8 Red Flags When Buying a Business

by Vanessa Lovie 6th of February, 2021

8 Red Flags When Buying a Business

Throughout our lives, we make several big purchases that require common sense, research, and a professional's opinion. These purchases might include a car, property, investing on the stock exchange or buying a business. These decisions shouldn’t be made lightly and there are several factors that should be reviewed.

Here is a list of 8 things you should consider when buying a business. If you don't have these then you might consider them a red flag and not proceed with the sale.

1. Is Buying a Business like this good for me?

The idea of buying a business such as a country cafe for sale with its idyllic setting along the river with tables adorned with flowers sounds delightful, but have you ever made a cup of coffee? Have you ever worked an 8-hour shift on your feet serving customers?

If the answer is no, it’s a good idea to give it a go before committing to buying a business. Time to back-pedal and get a job at your local cafe before you invest $100,000+ as you might find it was just a dream you created from the latest Netflix film. The experience you have in an industry is important. Going in blind is possible and the seller will usually approve you buying a business, but is it the best option for you.

Ask yourself this very important question… Is buying a business like this good for me? Do I have the experience and capabilities?

If you are confident in your skills, then onto the next step!

2. Do you Connect with the Current Owner?

With looking at buying a business, it is extremely important you meet the owner. Whether it's a country cafe, online website business or major steel manufacturer, if they are serious about selling, you need to meet them face-to-face.

I know it sounds like common sense, but we hear too many horror stories of people committing to buying a business for it to all come crumbling down after the money was paid. You should know who you are dealing with by getting a sense of the current owner. After all, they own the company, it is their reputation you are taking over, it is their hard work that will become yours. If they want your money, they need to also invest their time.

Visiting the organisation and seeing how it operates will also give you an advantage. If you are buying a business like a restaurant for sale, visit it at different times and observe how busy it is. See if the sales they are claiming match what you estimate based on the clients walking in to the premises. Ask the owner if you can spend some time to see how it operates, how the staff perform, and client interactions.

Are there any similarities between you and the owner? The moment you walk into any company I'm sure you can see ‘what can be fixed’ - it's at the heart of all entrepreneurs and owners, especially when investigating and buying a business. We have that critical eye that leads to innovation and change.

You will find by meeting the owner whether they are similar and you share common values. Whilst not vital, it will tell you a lot about how the company operates.

3. Are they Telling you Everything?

It's that old saying “they could sell ice to Eskimos”. There are some very talented salesmen and saleswomen whose main objective is to get the company sold. They are ready to move on and they want you to purchase. That is their end game.

Whether its a broker or owner it’s important you see beyond what you are being told. Being analytical and checking all areas of the opportunity will be your best defence when buying a business. Strict due diligence can save you a lot of heartache down the track.

4. Can you Conduct Due Diligence?

It’s your right and you should take full advantage of this. It is the only way you can be confident that you are buying a business that meets your expectations.

If you are a first-time buyer, due diligence is the process in which you get to investigate the company in full before completing the purchase. The amount of information you will have access to varies with each sale, there may be some limitations due to confidentiality. This is to protect the seller in the instance that the sale falls through but you have been given privileged information such as client lists, profit and loss statements or sales history.

Often you will find a deposit is required before full due diligence can be performed.

You may have been in business for many years and think you understand all the moving pieces, but two pairs of eyes are better than one, three pairs are better than two... And so on.

If you are investing your hard-earned money into buying a business you want to be as confident as you can be that the information you are being told is accurate. It is so easy for a company to go backwards; some mismanaged accounts, bad cash flow, poor marketing, new shop fit-out, and suddenly you could find yourself sinking money into your newly bought opportunity that wasn't in any of your budget or cash flow projections. So always obtain professional advice.

5. Do you Understand the Financials?

Reading a profit and loss statement may come second nature to you, or maybe you’re the ‘idea’s person’ who can see the potential, or perhaps you’re the Chef with oodles of talent. Whichever category you fall under, getting external advice to help analyse the financials is important. Figures can tell a lot about a business, but they can also hide a lot of things.

