Why does this matter?
Most buyers, they don't lose money on bad deals. They lose time and money on deals that they should have walked away from.
So, in any small business acquisition, there are financial red flags. Especially in these small business acquisitions, a lot of folks are attracted to these businesses, but there's always a little bit of hair on them.
If you are actively searching or if you're under LOI, pay close attention to some of these financial red flags because as you are digesting these financials of the prospective companies and if you're under LOI, you want to be on the lookout for certain things.
30% of acquisitions, this is based on a survey, face post-close surprises.
It could be a surprise of a new thing about the business you've learned after you've closed on the business. It could be something about the operations of the company. It could be a skeleton in the closet that you weren't aware of.
Post-close surprises could be significant, which may have a financial implication depending on the size and shape of what it looks like, or it could be something minor, something you didn't learn about the business during due diligence.
When you're under LOI for a business or if you're actively searching, your goal as a prospective business buyer should be to mitigate the risks around some of these surprises and learn as much about the business as you can.
The primary focus should be:
What we're going to walk away with is a framework to spot red flags, signals that reveal when a seller may be hiding something or maybe concealing it, and some clarity on when to renegotiate and when to walk away.
Why do red flags get missed?
You feel the time pressure to get a business closed. The time pressure to secure something under LOI.
As a result of this pressure, when you do find a business that checks your buy boxes, you get excited about it.
Most buyers need a third-party attorneys and CPAs to do due diligence because they have shiny object syndrome or the rosy red glasses of this business may have issues, but due to the pressure of closing, you often try to look past it and justify it.
When in reality these red flags or yellow flags as I call them, they may be material and you may need to renegotiate your deal and or walk away from what you thought was a great business because the deal and the business once under contract looks very different.
We were doing a quality of earnings for a construction company who was leveraging subcontractors.
The subcontractors were being negotiated and they were paying a rate that was below market and it was due to a related party member owned the subcontracting company.
In reality, those subcontractor costs following closing would be significantly higher.
There was significant related party items going on between the two businesses. That's something that was discovered during due diligence.
Other red flags that may get missed or overlooked are things like customer concentration and significant cash cycles of the business that are not as favorable if not managed correctly.
There might be a significant owner concentration or owner dependency of the business.
Every legacy business has these exceptional owners that may be the face of the business and the sales engine of the business.
You need to ask yourself what does life look like for this business once that owner seller who was a staple of the community goes away.
Deal pressure and this bias are really the worst enemies of business searchers.
You need to be careful and surround yourself with third-party counsel representatives to give you information that's unbiased because you are inherently biased.
Profit and loss or the P&L red flags are some of the warning signs in the income statement.
It looks like:
When you're looking at a profit and loss statement, you want to first obtain this profit and loss statement in the form of an Excel spreadsheet from the company's accounting system.
Typically, most of these small businesses use QuickBooks Online, QuickBooks Desktop, Netsuite if it's a little bit of a larger company, or Sage if it's a manufacturing company.
Regardless of the accounting system, you want to obtain a monthly or at least annual income statement, also referred to as the profit and loss statement.
You'll see things like revenues, cost of goods sold, net income.
Some of the red flags you want to look for are margin changes. There is going to be your gross margin or net margin.
You may notice things like the cost of goods sold or your expenses are decreasing at a faster rate as revenue grows.
This is a signal of you need to learn more information.
If revenue is growing faster than expenses or if expenses are declining as revenue grows, the business is going to be starting to produce significant income.
You need to understand why is that happening.
If a business's margins significantly change year-over-year, it could be a change of the business, an accounting error, or something else.
Very likely if the business is a legacy stable company, the margin should be relatively similar year-over-year unless there's been a significant event.
Additionally, you want to understand what are typical margins of the business and the industry it works in.
When you're looking at the prospective business, if it falls outside the norm, there's something you want to clarify with the accountants of the company.
Only focusing on the fact that this business is producing a ton of income is dangerous because it perceives that this is either sustainable going forward or it warrants a higher valuation.
The risk is as a new buyer comes in that these income levels are not sustainable.
As an example, if the business is producing a million dollars of income and that million dollars is a percentage of total revenue that is significantly higher than what is the industry average or typical going forward, if you take on too much debt, assuming that $1 million of income is going to be produced going forward, if the business experiences a significant decline or a return back to normal, the company might not be able to support the debt you're taking on.
Whenever I look at an income statement, I immediately go to the margins of the company and assess that compared to industry averages.
This is not to poke holes at the company, but it is helpful to establish a baseline and understand why is this margin higher or lower than what it typically should be for a company.
Other things we see significantly are owner compensation either being well below market, not included on the profit and loss or significantly above.
Typically what we see is owner compensation being well below market rate.
If you're looking to buy a business and install like a general manager, you need to understand what that cost looks like and compare that to what market rate is and what that rate is on the business currently.
