What are potential red flags for searchers acquiring small businesses?

February 13, 2023

by a searcher from University of Mumbai in Fairview, TX 75069, USA

Hello Searchers,

I am a new searcher, recently joined this forum and wondering if y'all looked into potential red flags for small, sweaty startups.

Please tag me with your answer so I don't miss out.
Please don't DM as this could be good public knowledge.

TIA!

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Reply by a professional
from Villanova University in West Chester, PA, USA

Hi, welcome! There’s many things i look for in legal due diligence, many of which would require confidential information provided by the target company, so it may be something you don’t find out until the due diligence period. However, you can always ask initial questions before you see full documents. Here’s a few examples: (i) none or poorly drafted contracts - you want a business with limited liability and exposure, clear documentation on transfer of assets, clear obligations with customers and suppliers, etc.; (ii) run a trademark search with USPTO, Google, etc. to make sure their name is not infringing on the rights of others - most small businesses skip this if they don’t have an attorney they’re working with, and it could require a rebrand (with loss of brand recognition) or be a liability down the road; (iii) review corporate structure - what acts require authorization & by whom, are they on board with the transaction, etc. - if key persons are not involved in discussions, there may be something there (iv) are key contracts assignable by asset or stock purchase, or are you able to terminate unfavorable contracts - contracts support the value of the business and can protect assets of the business and support receivables or be an issue that you need to resolve; (v) related party transactions and whether any will survive past closing - often times the terms are overly favorable and in certain circumstances may become an issue if they need to survive post closing; (vi) key employees and their employment relationship - will you need anyone after closing, do they have employment contracts currently, how can you create an environment for success to encourage them to stay with you post closing, how is the company culture, would you like to continue working with them, etc; (vii) ask if there are any third party approvals that would be required and if there are any regulatory matters that would need to be addressed (i.e. approval for transfer of licenses, etc.). Some of these aren’t red flags themselves, but they’re areas to dig into to uncover red flags early on. Let me know if you have any questions or need any support!

Reply by a lender
from Eastern Illinois University in 900 E Diehl Rd, Naperville, IL 60563, USA

Welcome to the community. Here are some red flags we look for from a lending perspective:
1) Have revenues been declining, consistent or just saw a short-term bump. When revenues are inconsistent or declining, you need to be sure you can get your arms around why and that it won't be an issue going forward.
2) How involved are the sellers in managing and generating the revenue for the business? There are businesses out there where in just about all aspects the business is the owner. If that owner leaves, so may the business. Either because it is highly technical and requires that owner's expertise of because that owner really holds all of the relationships. So you want to be sure that the owner can be replaced.
3) Does the business require licensing and can you get that licensing easy enough or have someone else to handle that license? Lenders want to be sure that there will be a license going forward to operate the company.
4) What are the add-backs and are they realistic? We see many brokers include add-backs that are pretty much impossible to back up are true add-backs and not necessary operating expenses for the company. Some examples are adding back random cost of goods sold, office supplies, or other categories that are not typical add-backs, travel & entertainment, meals, etc. You need to be sure the cash flow works without these add-backs,
5) Verifying the accuracy of the financial information provided. Sometimes the business is relatively simple and you can request bank statements and verify this on your own. However, we usually recommend for larger deals or businesses with any complication that you get a QofE done.

I hope this helps. Happy to discuss other items at any time at redacted Thank you and again good luck with your search.

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