Red Flags to Look for When Buying a Business

January 2023

Red Flags to Look for When Buying a Business

Buying a business is a huge decision and you can’t afford to turn a blind eye to anything that could lead to years of potential problems.

The truth is that most businesses fail. Statistics show that 20% of businesses close within the first year, while around 60% fail by the three-year mark.

So how do you know when it's a good business to buy? A good place to start is by looking for red flags like declining sales figures or poor record keeping. These don't necessarily mean you can't turn the business around, but they should be investigated further.

In this blog, we'll explore the biggest red flags to look out for along with green flags that will help you find a profitable startup to acquire.

What are the biggest red flags when buying a business?

Buying a business always comes with some risk but there are steps you can take to avoid nasty surprises. One of the best ways to protect your investment is by carefully analysing every corner of a business to check for warning signs.

Let’s look at some of the biggest red flags to watch out for when searching for a profitable startup to acquire.

Negative customer reviews

Did you know that 80% of customers only trust companies with a 4 or 5-star rating? Or that 97% of consumers read reviews online to search for local businesses?

Negative reviews have the power to damage your reputation, lower your search rankings, and ultimately, reduce sales and profits. A high number of negative reviews should definitely be considered a red flag when you’re searching for a good business to buy.

Inconsistent tax history

When you buy a business, you’re also buying the tax history of that business. Any tax inconsistencies or errors are a major red flag when you find a business to buy.

  • Perform a due diligence check and evaluate the company’s financial records thoroughly.
  • Make sure the company’s internal financials match the tax file - if numbers don’t add up, investigate it carefully.
  • Go through at least three years of tax returns, but preferably five.
  • Check that the company is up to date with its tax payments and remember that you’ll be responsible for any outstanding debt.

Suggested reading: How to Analyse a Company’s Financial Position

Declining sales

Declining sales figures aren't always a major issue and they may even give you some leverage in negotiations. That said, you should do some investigating to find out why sales have declined.

The bottom line is that you need to make sure you can bring sales revenue back to normal levels by fixing whatever issue is causing the drop. Avoid buying a company if it’s obvious that there’s a fundamental issue with the business model or the market.

Poor Employee Morale

If the business has a history of high employee turnover or if current employees seem unhappy or disgruntled, this could be a red flag. A happy and engaged workforce is crucial to the success of any business.

Suggested reading: The Recipe for Creating an Engaged Workforce

Unclear Ownership

If the ownership of the business is unclear or if there are disputes among the owners, this could be a problem. It’s important to have a clear understanding of the ownership structure to know what you’re getting into.

Dependence On One Customer or Supplier

If you’re buying a business which relies heavily on one customer or supplier, this could be a red flag. This dependency could leave the business in a vulnerable position if the customer or supplier decides to cut ties or raise prices.

What are the green flags to look for?

On the flip side, there are also plenty of green flags that suggest you’re making a good investment. Let’s look at six signs it’s a good business to buy:

  1. Growing industry: Look for a company with high growth potential e.g. demand for digital 3D printing is growing whereas demand for photo printing is shrinking.
  2. Clear systems and processes: Check that the business operations in place are efficient and can easily be taught and replicated.
  3. Good brand reputation: In business, reputation is key. Carry out searches on review sites and social media channels to gain insight into the company’s reputation.
  4. Talented team of employees: You need a team who will continue to be productive and bring in revenue whether the founder is there or not.
  5. Diverse pool of customers: This will reduce your investment risk as you won’t be relying on a small customer base.
  6. Automated marketing campaigns: High-performing, optimised marketing systems will bring in a steady stream of leads and revenue.

TIP: An M&A advisor can offer valuable advice when you’re searching for a high-potential startup to acquire. Browsing an M&A advisor directory is an easy way to find an affordable advisor that suits your needs.

Foundy can help you find a profitable startup to acquire!

There is a lot to consider when buying an existing business and the process can seem daunting - we get it and we’re here to help!

Our acquisition marketplace has hundreds of startups for sale and the perfect business could be advertised there right now. If you want to find a profitable startup to acquire, join Foundy today or send us a message if you have any questions.

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