Buying a business is an exciting endeavor—one that brings the possibility of a satisfying and financially rewarding career path. Part of the excitement, admittedly, comes from the fact that it is also a risky endeavor. Buy the wrong business, and you could lose your investment…and then some. For that reason, it is crucial to know how to identify red flags when buying a business in order to maximize your chances of achieving a successful acquisition. 

In this article, we discuss nine red flags to look out for as you go about buying a business. These include:

• Loss of a major revenue source.
• Seller avoiding difficult questions.
• Seller refuses to acknowledge or address mistakes.
• An overly aggressive add-back schedule.
• Dishonesty about weaknesses in the business.
• Unhappy employees.
• Ad costs have increased dramatically recently.
• Seller withholds information during due diligence.
• You get a bad feeling about things.

Lastly, we discuss how having a business Advisor on your team can help you detect and avoid red flags when analyzing businesses.

Related Article: 10 Key Questions to Ask When Buying a Business

9 Red Flags to Look Out For

It is easy to rush forward with rose-colored glasses when buying a business. Naturally, you are focused on the benefits it promises. Or, you may be charmed by a charismatic and convincing seller. To ensure the success of your acquisition, however, you must approach each potential business with a discerning eye. Knowing what red flags to look for can help you avoid a disastrous acquisition. 

In this section, we break down nine key signs a business may not be worth your while. If you notice any of these red flags, proceed with extreme caution. 

1. Loss of a Major Revenue Source.

When you buy a business, you are placing a bet on its expected future performance. One of the best ways to estimate future performance is to look at past performance. If a business has performed well in the past, there is a good chance it will continue to do so in the future. 

There are exceptions to this, of course. When a business has recently lost a major revenue source, it could spell disaster for its future performance. For example, let’s say you are looking at purchasing a well-priced Amazon business. It has strong revenue and profit figures and a clear pattern of growth. Based on this information alone, it appears to be an attractive opportunity.

“When you buy a business, you are placing a bet on its expected future performance.”

Once you dig a little deeper, however, you notice that it has recently been the target of a patent infringement lawsuit. As a result, the business was just forced to pull its best-performing product, accounting for 50 percent of its revenue. Clearly, this would have a significant impact on the potential future earnings of the company.

Depending on the seller, they may try to omit this kind of information. It is your job as the buyer to ask the right questions and dig deeper when analyzing the business. 

2. Seller Avoiding Difficult Questions.

Ideally, you want to deal with a seller who is up front and forthcoming with information. Unfortunately, that is not always the case. You may encounter sellers who avoid answering difficult questions or provide roundabout answers to your inquiries. 

Most often, sellers avoid difficult questions when a direct answer would reveal unflattering information about the business. Any hesitation to answer your questions should raise alarm bells in your mind. Knowing this, you can note the topics that cause avoidance as ones that warrant deeper exploration. 

Selling and buying a business can be a challenging process. Even in the best of circumstances, it requires the buyer and seller to complete a number of different steps and navigate many potential hurdles together. In a perfect world, you want to go through the process with a seller who is transparent and honest with you, even when you ask tough questions. 

3. Seller Refuses to Acknowledge or Address Mistakes.

Ideally, the seller won’t make mistakes when presenting their business information or answering your questions. Given the complexity of most business transactions, however, mistakes can and do happen. When you identify a mistake and bring it to the seller’s attention, the way in which they respond to the mistake really matters. 

Whether it’s ego, pride, or plain tomfoolery, some sellers may refuse to acknowledge or address mistakes they have made. This can be true even when the mistake is clearly visible in the P&Ls or other financial statements.

“Look for buyers who are willing to admit their mistakes when brought to their attention and work with you to find a solution.”

This is a major red flag to watch out for. If they don’t acknowledge their mistake, it can be hard to find a workaround or solution. Further, it erodes the trust needed to navigate the rest of the transaction.

Instead, look for buyers who are willing to admit their mistakes when brought to their attention and work with you to find a solution. 

4. An Overly Aggressive Add-Back Schedule.

The most common way of valuing an online business is the SDE multiple method. According to the SDE multiple method of valuation, value = SDE x the multiple (to learn more about SDE, multiples, and business valuations, check out this article). 

To calculate SDE, certain expenses are added back to income. These expenses usually include:

• Interest
• Taxes
• Depreciation
• Amortization
• One-time expenses or income
• Owner’s salary

Whoever values the business must decide which expenses qualify as an add-back. Clearly, a business owner has an incentive to add back as many expenses as possible in order to raise the total value figure of their business during the business sale.

