Warning signs that alert you all might not be as it seems — and how to spot them in the data before it's too late.
There are very many things to look out for when buying a start-up or an existing business, warning signs that alert you to the fact all might not be as it seems. In this article, we're going to take a look at some of those real-life red flags and we'll tell you how they show themselves in the information you get about a for-sale small business so you know how data translates to understanding.
Getting a feel for what to look for, what to ask and what the underlying issues might be will help you to better negotiate the acquisition process, become a more savvy entrepreneur and have a better chance of avoiding potentially costly mistakes.
The turnover of a business is the total income over a stated period of time. Divide that by the number of staff and you can see what each, on average, contributes to turnover. A low contribution per head might indicate operational inefficiencies in the business model, or suggest limited scalability.
In this video, Jonathan Jay looks at an installation business with a turnover of £385,000 that employs five people and explains what that can tell you about the business.
Following on from turnover is profitability. You can generally expect an efficiently run company to be more profitable than a less well-organised business.
When you are looking at a business to buy, it's important you know how profitable it is, and to understand how that compares with the competition. Where ranges are shown in listings – for example, the £100,000 to £255,000 quoted in this video — it complicates matters. It suggests inconsistent financial reporting, potentially even manipulation of the financial information. Most of all, it raises questions about the long-term financial health and stability of the business.
Tangible assets, such as plant, machinery or real estate – and some intangible ones, like intellectual property – make a business much more desirable. Without them, it's harder to raise finance, for example, as a lender will generally look for some form of security.
Looking again at the installation business in this video, not only do they lack assets, but they rely on project work. There is no way to generate recurring revenue. If they have no clients, they have no business, and that makes them unattractive to potential buyers.
If the net profit stated fails to justify the asking price, the business valuation is likely to be exaggerated. You also need to look out for undisclosed costs, which can have a detrimental effect on the financial viability of a business sale.
In this video, Jonathan Jay looks at a business with wide ranges given for both net profit (£50,000 to £100,000) and asking price (£200,000 to £500,000). Clearly, a business making £100,000 net profit at an asking price of £200,000 is much more attractive than a business making £50,000 that sells for £500,000. Proceed with caution – and aim to verify and nail down those figures.
The more a business is dependent on the business owner for day-to-day operations, the less of that business there is left when they go. Also, the less profit there is left for a new owner who puts in a manager and has to pay their salary!
In this video, Jonathan Jay discusses the potential problems with having an owner heavily involved in the business, and the need for someone to be able to step into their shoes when they leave.
If a business requires significant amounts of both manpower and management, this will strain operational efficiency and scalability.
In this video, Jonathan Jay considers the viability of operating a retail business with both a warehouse and showroom, and with a substantial amount of business done via e-commerce, while relying on few full-time staff backed up by casual labour.
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If a business has low profits relative to turnover – a low profit margin, in other words – then that needs to be investigated. As a rule of thumb, a profit margin of around 10% is considered healthy, and 20% is good. Under 10%, especially if it falls as low as 5%, is undesirable.
Two possible reasons for a low profit margin are that costs are poorly managed and so running higher than they need be, or prices are too low and need to be raised.
In this video, Jonathan Jay looks at a business with a 7% profit margin and asks, would you buy this business? Well, would you? And why?
If a business broker listing suggests a business would benefit from modernisation, you need to understand what they mean by that. Anyone who has viewed property knows that 'would benefit from updating' can cover a wide range of issues!
In business, it might mean that the premises are run-down and the technology used is outdated. It might be a way of revealing that the customer base is static or declining, and the business is losing market share and/or lacks competitive advantage. And while that could indicate a genuine opportunity and help drive down the purchase price, it might equally sound the death knell.
In this video, Jonathan Jay considers a business in that situation.
As mentioned earlier, where you see wide ranges of figures quoted, it's impossible to make a decision on a business acquisition. You don't know where in the range the actual figures sit, and you can't assume it's in the middle. The perils include that the figures reveal underlying financial volatility or conceal undisclosed risks. While due diligence would unearth the truth, it might not be worth pursuing the deal that far.
Jonathan Jay discusses this issue in this video, where he looks at the available information for a private GP clinic. If the range of figures quoted piques your interest, you need to find out more. That will very likely mean signing a non-disclosure agreement (NDA), which is standard, as businesses seek to protect sensitive information. It doesn't commit you to anything, it just allows you to see more detail in the figures, to understand assets and liabilities, and to spot any discrepancies and potential financial problems. You can also check tax filings.
A wide asking-price range makes it difficult for you to assess whether it's worth finding out more about a business for sale. Interest depends on where in the range the true figure might fall! Also, that figure doesn't exist in a vacuum. It needs to be congruent with things including turnover, revenue and profit. If they are also expressed in ranges, you are very much in the dark.
You will need to arrange to see financial statements, including balance sheet and cash flow statements and forecasts to help you to understand whether a business purchase is worthwhile.
Jonathan Jay discusses the issue of true market value relative to disclosed financial metrics in this video.
Some businesses operate in a landscape that is regulated, and when that's the case you need to be confident it holds both the necessary specialised knowledge to confidently assure regulatory compliance, and staff with the essential skills to operate safely. This clearly has implications for recruitment and vetting, so it's wise to be clear as to obligations and requirements from the outset. Prospective small business owners need to undertake thorough due diligence and call upon legal expertise.
Jonathan Jay considers these issues in this video, looking at a private multi-disciplinary clinic.
When you look at the financial statements of a business, you want to see not only the current situation but also the past history, ideally a long history of stable growth and profit. Next, you can turn your focus forwards and consider whether there is future growth potential.
The key information here is the historical growth data as this offers genuine insights into how the business has performed. Without this information to underpin current performance, any forecasts produced are just guesswork and wishful thinking.
Jonathan Jay considers these issues in this video, looking at a private multi-disciplinary clinic.
There are lots of red flags to look out for when you are a business buyer, including overvaluation, employee turnover, and the company's reputation on social media sites and LinkedIn. In addition, you need at least a grasp of things like leases, legal issues and industry trends.
It can be a huge bonus to have someone with years of experience in business mergers and acquisitions on your side. Jonathan Jay has helped more than 3,000 people buy successful businesses and become acquisition entrepreneurs, and he has put together the most comprehensive FREE package of business buying resources available today.
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