Last week, we went over some of the risks entrepreneurs and investors face when buying a small business. This week, we continue exploring these risks and the red flags to keep your eye out for. Read on to learn about some more of the risks of buying a small business.

What’s At Risk

When you buy a business, the belief is that you are establishing your financial freedom. The reality is that you are risking everything you invest into that business. You risk your time, your money, your savings, and even your retirement. To limit that risk, you must do your due diligence. When performing your due diligence, it is important to identify the risks and liabilities associated with the business. Consider the risks and liabilities as faulty parts in a car that may give out at any moment.

Even More Risks

Understanding The Financials

The value of the business you are buying starts with the financials. The most important are those reported over the last 3 to 5 years. The purchase price is usually calculated using the EBITDA of the business and a multiplier based upon the industry and a number of other factors. Because of the multiplier, small adjustments in the EBITDA can cause big changes in the value of the business.

Most business owners believe their business is worth more than it is. Which causes business brokers to adjusting and manipulating the numbers to reach an acceptable number to the seller. The buyer must carefully examine the financials to understand the trends and anomalies. Declining sales may be blamed on an owner retiring or it may be indicative of a bigger problem. By the same token, large isolated transactions may skew the profit and result in misleading financials.

And only consider those financials that are reported. A small business will not report more income to the IRS than it earned, because it would have to pay taxes on that income. However, many small cash-based businesses fail to properly report all of their cash proceeds, but want credit for it when they sell. Unfortunately, unreported income cannot be verified and you are now looking at buying a business that may have commit tax evasion and tax fraud. Another risk and liability that affects the value.

Unexpected Competition

Any business dreads an intense competitor. It can definitely make the road rougher, and there is a distinct possibility it could sink the ship. A buyer should be aware of any competitors, even those new to town. However, that competitor could come from within the business. And, they could take some of the goodwill you paid for with them.

Many small businesses fail to get non-competes or non-solicitation agreements with their employees. If a new owner comes in, employees could jump ship to a competitor or start their own competing business. Without an enforceable non-compete or non-solicitation agreement, the buyer could lose key employees and customers.

A Sales Tax Surprise

Many buyers will acquire businesses through an asset purchase instead of an equity purchase (stock) because they do not want to be responsible for the seller’s debts. While we discussed how liens can attach to the assets, many buyers don’t realize that a buyer can be responsible for a seller’s sales tax liability. To avoid this risk, a seller needs to deliver to the buyer a certificate of compliance from the Florida Department of Revenue. Usually this means that the old owner does not owe any sales tax. However, even if they do, whoever the tax authority is cannot come after the new owner once a clearance certificate is issued.