You’re ready for your next major move - buying a business. This can be a smart investment, but executing such a large purchase, of course, comes with its share of risks. Small and medium businesses can offer extremely attractive opportunities—but it’s important to do your research and be aware of any warning signs. Before signing any deals, here are five red flags to watch for, as well as tips for conducting thorough due diligence to ensure your investment is sound.
Possible Red Flags
Inconsistent Financials: Fluctuating or unclear financial statements can be a sign of poor management or, even worse, intentional misrepresentation.
What to watch for:
Financial statements that don’t match tax filings
Sudden changes in profit margins without explanation
Poor record-keeping or missing key documents like balance sheets, profit and loss statements, and tax returns
High Employee Turnover: Businesses with consistently high turnover suggests there are deeper issues within the company. This could be due to culture, management, or even financial stability.
What to watch for:
Employees leaving shortly after joining
Negative reviews on workplace platforms such as Glassdoor
High percentage of short-tenured employees on LinkedIn
Pending Legal Issues: These can include active lawsuits, regulatory violations, or unresolved legal disputes and can create financial liabilities for the buyer.
What to watch for:
Ongoing lawsuits or compliance violations
Regulatory investigations or history of fines
Unsettled contracts or disputes with vendors or partners
Customer Concentration Risk: Having only one or two customers account for the majority of the business's revenue is not a safe bet. In this situation, losing even one of the customers could have a disastrous impact post-sale.
What to watch for:
Over-reliance on a few customers
Contracts that may expire or are up for renegotiation soon
Signs that key customers are unhappy or might leave
Declining Industry or Market: Though perhaps common sense, this one bears pointing out. Even a seemingly stable business can start struggling to grow or maintain profitability if it is in a declining industry or market.
What to watch for:
Declining industry reports or trends
Decreasing customer demand
Market saturation
Tips for Conducting Thorough Due Diligence
Basically, do your homework. Doing what you can to ensure that you have conducted thorough due diligence before finalizing a sale will save you a lot of time, money, and headaches in the future. Here are some tips that go hand in hand with the red flags above.
Examine Financials in Detail: You need to go beyond basic financial statements. Make sure to cross-check tax filings, review profit and loss statements for several years, and double-check cash flow consistency.
Interview Key Employees: This is where you will get the real story about the business you are seeking to buy. Be sure to speak with key team members to understand the company culture and management style.
Check for Liabilities: Review any pending lawsuits, regulatory issues, or other legal liabilities. It’s imperative that you use legal experts to conduct thorough reviews of contracts, vendor relationships, and compliance.
Assess Customer Retention & Contracts: Look at customer retention data and ask for insight into existing contracts, especially those with key customers. Find out when contracts are up for renewal and how satisfied the current customers are.
Review Industry & Market Trends: Analyze the industry to find out if it is in a healthy market and evaluate the competition. Determine if the future outlook shows growth is sustainable.
The Takeaway
Buying a business is exciting and could be a life-changing opportunity, but it’s crucial to recognize potential red flags to ensure your investment is sound. Conducting thorough due diligence will help you mitigate risks and be able to proceed confidently with your business acquisition. Consulting with financial and legal professionals, like HartmannRhodes, can aid in this process and make sure no stone is left unturned.
Mark Hartmann is a three-time Inc 500|5000 CEO with a rich sales, operations, and leadership background in the insurance, financial services, and healthcare sectors. With extensive experience growing and selling his own businesses, Mark leverages his expertise to help owners grow and sell businesses valued at $1M —$25M. He’s earned a Master of Business Administration from Eastern University, a master of science degree in organizational change management from St. Elizabeth University, and a graduate certificate in executive coaching from Columbia University. Mark’s professional certifications include Certified Mergers and Acquisitions Professional (CM&AP), Certified Business Intermediary (CBI), Certified Exit Planning Advisor (CEPA), and Certified Value Builder (CVB).