However, you should be wary of an overly aggressive add-back schedule. At best, it could indicate that the business owner (or whoever valued their business) doesn’t know what they are doing. At the worst, it could indicate that they are trying to inflate the value of the business without justification. If this is the case, they are simply hoping to find a buyer that doesn’t notice.

During any business acquisition, you should be able to spot overly aggressive add-backs. However, knowing which expenses qualify as legitimate add-backs and which don’t can be tough. If you don’t feel confident in your ability to discern accurate add-backs, it is best to work with a knowledgeable business Advisor.

5. Dishonesty About Weaknesses in the Business.

When you buy an existing business, you must do your best to learn about its weaknesses. While there are things you can do to find this information on your own, it is much easier if the seller is up front about weaknesses from the beginning.

Unsurprisingly, some buyers will avoid sharing their business’s weaknesses. They may not answer questions directly or outright lie in order to hide information or put things in a positive light. When you sense this is happening, recognize it as a red flag.

Instead, it is preferable to work with buyers who voluntarily explain all aspects of the business, both the good and the bad. For example, an owner may share positive sales figures but also explain that the business sees few repeat clients, a potential weakness.

6. Unhappy Employees.

Another big red flag is when a business has unhappy employees. This could indicate poor management, poor work culture, or an otherwise struggling business. Poor employee satisfaction could lead to high employee turnover down the road, adding to your costs and hurting the business.

If you are considering buying a business with employees, take some time to get a feel for their happiness and satisfaction levels. Ideally, you want to buy a business whose employees plan to stay on after the acquisition is complete.

“You should be wary of any business whose ad costs have recently increased dramatically.”

7. Ad Costs Have Increased Dramatically Recently.

For many businesses, advertising costs can eat up a significant portion of the revenues. The old adage “you have to spend money to make money” can often be true. However, you should be wary of any business whose ad costs have recently increased dramatically.

For starters, the business owner could be trying to boost revenue in the run-up to the sale. While this can pad the numbers temporarily, it can also be an unsustainable business model or hurt profitability. Or, the owner could be trying to make up for other weaknesses or patterns of decline before the exit.

In either scenario, you will likely need to be thorough in your analysis of the company. For an astute buyer, this underscores the importance of obtaining accurate financial information.

8. Seller Witholds Information During Due Diligence.

Due diligence is a period of the transaction process where you and your team have the opportunity to verify the performance of the business. It is an incredibly important stage and your last chance to analyze the business to make sure it is a worthwhile investment. You will likely spend a huge amount of time verifying the company’s financial statements, conducting market research, and more.

During due diligence, it is natural to have lots of questions for the seller. Any seller that withholds information during due diligence should immediately set off alarm bells in your mind. Again, this is an indication that they are hiding information or covering up weaknesses in their business.

Instead, seek to work with a seller who thoroughly answers your questions during the due diligence process. Even better, they should volunteer all relevant business information, regardless of whether it is flattering or unflattering.

“Any seller that withholds information during due diligence should immediately set off alarm bells in your mind.”

9. You Get a Bad Feeling About Things.

Sometimes, you need to just trust your gut. If you get a bad feel for a business or the owner, treat it as a red flag. Maybe you can point to the reasons for the bad feeling, and maybe you can’t. Either way, proceed with caution or cut your losses and move on to the next prospect.

How a Business Advisor Can Help You Detect and Avoid Red Flags

Buying a business can be a complicated endeavor. With so much information to analyze, it is easy to overlook important details. For most buyers, it can feel overwhelming to ensure you cover all of your bases.

“If you get a bad feel for a business or the owner, treat it as a red flag.”

For this reason, many buyers choose to hire outside professionals to help them navigate the process. From asking the right questions to identifying mistakes, an experienced Advisor can make the difference between success and failure.

Ask the right questions

Sometimes, even knowing which questions to ask can be challenging. From initial conversations with the seller to closing the deal, the right Advisor will know which questions to ask at each step of the exit process.

Calculate add-backs correctly

As mentioned, getting add-backs right is crucial to creating an accurate valuation. Unfortunately, it can be challenging to know where to start when analyzing a seller’s add-back schedule. An experienced Advisor will know which add-backs are appropriate and which don’t make the cut. If the seller has made any mistakes with add-backs, willful or otherwise, your Advisor will know how to identify them and address the issue with the seller.

Identify mistakes

Your Advisor will also be able to recognize and address any other mistakes along the way. Whether you are verifying business expenses or ensuring accurate financial statements, having an Advisor on your team can make all the difference when it comes to detecting seller mistakes.

Conclusion

With so many hurdles to navigate when buying a business, success ultimately comes down to building rapport and fostering honesty and trust with the seller. By doing so, you are better equipped to navigate the many potential challenges you are likely to encounter along the way, helping you achieve a profitable and successful acquisition.