M&A: Top 6 Red Flags to Look for When Buying a Business
Buying a business is a significant investment. Whether you are leaving corporate America to go into business for yourself or adding to a portfolio of businesses you already own, buying an existing business can also be fraught with risks. Of course, any business has risks, but a smart businessperson looks for those risks that can be avoided and does whatever he or she can to reduce the risk profile of the transaction.
Most business acquisitions are done via an asset purchase agreement (“APA”), which is when the business entity that owns the assets of the business – customer information, contracts, leases, inventory, etc. – sells or assigns those assets to a business entity owned by the buyer. This is a multi-step process that involves initial disclosures and negotiations, a letter of intent that outlines the broad structure of the transaction (“LOI”), due diligence into all the details of the transaction, and, finally, closing.
This process often takes a few months to complete, and it is important for buyers to remain on alert for potential issues. Explained below are some of the most important red flags to look for when buying a business.
Not Knowing Your Seller
It is vital that you know the personalities, patterns, and practices of the seller and their attorney. With this information, you can prepare for potential issues, unreasonable demands, or potential delays that may threaten the transaction. Knowing the seller will help create a course of action and lets you keep the big picture in mind so that you can achieve a fair outcome.
Not Knowing the Transaction
Just as you need to know the seller, you need to know the business the seller is selling. Attorneys, accountants, and brokers are often guiding and advising you on what to look at and what to do. However, after the closing, you will be the one running the business, which means you should know as much as possible about it yourself – not just through your representatives – to take the reins on day one. Be involved in reviewing the due diligence materials that are provided, asking questions about anything you do not understand, and doing whatever else you need to do to feel informed about what you are buying.
Don’t Fall in Love
Buyers sometimes fall in love with a business without looking into their other options. One business only is a representation of how a single owner has managed to interact with the market, so unless you have a good idea of how the business fits in, what other options are, and whether there are better alternatives, it’s probably too soon to buy.
Why is the Business Being Sold?
If you are paying a substantial sum of money to buy someone’s business, you have the right to ask them why they are selling. Oftentimes the seller is simply retiring, making life changes, moving, or getting out of the market. Sometimes, though, sellers are trying to get out before the proverbial fan gets hit with you-know-what. Your job as the buyer is to give the business a full physical, so to speak: to look behind the curtains and under the rug, ask the types of questions you might not otherwise ask a stranger. If you can’t get a straight answer, that may be a problem.
Unusual or Nonexistent Financials
The first thing every buyer looks at when buying a business is the financials: tax returns, balance sheet, income statement, cash flow, and so on. These provide much of the information you will need to analyze the company’s financial history, and, potentially, to project the company’s financial future.
The balance sheet is a statement of financial condition that gives a general idea of how much the company is worth based on assets, liabilities, and equity. The income statement shows how much profit the company is making by providing the revenue and expenses over a period of time. And, the cash flow statement shows inflows and outflows of cash over a period of time, and often tells you what the core activities, non-core activities, and other financing activities are of the company that contribute to these numbers.
If the seller doesn’t have these financial statements ready to go when you request them, that is a problem. That means that the company has not been tracking this critical information, and that the numbers you are (eventually) provided with were produced in a rush, and may not be accurate.
Not Dealing with the Right People
Companies may be owned by investors, shareholders, or other equity stakeholders. Approval by these people will be required before a company can be sold. For instance, there may be a majority shareholder who does not run the day-to-day operations, but nevertheless has final say over whether it can be sold. Some the information about who has to authorize the transaction will be contained in the company records provided during due diligence, such as articles of incorporation or organization, bylaws, or the cap table. But if you, as the buyer, go into a transaction that has not been approved yet, you may be wasting time and money on a deal that was dead on arrival. This is why you should always ask for the required corporate resolutions or consents authorizing the sale early in the transaction.
In conclusion, it is important to remember that the red flags for any asset purchase agreement are limited only by the details of the transaction. Each deal is different, the parties are always different, and the businesses are always different. This means that the red flags may be different. Your attorney’s job is to look out for these, advise you, and make sure that any good deal closes. But the better informed you are about what to look for, the more you can make sure that you get exactly what you are paying for.
Dye Culik PC is a Charlotte, North Carolina business law firm handling mergers and acquisitions in a variety of industries. We represent both buyers and sellers in transactions throughout the state. Our philosophy is outcome-oriented, and our goal is to ensure that our clients are informed and protected in transactions that ultimately give them the results they bargained for. Connect with us if you are considering buying a business.