Are you in the market to buy a business? If so, doing your due diligence is completely necessary when looking under the hood of a potential business investment to see whether it’s the right move.
Businesses, like people, come with a few red flags that will determine if it will be a good investment.
These red flags indicate an unstable or failing business, which is why you may eventually lose your investment and face financial difficulties.
So, in the blog, I am going to talk about all the potential red flags when buying a business and how you can avoid them to make a successful purchase!
What are Red Flags?
Red flags in a business sale generally indicate something is wrong with a specific part of that business.
This could be related to its operations, employee base, marketing, financials, or legal compliance.
In the end, some red flags can be addressed and dealt with as a condition of the purchase of the business, potentially reducing the business’s price for you too, but others you might want to stay clear of.
Below is a list of common red flags that we would recommend you look out for if you’re attempting to buy a business:
Financial Red Flags
Financial red flags are more like a warning sign that indicates a potential problem to your company’s financial health.
You can find them in your financial statement, news, reports in the form of financial statements, fluctuation in cash flow, accounting revenues and even irregularities. Let’s understand these in detail to understand the potential red flags when buying a business!
Too Much Debt
Debt in and of itself isn’t a bad thing, but it needs to be used well and responsibly. A business that has racked up too much debt starts you on the back foot when you buy it.
When debt is too high, it strangles the business’s ability to grow, stunting it until the debt is paid off.
Again, debt shouldn’t be a deal breaker. Ask what the debt was used for. If it was used to expand, then you may have something to work with; the business could be ripe for expansion. However, this is a huge red flag if it was used to cover losses.
Falling or Unstable Revenue
Consistent revenue drops or shrinking margins can also be signs that the business is struggling.
This could be due to rising competition or issues with customer satisfaction. Either way, it’s cause for concern.
Inflated Assets
During your due diligence, you may notice inflated assets on the balance sheet. Don’t take this at face value; in some cases, if it looks too good to be true, it may as well be.
Make sure that you check that all the inventory or assets are legitimate.
Poor Cash Flow
Lastly, if the business constantly struggles to pay its bills, it is likely a sign that it is either not managing its finances properly or has taken on more expenses than it can handle.
Operational Red Flags
These red flags only have one role to play: to act as a warning sign, which can further suggest potential issues, weaknesses, and irregularities in organizational operations.
Let’s take a look at the detailed breakdown of the common operational red flags:
High Employee Turnover
Businesses that have a high employee turnover are never a good sign. This can mean a few things.
Either the employees aren’t finding satisfaction in their work, or there’s a deeper issue in the company that’s undisclosed. Either way, if a company can’t retain employees it’s going to struggle to grow.
Dependence on One Client, Supplier, or Employee
Businesses dependent on an individual client or supplier put themselves in a challenging position, even if that client pays the bulk of their earnings.
The risk here is that if that client leaves, so does the business’s source of income, leaving them in a difficult spot.
The same applies to a supplier. If the company relies too heavily on one supplier, it risks disappointing its clients if the supplier cannot deliver their goods.
Legal and Compliance Red Flags
Under any circumstances, it is necessary to identify all the legal and compliance red flags! Reasons? Well, this can help you to strengthen your compliance programs and minimize the potential risks. Read on…
Pending Lawsuits
This is a tough one because some businesses may have brilliant prospects on pay and in every aspect, but could also have pending lawsuits.
If so, we recommend asking the seller about these lawsuits and inspecting them yourself. If they are nothing serious, then you shouldn’t worry.
But, if the business has a class action coming its way, you would just be buying a headache.
Tax Trouble
Tax issues can follow your business long after its sale is over. If the seller hasn’t paid their tax for a season, whether it be income, payroll, sales, or property taxes, you would inherit those responsibilities by buying the business.
Worse, if the business is being audited, that process could uncover even more problems. Ask to see tax returns from the past 3–5 years and documentation of any payments or penalties.
Hidden Liabilities
Sellers may fail to disclose outstanding debts, unresolved vendor disputes, pending warranty claims, or even personal guarantees tied to the business.
These liabilities often don’t show up on basic financial statements. To find these liabilities, you may need to have the business audited first, especially those buried in contracts, informal agreements, or legal proceedings.
If anything seems intentionally concealed, proceed with extreme caution or walk away.
Hire A Corporate Advisor To Help You Avoid These Red Flags
One of the easiest ways to avoid red flags when buying a business is to have a professional trained to help you identify issues in a business and help you.
If you’re looking for a corporate advisor, here is a helpful page from Lloyds Corporate. Here you’ll find professionals with a keen eye for spotting good and bad investments.
If you’re looking for a reputable corporate advisor, give Lloyds a call and they will be happy to help you out.
Your Legal Guide: Should You Buy That Business?
Unfortunately, many businesses out there would conceal any issues they have with their operations, legal cases, or financials.
Thankfully, most of these issues would come to light during due diligence if done correctly. Consider the red flags above and remember them the next time you consider buying a business.
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