Before buying a business you should do plenty of research and gather as much information as possible on your prospective purchase. You will typically hear great things from the seller, who may even provide you with background material touting the company’s success. As a buyer, however, you must approach this transaction with your eyes wide open.
First, you’ll need to generate a valuation of the business to determine if it is in line with the asking price. If there is a significant discrepancy between your numbers and the asking price, find out why. How did the seller arrive at the asking price? Was an independent appraiser involved? If there is no supporting evidence to support the seller’s valuation, proceed with caution.
Conversely, if the asking price of a business is far below what you would expect, there may be something wrong. Typically, anything that sounds too good to be true is.
Among the other red flags that you should be aware of are:
- Frequent turnover. Be weary of a business that has been sold and resold several times within a short timeframe. Most likely one or more buyers has tried to make a go of this particular business and has not been successful. If this is the case, perform extra due diligence to uncover the cause of the multiple sales.
- Ambiguities in the contract. The contract should spell out all of the necessary details, especially if you have discussed and negotiated specific terms. Have an attorney review the contract before you sign it.
- High-pressure sales techniques. If someone is pressuring you to make a deal, back off. If the deal is a good one, it will be obvious. More often than not, high-pressure tactics are evidence of a bad deal.
- Too much debt. Establishing and maintaining a profitable business is hard enough, even without substantial debt. Carefully review the current debt and debt ratio of the business you are considering purchasing, and make sure the amount of debt is manageable.
- Oddities on the balance sheet. When reviewing the balance sheet numbers for the past three to five years, look for significant changes, such as a major increase in accounts receivable. Any drastic changes should be explained.
- The reason the seller is selling. Sometimes the seller is retiring or looking to open a new business elsewhere. If that’s not the case, do plenty of research to uncover the reason. Evaluate why the seller is selling and determine if that is reason enough not to buy.
- Lots of promises. When promises outweigh a proven track record it may be best to back away from the deal.
- Reputation. While a new owner can turn things around financially, if a business has a bad reputation — such as numerous customers filing reports with the Better Business Bureau — it’s especially tough to dig your way out of a hole. A negative reputation is hard to overcome and might be reason enough not to buy a business.
- Lease or landlord problems. The business may be running smoothly, but what about the lease terms and the relationship with the landlord? Review the lease carefully before you buy, and insist on meeting the landlord in advance.
- The neighborhood. Even a great business idea can be a disaster in the wrong neighborhood. Determine if the surrounding environment suits the business.
Red flags do not always mean that you should walk away. They simply mean that you should proceed with caution.