Buying a business is a challenge even in the best of circumstances and carries risk. Potential buyers should make sure that ample time is allowed for due diligence in the purchase agreement, and that the time is efficiently used to fully investigate the business. There will often be red flags that require extra attention. As with all major purchases, emotion should play no part in the decision-making process.
The truth that no one wants to hear is that most businesses fail. Statistics for U.S. businesses show that nearly 20% fail within the first year, 50% have failed within five years, and by the ten-year mark roughly 65% have shut down. The take-away is that the due diligence period should be used to make sure that there are no indicators of potential failure, or if there are that the buyer is aware of them and willing to take the risk, before signing the check.
The following are some of the things every prospective buyer should investigate:
Why does the owner want to sell?
It is important to know why the owner wants to sell the business. It could be as simple as a desire to retire, or it could be that market conditions have changed making the continued success of the business less likely and the owner wants to get out while the getting out is good. It pays to have a good face-to-face conversation in a formal setting (not over drinks or dinner), and ask the hard questions. Watch the owner’s body language and listen carefully to what is said. If the seller puts on a huge sales pitch, consider that a red flag and ask yourself why it is necessary. Watch for anything that leads you to believe that the seller is less than honest, is hesitant in disclosing information, or is evasive in responding to pointed questions. Remember, you are there to make a good business investment and not a new friend.
Are there any recent developments that make it an attractive time to sell but not to buy?
Dive into the relevant markets to find out if anything has changed or will change that will put pressure on the business. Are there any new competing businesses in or about to enter the market? Is there an employee who is about to leave to start a competing business? Is technology changing in such a way that the business may become obsolete? Is the company’s brand diminishing, and if so, why? Have there been any changes in the business’ relationship with its customers?
What is the condition of the business’ equipment?
Have any necessary equipment evaluated by professionals to make sure that there will be no post-closing surprises in the nature of required equipment purchases or major repairs. It is also important to know whether the equipment is owned or leased, whether there are any liens, and whether any consents will be required for the transfer of equipment.
Is the money real or funny?
A careful and thorough review of the books and records with an accountant is critical to making a proper business investment decision. If there is any resistance to providing financial information or if the provision of information is not thorough, then there is reason to be suspicious. At least 5 years of information should be reviewed and studied with the financial statements and tax returns being a starting point. Backup documents should be obtained to verify the accuracy of both. Make sure all tax filings and payments are up to date and were timely, especially payroll taxes, and that there are no tax liens filed against the business or seller. Declining sales should be carefully investigated and are often a red flag.