The red flags that matter most when buying a business are earnings you cannot prove, a company that depends on its owner, and customers who can walk away. People, license, legal and insurance problems come next. A red flag is a reason to look closer, not proof of a bad deal, and buyers commonly respond in a few ways: ask for proof, re-price, restructure, add a closing condition or walk away. This guide is for buyers in diligence who want to know what to do when something looks wrong.
The short answer
- A red flag is a prompt to verify. Most deals have a few, and what counts is how the seller responds when you ask.
- Financial flags (unsupported add-backs, revenue that does not match the bank, hidden expenses) get multiplied by the price multiple, so they deserve the most attention.
- Customer, people and license flags are about whether the business survives the seller leaving.
- Insurance and claims flags are easy to check and are often skipped: ask for loss runs, full policies and the contracts that set coverage requirements.
- Responses run from a question to a price change to a closing condition to walking away. That is a business decision to make with your deal attorney, accountant and lender.
What is a red flag, and what do you do when you find one?
A red flag is something that does not fit the story you were told, or a fact that a careful buyer would want explained. It is not a verdict. Diligence findings can end deals. One advisory firm, summarizing Stanford's 2026 search fund study, reports that searchers most often cited diligence findings as a reason a letter of intent failed. Search funds are a narrow group of investor-backed buyers, so read that as context, not a measure of all small deals. Finding a flag early, while you still have leverage, is the system working.
| Response | When it fits | Example |
|---|---|---|
| Verify | You do not know yet whether it is real | Ask for the bank statements behind a revenue figure |
| Re-price | The problem is real and measurable | Ask your accountant whether an add-back the seller cannot support should count |
| Restructure | The risk is about the future | Move part of the price into a seller note or a holdback (part of the price kept back) |
| Add a condition or contract term | A specific event must happen first, or a specific risk needs an owner | Make a key customer's consent a closing condition, or add an indemnity for a known claim |
| Walk away | The flag points to a problem you cannot price or the seller will not engage | Records that do not exist or a seller who refuses to answer |
A new policy generally does not cover losses or circumstances you already know about, so known problems are usually handled by price, indemnities, escrows or conditions. Claims from events before closing may still fall under the seller's older occurrence policies, depending on the deal structure and wording, and an unknown future claim is what insurance is mainly for. See seller indemnities vs insurance.
Can I trust the earnings I am paying for?
Start here because price and loan size hang on the numbers. One advisory firm lists inflated revenue, hidden or deferred expenses, revenue booked early and unusual year over year swings as the classic signs. For U.S. Small Business Administration (SBA) 7(a) acquisitions with a purchase price of $3 million or more, the lender must obtain a quality of earnings report that includes a cash proof: rebuilding receipts and disbursements from bank statements. The habit is worth copying in any deal. The matching questions are in questions to ask a seller before you buy.
| Warning sign | What it may mean | Common responses |
|---|---|---|
| Revenue that does not match bank deposits | Cash sales outside the books, early revenue booking or mixed personal and business accounts | Reconcile deposits to the ledger and ask the seller to explain each gap |
| Add-backs with no support | Earnings overstated. A weak add-back is multiplied by the price multiple | Ask for invoices or payroll records for each add-back. Your accountant decides which add-backs are supported |
| Several versions of the financial statements | Statements prepared for different audiences, such as taxes and the sale | Tie the tax return, internal statements and bank records together |
| Sudden margin improvement just before the sale | Deferred maintenance, delayed hiring or cut marketing | Compare the last three years month by month and ask what changed |
| Payables stretched or deferred | The seller may be managing cash ahead of closing, or the business may be short of cash | Ask for aging reports and see working capital and the peg explained |
| Premium or other costs that look too low for the operation | Thin coverage, unpaid balances or owner-paid items outside the business | Compare insurance cost with payroll, vehicles and contracts. See was the seller underinsured |
Will the customers and the business survive the owner leaving?
