Red Flags When Buying a Business: Financial, Legal and Seller Signs

The main red flags when buying a business are earnings that do not match bank deposits or tax returns, large unexplained adjustments, heavy dependence on one customer or on the owner, a short or non-transferable lease, missing licenses, undisclosed debts or disputes, and a seller who delays documents or pushes you to skip due diligence. Each one should change the price, the terms or your decision.

Few businesses are free of problems. The point of spotting red flags is not to find a perfect business but to know what you are paying for. Below, warning signs are grouped by area, with what they may mean and how to check them.

What financial red flags should you look for?

Financial red flags matter most because the price is a multiple of earnings. A small overstatement of profit becomes a large overpayment.

Bank statements are the hardest data to adjust, which is why our due diligence starts there. For larger deals, a quality of earnings report tests adjusted earnings in depth, and the price multiple should apply only to verified earnings.

What operational red flags matter?

Operations tell you whether the earnings will continue after the owner leaves.

• Owner dependence. The owner holds the key customer relationships, does the technical work, or is the only person who knows how things run.
• Customer concentration. One or two customers provide a large share of revenue, especially without written contracts.
• Key staff at risk. A manager or senior technician is likely to leave, or has no agreement with the business.
• Supplier dependence. A single supplier, platform or marketplace account controls access to customers or inventory.
• Old equipment. Major equipment needs replacement soon, and the cost is not reflected in the price.
• No documented processes. Pricing, scheduling and quality depend on memory rather than systems.
• High staff turnover or recent loss of several employees.

None of these is automatically a reason to walk away, but each should be reflected in the price, the transition period or the deal structure. The absentee owner business guide explains why businesses marketed as running without the owner often do not.

What legal and compliance red flags should you check?

Legal issues can survive a sale, especially in a stock purchase, where you buy the company with its history.

• Liens on business assets or UCC filings by lenders.
• Unpaid sales tax, payroll tax or other tax debts.
• Pending or threatened lawsuits, or a history of disputes with customers or employees. Federal cases can be searched through PACER; state courts have their own systems.
• Workers treated as independent contractors who may be employees in law.
• Licenses or permits held in the owner’s personal name, expired, or not transferable.
• Contracts that require consent to assign, or that terminate on a change of ownership.
• Intellectual property, domain names or social accounts owned personally by the seller.
• Open inspections, citations or environmental issues at the premises.

Your attorney should run lien, litigation and entity searches, and your CPA should check tax compliance. An asset vs stock purchase decision is often driven by what these searches find. See also when you need a business acquisition attorney.

What lease and location red flags matter?

For any business that depends on its premises, the lease is part of what you buy.

• Less remaining lease term than you need to recover your investment.
• No assignment clause, or a landlord who will not commit to assign or re-lease.
• Large rent increases scheduled soon, or a property that is being sold or redeveloped.
• The tenant behind on rent or in default.
• Zoning or use restrictions that limit what the business can do.

If the landlord will not agree to acceptable terms, the deal should not close.

What seller and broker behavior should worry you?

Behavior during the sale often says as much as the documents.

• Documents arrive late, incomplete or in formats that cannot be checked.
• The seller resists access to bank statements or tax returns.
• Pressure to sign quickly or to shorten due diligence.
• The story about why the business is being sold changes.
• The seller refuses any transition period or any seller financing.
• The seller asks you to keep advisors out of discussions.
• A broker presents asking price as fact rather than a starting point.

A seller has the right to protect confidential information, and many sellers are simply disorganized. The difference is whether they cooperate once you explain what you need. Our list of questions to ask when buying a business shows what to request.

What red flags are specific to E-⁠2 buyers?

If the purchase must support an E-2 visa, some problems matter more:

• A business too small to generate more than a minimal living for the investor and family, which risks being marginal.
• A structure in which you would own less than 50% and lack operational control.
• A purchase funded mainly with loans secured by the business, or seller financing secured by the business, which generally do not count toward the investment.
• A seller who will not accept a visa-contingent escrow or closing condition.
• Funds whose lawful source you cannot document.

These points come from 9 FAM 402.9 and should be confirmed by your immigration attorney. See businesses that fit E-⁠2 requirements.

When buying an existing business, what is it important to do?

It is important to verify earnings against bank statements and tax returns, confirm that the lease, licenses and key contracts can transfer, search for liens, debts and disputes, test how much the business depends on the owner, agree a working capital target and a transition plan, and keep enough cash after closing to run the business. Our due diligence checklist lists each item and what to request.

How should you respond to a red flag?

Raising a red flag after the LOI is not retrading if it is based on evidence. Present the finding, the document behind it and the proposed adjustment. Our guide on how to make an offer covers how to negotiate these changes.

Next step

TealBridge reviews each business on the buyer side: we rebuild earnings from bank statements, test owner and customer dependence, check the lease and licenses with you, flag legal issues for qualified counsel and translate findings into price and terms. Contact us before you commit to a business that worries you.