move expediently, buyers should avoid being pressured and take as long as they need to perform the required due diligence.
15. Company reputation
Buyers must examine the target company's reputation carefully. Acquiring a company with a bad reputation could be a good opportunity if the price is low enough and the buyer has the right skill set. However, engaging in a turnaround always carries substantial risk. Buyers tend to be overly optimistic in these situations, leading to losses.
Can you avoid red flags with a Quality of Earnings report?
Using a Quality of Earnings (QoE) report during due diligence can help you minimize the chances you will be surprised by serious problems after you close the transaction. The QoE report provides a detailed analysis of the company's financial health and potential risks. The report is developed by a CPA with experience in acquisition due diligence.
We believe most small business buyers should consider getting a QoE report. They can be expensive, so the transaction size has to justify buying the report. If you decide to get a QoE report evaluation, work with a company with experience in small business acquisitions, ideally in the target company's industry
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Given the complexity of how businesses can be purchased and the products that are used, this document is not guaranteed to be 100% accurate or cover every potential option. However, we make every effort to provide the best information. If you have comments, suggestions, or improvements, contact us via LinkedIn.