Lastly, red flags we see are large material journal entries booked in year end or the period end without supporting documentation.
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| Financial Due Diligence | Business Acquisition |
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The income statement tells the story.
The balance sheet reveals whether it's true. The balance sheet also reveals some of the skeletons in the closet.
The place to start is looking at the accounts receivables.
The accounts receivable is a current asset sitting on the balance sheet and it's typically the most significant or material item on the balance sheet of a small business.
If you look at the accounts receivable, you want to ask yourself:
The risk with accounts receivable is the aging amounts.
Are these accounts receivable actually getting paid or is the company simply just billing these receivables without collection?
Additionally, if the company has inventory, what does inventory look like on the balance sheet?
Is the inventory usable? Is it sellable?
When you're looking at a balance sheet, if inventory is increasing and starting to balloon year-over-year, you want to unpack that inventory and assess the obsolescence and is it sellable.
Other balance sheet items look like accounts payable.
Are payables being processed on a timely basis? What does that look like in relationship to expenses?
Are there related payables and receivables on the balance sheet?
Things like loans to shareholders, owners receivables, loans to owners.
You want to understand what some of those liabilities look like on the balance sheet because those should be settled before closing.
A lot of areas where buyers get hurt are in the accounts receivable and the inventory.
I've seen several companies that bill in excess of what they actually collect.
What it looks like is AR and revenue starts to increase rapidly, but cash coming in the door is actually not increasing.
The company's not collecting.
It could be due to overbilling.
All of these things you need to understand before you get to the closing table.
If you're pursuing an asset heavy business, capital heavy business, some of the things we see in practice are inventory obsolescence.
Goods sitting in a warehouse that might be 10 to 15 to 20 years old that the owner says, one day, we're going to sell them.
They're still on the balance sheet.
In reality, as a new business buyer, those items should not be included as part of your purchase price at the time of closing.
There's a percentage of inventory that is likely obsolete and not sellable.
That should be reduced from the inventory on the balance sheet.
Other things we see are capital expenditures.
When businesses are heavy capex, you want to ask yourself, what are the future needs? What are the future capital expenditures of the business I'm potentially purchasing?
What are the short-term needs?
What are the needs in the next 12 months?
And what are the needs in the next 24, 36 or 48 months?
If there are short-term capital expenditure requirements that are going to be needed to deploy on day one, those are things that might need to be negotiated before the purchase agreement is signed.
If there's a significant piece of equipment that is up for replacement and it's 10, 15, maybe even $50,000, you could make a case that you as a new buyer should not have to front that bill on day one.
It's important to assess the capital expenditure needs before closing and have that conversation.
Where buyers get hurt is the unforeseen capital expenditures.
On day 30 of the new business, you have to front that bill yourself without any recourse.
The things where buyers get hurt a lot are in inventory obsolescence and these unexpected capital expenditures that they could have identified during due diligence.
Things we see in practice are some payroll tax and non-compliance.
If you're pursuing a business that has a high number of 1099 employees, those 1099 employees are not paying payroll taxes.
Where buyers get hurt is in instances where these 1099 employees are not actually being classified correctly.
If the 1099 employees are working 40-hour weeks and they live in the US, the IRS is going to make the case that they should be classified as W2 employees and the employer, you as the prospective buyer, should be paying payroll taxes.
Where buyers get hurt is at the change of ownership.
If you are found liable for some of these non-compliance issues, you can be fined significant amounts of money and have to pay back taxes for some of these missing payroll taxes.
You want to either assess them yourself or engage with a tax due diligence expert.
You want to calculate what are some of the compliance liabilities that I might be on the hook for.
As there's more, with the increase the higher number of 1099 employees, the higher risk and potential liability you're on the hook for.
Other things we see often are earned but not paid bonuses.
If you are stepping into the business and these bonuses are technically earned but unpaid, the prior owner should be paying those amounts out prior to close.
Bonuses earned but unpaid should transfer with the business but be the responsibility of the previous owner.
Similar to if you were selling your business, you are getting credit and getting paid for a multiple of earnings, but you should be settling up your liabilities and debts earned but unpaid prior to closing.
Pending litigation and warranty reserves should also be assessed depending on the type of business.
If you sell widgets and they have warranty reserves, think about a one or two-year warranty, that also could be something you set aside and can calculate prior to closing and held in escrow.
You can find this and other content on my YouTube channel, including shorts, long-form videos, and guest discussions focused on buying small businesses and improving operations.
If you want to reach out on LinkedIn or X, share feedback, or suggest topics, feedback is a gift.
When I start financial due diligence on any engagement, I want to assess what is the seller's behavior like.
Are they being very guarded about some of the source level access?
Has there been key employee turnover?
Has there been significant changes of general managers each year or the last three or four years?
To me, that would signal weakness in a business.
Has there been things such as:
“We don't track that.”
“We don't keep records of that.”
