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5 Red Flags to Look for When Buying A Small Business

Acquiring or merging with another small business can significantly accelerate your growth strategy, or mark the beginning of an exciting new venture. At Evolution, we’re all about leaping into enterprising opportunities and taking calculated risks. But we’re always sure to watch for the five red flags listed below when buying a small business. Otherwise, we could find ourselves in over our heads and unable to continue doing what we love: transforming small business with evolutionary capital.

5 Red Flags to Look for When Buying A Small Business

Whether you’re thinking about buying a small business to expand your current operation, or just beginning your journey into entrepreneurship, be wary of these five red flags:

1. Debt

Existing debt may seem like an obvious red flag when buying a small business. But it warrants noting, because even attractive business opportunities with high revenue and potential for growth can be tethered to debt. Some small-business owners are willing to sell their indebted businesses for a lower price just to be freed of the responsibility. While it can be tempting to imagine that all you’d need to do is trim some expenses to make the business profitable, the reality is that taking on someone else’s debt is a radical liability. If you acquire a small business with existing debt, you’ll have to work twice as hard to lift it out of the black and into the green.

2. High turnover

Small businesses that haven’t established effective hiring practices and employee training aren’t prepared for the growth stage. Growing businesses need to regularly hire new team members and smoothly transition them into their positions, which is unlikely to happen if they can’t keep current employees long-term. In addition, high turnover indicates that a business’s employees are unhappy, which has been linked to an average 10% decrease in productivity and significantly lower profit margins. Turnover is costly to a small business, but it may also be a symptom of poor management and operations procedures, which can be difficult to completely rebuild when buying a small business.

3. Withholding owners

It may be evident when a small-business owner looking to exit their business is blatantly dishonest, but less so when valuable information is withheld or downplayed. For example, the small business’s revenue may appear consistent, but if you look deeper into the owner’s discretionary income, it could reveal that they’re taking home a smaller paycheck to avoid reporting declining earnings. Also, be sure to find out why the owner wants to sell the business and what he or she plans to do after exiting. The answer could clue you in on whether to expect incoming industry changes, increasing competition or if there’s a need to include a non-compete clause in your purchase agreement.

4. Inaccurate financials

A business that’s truly in good financial standing will readily provide its financial statements and income tax returns. If the owner only offers a self-produced financial review, consider it a red flag. If you’re able to gain access to the business’s tax documents, review them at least 3-5 years back and make sure they mirror the owner’s financial reports exactly. There’s a lot of due diligence involved in this step, so you should outsource the auditing to a CPA firm if possible. Should something be overlooked, you could be held responsible for outstanding taxes.

5. You’re not passionate about the business

Buying a small business is an active investment, even if you plan on hiring managers to handle the bulk of the work. You need to be hands-on and willing to grind every day for it to achieve sustained growth. Most small-business owners work more than 50 hours per week, and 25% work more than 60 hours per week. If the idea of spending that much time working on the business doesn’t appeal to you, consider it a sign to seek a project your more passionate about.

Now that we’ve covered a few red flags, what are some traits of a small business that indicate it’s a good buying opportunity? The green flags for buying a business are similar to our 5 Pillars of Business FreedomSM: good financials, an effective business and growth plan, a strong team, transparency and accountability. These pillars are the foundation for small-business success, as demonstrated by our realized portfolio companies.

Want to learn more about our small-business investment process?

Check out what we do and who we work with. Or, listen to our 5 Stages of Value Maturity podcast series.

 

Posted by: Jeffrey Kadlic A co-founder and managing partner at Evolution, Jeffrey has spent the past 15 years as an investor and private equity professional with a true passion for working with dynamic small businesses. @kadlic

Comments (2)

Comments:

  1. David Ellis:

    Jeff, some very helpful comments that I will share. I do have an opportunity that I am pulling together that I hope to share shortly. I am having lunch with Doug Tatum today. Best regards, David

    • Jeffrey Kadlic:

      David, thanks for continuing to think of us.

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