8 Red Flags of Buying a Business

Becoming a business owner through acquisition can be a smart move to avoid the hassles and headaches of launching your own startup. With so many new businesses failing within the first five years - not to mention the time it can take even to turn a profit - starting from scratch is risky business, sans a dancing Tom Cruise. 

That’s not to say that acquiring an existing business is a cakewalk; it will come with its own set of unique challenges. But in many instances, the pros outweigh the cons, and buying a business could be your first step to building your empire. (We like to think big here.)

A big part of the purchasing process is doing due diligence. Not every opportunity on the market is a good one, and while it might be tempting to jump at the first eye-catching deal that comes along, keep in mind this isn’t a new mattress you can try out for 120 days and return for a full refund after four months of fitful sleep. These transactions are a lot of time and (probably) a lot of money, and you want to go into any agreement with a clear understanding of what you’re buying. This is not a time for surprises.

As you’re doing your research, you should be mindful of certain red flags. By definition, a red flag is used as a warning of danger. So if you’re at the beach and the red flags come out, don’t ask questions, just get your a** out of the water to avoid becoming shark food. On the other hand, while a red flag could mean Avoid At All Costs in the business world, it could also point to an opportunity you can use for your own advantage. 

Depending on what you uncover, the red flags that have kept others from sealing the deal could be your ticket to negotiating a better purchase price and working out more agreeable terms that benefit you as the buyer.

Here are eight red flags to keep an eye on. 

1. A needy sales pitch: A good deal will sell itself. If the owner is laying it on thick and trying too hard, that’s a red flag. On the other hand, if they’re desperate to sell, why not use that as a bargaining chip to decrease the sales price? If you feel confident you can turn things around, it might be worth the risk if the price is right.

2. Few repeat clients: If the business relies heavily on the revenue it makes from one or two customers, that’s a potential red flag. The general rule of thumb is that no more than 10% of revenue should come from one customer or 25% from the top five customers. If just one of those were to take their business elsewhere, that could significantly affect your bottom line. There may be an opportunity for better marketing and advertising to attract more customers, but you’ll have to decide for yourself if it’s a risk you’re willing to take.

3. Old or outdated equipment: If you’re purchasing a business that relies heavily on expensive machinery, the last thing you want to do is fork over funds to update, fix, or replace it. That could be an enormous expense. Ensure you’re checking all their equipment thoroughly and inquire about how often they require maintenance or repairs. If it’s brand new equipment, you’ll probably pay more but have fewer headaches. If it’s older equipment that needs a regular tune-up or is on its last leg, adjust the value of the business and renegotiate the purchase price, or walk away from the deal.

4. Employee turnover: What are their average employee turnover rates compared to the industry average? Is it a revolving door of hiring, training, and replacing employees on a regular basis? There is definitely a potential for improvement in this area, especially if it’s due to ownership or management issues. But it could also be indicative of a more serious problem and one you need to evaluate if you can correct.

5. Community reputation: Whether it’s the local community or the one online, when you acquire a business, you are taking on the good, the bad, and the ugly. And that includes every pissed-off customer they’ve ever dealt with. When doing due diligence, ensure you’re reading reviews and talking to past customers. Does that tire center have a reputation for slow service and rude staff? Do people complain about shipping delays or poor customer service on that e-commerce site? As the new owner, you’ll have the opportunity to rebrand and revamp, but you will want to consider whether that uphill battle is worth it.

6. Declining sales figures: A business with a solid track record of profitability over a significant amount of time is probably a safe bet. (Albeit, it will come with a higher price tag.) But if you notice those numbers have been in a steady decline, and they’ve barely been breaking even, that’s a red flag. You could chalk this up to incompetent management or poor budgeting. But it could also signal a larger, systemic problem that you may or may not be able to fix. If it’s a challenge you want to take on, you can use their poor sales figures to bring down the asking price. 

7. Contracts and leases: A lot of businesses will have long-term contracts or leases for properties, buildings, supplies, services, and more. And these relationships will probably come with the deal. You need to know who they’re in bed with before you pull back the sheets and hop in (or you might be in for an unpleasant surprise). Do the agreements make sense financially? How much time is left on the contracts? Is there room for negotiation? 

8. Competition and market direction: This is a double-edged sword. No direct competitors could mean good things…or it could mean that you’re a Blockbuster and the Movie Gallery on the other side of town has closed up shop. (And we all know how that ended.) Having little to no competition and a majority share of the market is a red flag you should examine closely. 

If you encounter any of these red flags while doing your due diligence, don’t write them off immediately. While you might initially see them as reasons to run, they can also be opportunities for massive potential. Make sure you’re looking at the big picture and carefully consider the pros and cons for yourself, your family, and your goals. At the end of the day, only you can decide if it will be the right choice.