A healthy business with strong margins and profitability should have very strong financials or be able to track job costs, customer retention and margins correctly.
When a business that looks good on paper has poor systems, this begins to cause concern of the reliability of the financials we're looking at.
You as a buyer likely submit prospective LOIs or have secured an LOI based on a SIM or marketing materials that is largely unverified.
You need to look under the hood into the accounting system of the company and verify all that information.
Other behavioral signals that could cause some red flags are things like restating the financials mid-process.
During due diligence, if we ask for financials from 2022 through today, if they come back to us and say some of the 22 and 23 and 24 numbers haven't been finalized, this starts to paint a different picture into the financial accuracy of the company.
It's not necessarily going to kill your deal, but it's something you want to gain clarity around.
If you sign a purchase agreement for financials that are misstated, there's a risk that the business is not as profitable as you think.
The last thing is overly rehearsed answers.
When you ask questions about the company, if it feels like it's overly rehearsed or too pointed, that could also be signals that it's either not true or you want to ask more questions.
All of these things should be conducted prior to closing.
If you are under LOI and you have about 90 days, this is a typical due diligence timeline.
Financial due diligence typically starts when the LOI is signed.
That is because you want to verify and vet your financials almost on day one before you spend a bunch of money on legal and even conduct the bank process.
From there, once the QV or financial due diligence analysis comes back, you can kick off the work stream such as tax, legal, and then push towards that final closing docs, which is the purchase agreement time.
If you have 90 days of exclusivity, financial due diligence typically takes about 30 to 45 days.
If you spend the first two or three weeks trying to conduct your own due diligence, you're wasting time.
The risk is if you start these processes too late, you won't complete them in time and you will either need to make a decision based on incomplete information or you will try to get an extension of your LOI and the owner will say no and you will lose the deal.
Starting these processes and taking it seriously once you have the LOI signed is how you actually close deals.
Should I pursue with this business? Should I go forward with it? Should I walk away?
Walking away is entirely dependent on the deal and it's entirely dependent on you, the acquisition entrepreneur or the quarterback of this deal.
The providers you work with such as legal counsel and the CPA team can give you information.
But you ultimately have to make the decision and you need to take responsibility and accountability in whatever you pursue.
If the deal is struggling, you want to conduct a DSCR test, which is a debt service coverage ratio test.
If you are not passing the typical DSCR test, you might want to renegotiate the price or restructure the deal accordingly.
You can leave the total purchase price the same and just restructure the cash at close or maybe the seller note.
These are some of the things you want to think about before you sign the purchase agreement.
If you cannot restructure the deal with a pencil and it doesn't make sense and the business can't support the loan, you need to walk away.
If you're unable to reach an agreement and the business cannot support the debt you're about to take on, you are taking a chance that is too great.
You need to ask yourself, do I want to close on any deal or do I want to close on the right deal?
Walking away is a choice.
If it's your first time buying a business, you really only get one shot at this.
If you screw it up and do it wrong the first time, it has multi-year consequences.
So it's never worth it.
The first thing is requesting three years of tax returns and profit and loss and balance sheet statements.
This is the foundation of your analysis.
Also asking for AR schedules, customer concentration or customer revenue schedules, and then your bank statements over the last 12, 24, and 36 months.
The red flags don't announce themselves.
You need to identify some of these items and ask those difficult questions.
If you know how to read a financial statement, but you've never done a deal before, you want to engage a financial due diligence team because when we come across some of these issues, we raise our hand and we ask those difficult questions.
Some of these sellers might not want to answer the question.
They may try to explain it away in a complicated, convoluted response.
You want to understand what is the actual answer to the question.
Why has margins changed?
Has there been a change of vendor?
Has the expenses of the company gone up because the prices have increased due to inflation or the current economy?
When you identified the red or yellow flags, you need to ask those questions with management immediately.
If you don't, you risk taking on these new changes with the business on day one.
Asset heavy deals need independent appraisals.
If you're pursuing an asset heavy deal, you need to hire an independent appraisal to conduct a review of some of these asset items on the ground of the business.
This is something that's done outside of financial due diligence.
It can be a significant cash saver and can pay for itself 10, 15, 20 times over.
If you're pursuing asset heavy businesses, this independent appraisal needs to be conducted before closing.
The last two points is the EBITDA and incomes of the company.
That's the starting point of the business.
You need to confirm that that's real and accurate.
You need to conduct your stress test of the business.
This is done through financial due diligence.
The last point is you want to start financial due diligence and the bank underwriting process pretty close in once that LOI is signed.
These things take time.
If you do things the right way and you are able to pull the levers appropriately when needed, this is how you actually close on these businesses.
The businesses that don't make it to closing look like incomplete processes that are started late by folks who may have tried to cut some corners early on.
The red flags don't announce themselves.
You need to identify some of these items and ask those difficult questions.
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