The M&A Red Flags That Never Show Up on a Balance Sheet

What does Play-Doh, WD-40 and bubble wrap all have in common? Each were invested for reasons completely unrelated to what made them famous. Play-Doh started as a wallpaper cleaner, WD-40 was a rust-preventing formula developed for the aerospace industry, and bubble wrap was originally sold as textured wallpaper.

Just like Play-Doh, WD-40 and bubble, businesses often have quirks to them that aren't openly obvious on first look. 

Almost every buyer I work with will have an eventual red-line that forces them to walk from a deal. The most obvious is declining revenue, sometimes it couple be a litany of lawsuits, or too much customer concentration. Each are real problems and each matter when working on a transaction. 

But they're rarely the ones that actually get people in trouble because they are open and obvious.

The deals that blow up in due diligence, or worse, blow up eighteen months after closing, usually don't have a smoking gun sitting in the financials. They are hiding, sometimes in plain sight, in all the areas a buyer might never expect.

I've watched smart buyers ignore their gut because the numbers looked clean and the seller seemed like a straight shooter. Then they call me asking for what their options were because the business's revenue took a nose dive in the 12-18 months post-close.

What i've found is that the red flags that matter most aren't in the spreadsheet. They're in how the seller acts the moment you start asking real questions, they can hide in the contracts, or the ignored questions when diligencing the business. Behavior under pressure is much harder to fake for three straight months of diligence.

When "He's Just Busy" Is Actually the Answer

Watch what happens when you ask to talk to the seller's accountant directly instead of getting numbers secondhand.

A cooperative seller says yes and sets it up within a day or two. A seller who's hiding something suddenly gets vague. This logic applies across the board, when you have a Key Employee that Seller won't let you talk to, an absentee landlord that he "doesn't want to spook," or they are constantly saying they need to talk to their "lawyer" aka ChatGPT

A seller can have good reasons to control the timing of those conversations, protecting morale, avoiding a leak before the deal is signed. Timing concerns are normal. An outright refusal to ever let you near the people who actually run the business is not. Ask yourself why a good business would need that kind of protection in the first place.

Customer Concentration Dressed Up as Diversification

This one comes up from time to time.

A seller will tell you the business has forty customers, sounds diversified on its face. Pull the actual revenue by customer and you find that three of those forty make up sixty percent of collections. The other thirty-seven barely move the needle. Revenue concentration across a limited number of customers can often spell a receipt for disaster for buyer's.

Worse, ask how those top three relationships actually work. Sometimes it's a handshake deal that's been renewed informally for a decade with no contract, no minimum commitment, nothing that survives a change in ownership. The seller isn't lying when he calls it a stable relationship. He's just been the one showing up to lunch with that client for fifteen years, and you haven't. So guess what happens when the business changes hands or when you as a new buyer tries to introduce the idea of a contract to the relationship.

Don't take the customer count at face value. Ask for revenue concentration by dollar and ask specifically what happens to each of the top five relationships the day the business changes hands.

Urgency Is a Tactic, Not a Timeline

Real sellers have real reasons to move quickly sometimes. Health issues, retirement plans already in motion, a competing buyer who's further along in the process. Those are legitimate and the constraints can be real.

What's not legitimate is urgency used as a substitute for transparency. "We need to close by the end of the month" said by an intermediary or the Seller in hopes of getting you as a buyer to close quickly isn't a timeline,iIt's pressure designed to get you to skip steps you'd otherwise insist on.

The sellers I trust the most are the ones who tell you to take your time and talk to whoever you need to talk to, even when it slows things down on their end. The ones who push hardest for speed before you've even finished reviewing the books are usually the ones with the most to lose if you're allowed to slow down and actually look.

The Real Takeaway

Most buyers are trained to look for the big disqualifying items when buying a business: a bad number, a lawsuit, a red mark on the P&L. That's the wrong question, and it's the wrong question because it assumes the risk in a deal is static, sitting there in a document waiting to be found.

The right question is dynamic. Does the seller's behavior give you more access and more clarity the deeper you go, or less? A good business owner wants you to look closely, because looking closely proves what he's already told you. Someone protecting a weak spot wants you to stop looking before you find it, and he'll use friendliness, urgency, or exhaustion to get you there.

Remeber, there is always more to a deal that meets the eye, so rather than just trying buyer, look at their actions as your queue to look deeper or walk from the deal entirely. A good seller will understand that there's a process, one that just wants to offload a bad business will push the deal to close as quickly as possible so that the ink dries.

Until next time,

Josh