How To Spot Red Flags When Buying a Business
Starting a new company can be tough, so buying a business might seem easier. The prospect of stepping into an established framework can seem like a shortcut to business success, but it comes with its own set of challenges, particularly involving the intricate legal landscape that accompanies transactions such as buying a business.
The groundwork for a successful acquisition begins long before the ink dries on the purchase agreement. Similar to investing in real estate, prospective buyers must conduct thorough due diligence, with the help of legal and financial experts, to assess the viability of their options when it comes to deciding upon which business to buy.
With many years of experience helping people just like you buy businesses in Barrie, Simcoe County, and Brampton we know that superficial scrutiny can often unveil underlying issues that may prove to be deal-breakers. To help you make the best decision possible if you’re on the lookout for a business to buy, these are a few key questions you should ask and consider the answers carefully while keeping your eye out for any red flags.
Ask, What’s The Reason For Selling The Business?
When considering buying a business, ask why it’s for sale. If the owner won’t say, it’s a warning sign. But if they’re open about retiring or pursuing other ventures, it could be a good fit. You’d inherit their customer base, avoiding competition which is a big benefit to you as the potential new owner. If financial issues or inability to sustain the business are cited, think twice. Plus, ask more questions during due diligence to verify their answer.
Ask, Are There Financial Inconsistencies In The Business?
The business’s financial health is crucial for your investment’s safety. Reviewing financial statements for the past three years is essential to understand its performance. Even if you’re familiar with accounting, hiring a CPA for an unbiased audit is wise. They can spot unnoticed issues and they will have more insight when it comes to spotting or explaining why the numbers look like they do.
Discrepancies in reported revenues may indicate dishonesty or poor accounting this is why assessing the owner’s discretionary income for consistency, can help reveal risks and growth potential. You want to see consistent earnings preferably, as fluctuating figures suggest vulnerability to external factors.
Declining sales could lead to a better purchase price, but long-term decline warrants caution.
Ask, Are There Any Past Legal Issues With The Business?
You certainly don’t want to purchase a business that immediately lands you in legal trouble. A company with past litigation issues or lacking proper structure is a clear red flag during the acquisition process. With the assistance of a business acquisition lawyer, you can ensure the company you’re considering buying complies with industry licenses and regulations, has resolved any pending lawsuits, and has its contracts in order which is very important when taking over an established business.
A commercial lawyer plays a crucial role in the due diligence process, identifying potential risks associated with the purchase and drafting a purchase agreement that shields you from liabilities uncovered. There might be underlying issues that aren’t immediately apparent so having your lawyer review every detail with a fine tooth comb could be the best investment you make.
Ask, How The Business’s Credit Standing Is?
If your business deal has trouble securing financing, it’s a huge red flag. Lenders assess the potential profit from the acquisition and won’t finance risky ventures. If the business has financial problems, you’ll likely be unable to secure a loan, and knowing that in advance of making a purchase protects you from a bad deal. So be sure to check the company’s credit score online to ensure it’s debt-free and financially stable before proceeding with any purchase deal.
Ask, Are The Taxes Up-To-Date?
Each company operates within a specific tax regulatory framework based on its business nature and scope. Canadian businesses adhere to federal and provincial tax laws, while international companies must comply with tax regulations across all jurisdictions where they operate. Your accountant should be able to confirm the company’s tax filings in Canada but be sure that they are also complying with tax laws in countries they import or export to.
Check The Business Owner’s Reputation
Assessing the honesty of a business owner is crucial but challenging, as no one will openly admit to dishonesty. Experienced business lawyers emphasize the importance of due diligence in this regard and when they have worked in a specific geographic area for a long time they might also have insights from past experiences you could benefit from.
Examining the owner’s discretionary income, meaning the money they take home after expenses, can provide valuable insights as well. While consistent revenue may seem positive, declining discretionary income raises red flags for potential buyers.
Dishonest owners may also pose risks by starting competing businesses or taking existing customers, leaving the new buyer with debts. Including a non-compete clause and a disclosure agreement in the purchase agreement can help mitigate these risks, but consulting with a commercial lawyer is always recommended to make sure you will have a solid base to build off of without stepping into a rat race against the person you just purchased the business from.
Talk To The Business’s Employees
A company’s value heavily relies on its employees. Regular terminations or resignations raise red flags, especially if turnover rates exceed industry norms. High turnover suggests underlying issues like poor management, negative work environments, low wages, or difficulty retaining talent.
Ensuring employee satisfaction is vital post-acquisition to maintain continuity and receive necessary support and education for the next 12-18 months. Speaking with current employees, especially lead hands or managers, provides insights into the business culture, employee happiness, concerns, and intentions post-sale. It can also help uncover undisclosed issues like past legal problems or undisclosed motives for selling.
Ask Yourself, Is The Business Model Sustainable?
While a business may seem financially sound, it’s crucial to assess its underlying structure. Success may be tied to the owner rather than effective management. Additionally, the company may lack preparedness for industry changes.
Analyzing the company’s foundational strength beyond surface factors is essential before making the decision to buy the business. To get you started we recommend considering these potential profitability-affecting scenarios:
- Dependence on a few customers and suppliers
- Reliance on a handful of customers, possibly due to personal connections or tradition, can be risky
- Limited repeat clients may indicate subpar service or weak customer relationships
- Relying on a single vendor exposes the business to external risks
- Limited growth potential
- Assess industry trends and local market conditions to gauge future viability
- Conduct market research to determine if the target audience remains profitable
- Consider competitors and demand for the business’s offerings
Ensuring a solid business model involves scrutinizing these factors beyond surface-level financials. And, expanding your knowledge base to learn how your potential competitors’ services or products and their prices compare to the company you are looking to buy.
Ask Yourself, Are The Equipment And Assets Of The Business in Good Condition?
If the equipment looks outdated and the furniture seems straight out of the 70s, it’s time for a chat with the owner to find out why nothing has been updated. Sometimes, when a business is up for sale, the owner stops investing in upkeep which can hinder growth. Reviewing expenses from the past year can reveal areas of neglect beyond equipment, such as in advertising and staff training.
Immediate equipment or furniture replacement can lead to unexpected expenses on top of the purchase price as well so if everything else looks good, know that you need to include space in your budget to take care of the upgrades needed later on. Negotiating equipment replacement as part of the purchase contract is also possible, but first, you need to identify the need and build a case around why that upgrade is imperative to your purchase. When you’re talking with employees, who interact with the equipment daily, ask them their opinion of the equipment, they will know firsthand its condition and what necessary upgrades are needed.
Be Sure To Work With An Experienced Lawyer Specializing In Business Transactions, Warning Signs or Not!
Encountering these red flags doesn’t necessarily mean walking away from the business deal. Instead, it’s an opportunity to assess your options and collaborate with your business lawyer to mitigate risks while working to negotiate a price that suits your risk tolerance levels.
Not only does legal representation play a crucial role in identifying and addressing potential legal issues and negotiating safeguards, but it also protects your interests throughout the acquisition process. At Hukam Law, we specialize in business acquisitions and comprehensive legal support.
If you’re contemplating a business purchase, contact us at 📞 705-915-0884 or via email at info@hukamlaw.ca. We’ll ensure all legal aspects are in order and will help ensure the price you pay is fair allowing you to focus on the success of your new venture instead of all the minor details.