Red Flags to Watch Out For When Buying a Business

Buying an established business can provide a faster route into ownership than starting from scratch, but the apparent opportunity may not tell the whole story.

A business can look attractive because of its revenue, brand, customer base or assets while concealing financial, legal or operational problems.

Due diligence is therefore essential. The objective is not to find reasons not to buy, but to understand the risks well enough to make an informed decision.

Financial Red Flags

Financial information should be one of the first areas you investigate.

Look carefully at:

• Declining revenue.
• Falling margins.
• Unexplained expenses.
• Large debts.
• Unusual cash withdrawals.
• Outstanding tax liabilities.
• Large discrepancies between accounts and management figures.

Ask the seller to explain material changes rather than assuming that historical performance will continue.

Unexplained Revenue

Revenue should be supported by appropriate records.

Be cautious where reported sales cannot be reconciled with bank records, accounting records, customer contracts or other reasonable evidence.

Cash-Flow Problems

A profitable business can still experience serious cash-flow problems.

Review working capital, debtor balances, creditor payments, inventory requirements and recurring cash commitments.

Customer Concentration

A business that depends heavily on one or two customers may carry significant revenue risk.

Determine how much revenue comes from major customers and whether important contracts are transferable or renewable after acquisition.

Legal Warning Signs

Legal problems can materially affect the value of an acquisition.

Investigate:

• Pending litigation.
• Contract disputes.
• Regulatory issues.
• Intellectual-property disputes.
• Unresolved claims.
• Unusual contractual restrictions.

Employee Problems

A high employee turnover rate, unresolved disputes or dependence on a small number of key employees can create operational risk.

Review employment obligations, staffing levels, key-person dependency and any material employment matters.

Operational Weaknesses

A business may appear profitable because the owner personally performs many functions without charging the company a market-rate cost.

Determine what would happen if the owner disappeared from the operation immediately after completion.

Seller Behaviour

The seller's conduct during the transaction can provide useful information.

Be cautious if the seller:

• Refuses reasonable due-diligence requests.
• Provides inconsistent information.
• Creates unnecessary pressure to complete quickly.
• Cannot explain important financial figures.
• Changes material terms unexpectedly.

Missing Documents

Incomplete documentation can make it difficult to assess the true condition of the business.

Important gaps should be investigated rather than ignored simply because the business appears attractive.

Unrealistic Valuation

An asking price should be supported by evidence.

Compare the price with the company's earnings, assets, revenue quality, growth prospects and relevant market evidence.

Never Ignore a Question You Cannot Answer

One of the most useful principles in acquisition due diligence is simple: if you cannot explain a material issue, investigate it before proceeding.

The cost of asking additional questions is usually much lower than the cost of discovering a major problem after completion.

Buyer Red-Flag Checklist

• ✔ Verify financial information.
• ✔ Investigate unusual revenue or expenses.
• ✔ Review cash flow and working capital.
• ✔ Assess customer concentration.
• ✔ Review material contracts.
• ✔ Investigate legal claims.
• ✔ Review employee obligations.
• ✔ Identify owner dependency.
• ✔ Check intellectual-property ownership.
• ✔ Investigate missing documentation.
• ✔ Challenge unsupported valuation assumptions.
• ✔ Use appropriate professional advisers.