Typically, three years of financial information is analysed when buying a business. Obviously, some companies will have more, some will have less, but three years tends to be the number professionals advise to see when buying a business. The size and type of the purchase will also play a big part in this. If your spending millions obviously you will want a longer financial history.

When reviewing P&L and Balance sheets, it can be difficult to decipher what the owners are withdrawing, and what they’re investing. Often owners will try to move money around for tax purposes, making it difficult to get a clear view of what’s going in versus what’s going out. This is particularly true if an enterprise is dealing with a lot of cash transactions or has been established a long time; seeing the true cash flow can sometimes be a struggle. It's important you see BAS statements and Tax returns. Analysing the actual bank account can also help see things in black and white.

The tricky part of most analyses is understanding why and how the money came in and why and how it was spent.

Did the company have a good year because it landed a major contract that is about to expire?
Did they hire some more employees that may have driven up expenses?
Did the owner work 10 hours a week or 100?
What are the outstanding debts and loans?
Are there outstanding accounts receivable that may never come?
Did the salon lose its best hairdresser and now they have opened up their own salon opened up down the road?

Whilst reviewing finances helps paint a picture of the organisation and is the first place to start, they won’t tell the whole story. Profitability is all about numbers, but it’s also about understanding how those numbers came about.

6. Do you Check the Contracts When Buying a Business?

Yes, you should! Companies often have contracts such as phone bills, stock suppliers, marketing, computer rental, and the list goes on. Sometimes these contracts are in the owner’s name, especially if they are a sole trader or partnership. When you are performing your due diligence, you may not come across these contracts. They may be posted to the owner’s home address. But nine times out of ten, when the contract is found, it is the enterpirse that is liable not the previous owner.

I’ve heard stories of cafe businesses that order $100,000 worth of custom-designed cups that are still sitting with the supplier that they are gradually ordering from. The previous owner expected much higher sales. You purchase the cafe and realise it will take you 5 years to use all those cups and wonder how you’re ever going to repay it. So have a look at the expenses and determine if there are any contracts in place.

8 Red Flags to Watch for When Buying a Business
If you are investing your hard-earned money into a business you want to be as confident as you can be that the information you are being told is accurate

7. Is the Lease Good?

Without a proper lease agreement, most enterprises' value decreases, especially in the retail and hospitality sectors. Understanding the lease agreement is important.

These are 10 questions you should ask the landlord or check in the agreement:

How long is left on the lease? What are the terms?
Is the lease transferable?
Are there any fees to transfer the lease?
Are there any fit-outs required?
How is the water and electricity managed?
What are my trade restrictions?
What are my opening hours requirements and restrictions?
Do I require approval from the landlord to become the new owner?
Does the landlord intend to sell the building at any point?
Are there any restrictions on other operators? (If you are in a shopping centre, mall or community location.)

8. Buying a Business Like This, Will I Get Training?

You will want to ensure it's in your contract of sale!

If you have been a barista for 10 years you may think you understand how a cafe works, how to make coffee, how to serve customers, etc But do you understand how this particular cafe operates?

Who handles the bookkeeping?
How are orders tracked?
Who are the couriers?
Who are the cup suppliers?
What employee contracts are in place?
Who are your repeat clients?
Who owns the other local businesses?
How will you bond with the current team?
So on and so forth.

Ensuring training is included in the contract of sale is vital. You don’t want to walk into the business blind - no matter how much you know. If after one day of training you think you have a grasp of everything, then you can just advise the previous owner they won’t be needed anymore, but placing it in the contract as a requirement is very important.

If the owner cares about the person who is buying a business they own, then they will want to include training. They will want to ensure their clients and staff are being looked after.

At this point, if you have run through the last 8 factors and don't have a definitive ‘yes’ or ‘no’. You will have a better understanding of your situation and if buying a business like the one your are investigating is right for you.

Every business is different, every owner is different, everybody's skill set is different. There isn’t a no yes/no case for every situation.

There are opportunities with massive potential that haven't been utilised by the current owner. They just need some fresh ideas to see the operation go to the next level. There are some opportunities that are beyond repair or need a specialised skill set to see them performing at an optimum level.

At the end of the day, as someone who is looking at buying a business, you need to conduct research, seek professional advice and make the decision that is right for you, your goals, and your family.