The question behind each of these is whether the revenue survives the change of owner.
| Warning sign | What it may mean | Common responses |
|---|---|---|
| One customer or a few accounts make up most of revenue | A single loss could break debt service. There is no standard safe percentage, so judge it against your lender's file and cash flow | Talk to the customer with the seller's consent, read the contract and consider a condition or a price-linked structure |
| The owner does everything and nothing is written down | Earnings may fall when the owner leaves, and a lender may price that risk | Ask for a day-in-the-life of the owner, written procedures and a transition plan. See questions to ask a seller |
| The seller rushes you, sets a short deadline, or will not let your accountant see records | The records may not hold up, or the pressure may be a negotiating tactic | Slow down and put each request in writing. Many buyers treat a refusal of access to records as a reason to walk away. Discuss it with your attorney |
| Customers tied to the seller personally | Relationships may leave with the owner | Plan a transition period, and agree how the seller will introduce you and stay reachable for questions |
| Contracts with consent or change of control clauses | A customer, landlord or vendor can renegotiate or exit at the sale | Have counsel list them and ask whether key consents should be a closing condition |
| Deferred maintenance or aging equipment | Capital spending that the earnings do not show | Inspect equipment and add the repair cost to your model |
| Key systems and accounts in the seller's name | Domains, phone numbers or software that may not transfer | List them and ask counsel whether transfer should be a closing term |
Are the people, licenses and legal matters in order?
People and legal problems often surface late. Look for them early.
| Warning sign | What it may mean | Common responses |
|---|---|---|
| Key employees unaware of the sale or unhappy | They may leave, and the business may rely on them | Ask about retention plans. Employment counsel can advise on agreements |
| Workers paid in cash or classed as contractors who work like employees | Wage, tax and workers' compensation exposure. In a stock purchase it stays with the entity. In an asset purchase it depends on what you assume and on successor liability exceptions. At audit, pay to uninsured subcontractors can be added to the premium base | Review payroll with your accountant and see inherited wage and hour exposure |
| A license held by the seller or one person who is leaving | The business may not be able to operate without them | Ask the state licensing board and your lender how it will work. See when the seller holds the contractor license |
| Pending or threatened disputes, or a seller who is vague about them | Liabilities you may inherit. In an asset purchase the buyer generally takes only what it agrees to assume, but exceptions exist | Ask counsel about indemnities and exclusions. See successor liability in an asset purchase |
| Unpaid taxes or liens | Some states make a buyer of assets liable for the seller's unpaid taxes unless a notice and clearance process is followed. Indiana is one example | Ask counsel and the state revenue agency about clearance before closing |
| A lease that is not in writing or cannot be assigned | Loss of the location | Have the landlord's position in writing before you commit |
What do the insurance and claims records say?
Insurance records are some of the quickest facts to check. They are issued by third parties and they show how the business handled problems. Frame what you find as fit for you as the new owner: the seller's broker may have done a fine job, and a gap may simply reflect that the seller's needs differ from yours.
| Warning sign | What it may mean | Common responses |
|---|---|---|
| No loss runs, or the seller will not request them | A claims history the seller has not reviewed or is reluctant to share, or a slow carrier request | Ask the seller to request them from each carrier. See how to read loss runs |
| Frequent claims of the same kind | A repeating cause such as vehicle accidents or injuries | Ask what changed after each one and what controls exist |
| Open claims with large reserves (the carrier's estimate of what it will pay), or incidents never reported | Cost not yet visible in earnings. Late reporting can also threaten coverage | Ask the seller to list every incident and ask counsel about an indemnity (the seller's promise to cover a loss) or a holdback (part of the price kept back) |
| Cancellations, non-renewals or a new carrier each year | A carrier may have non-renewed or cancelled for underwriting reasons, or the broker may simply have remarketed for price. The reason matters | Ask for the reason in writing |
| Claims-made policies with no tail (extra time to report claims after the policy ends) or plan | Old claims may fall into a gap after the sale | See prior acts and tail coverage |
| A workers' compensation experience mod (a score of claims history) above 1.00 | A mod above 1.00 generally means claims experience worse than expected for the class. Under National Council on Compensation Insurance (NCCI) rules, experience often follows the business to the buyer. Rules differ in states with independent bureaus and in the four state-fund states (North Dakota, Ohio, Washington and Wyoming), and small employers may have no mod | Review the experience worksheet. See the glossary entry on the experience modification rate |
| Uninsured subcontractors | Their injuries and premium can land on your policy at audit | Collect certificates and see 1099 contractors and your first workers' comp audit |
| Contracts or a lease that require coverage the policies do not provide | Breach of contract on day one | Compare requirements with the policies. See coverage gaps new owners find |
| Policies listing the wrong company or the seller's name | The new owner's entity may not be covered | Confirm the named insured. See wrong named insured after an acquisition |
The insurance checklist for buying a business lists what to request. A quote is not bound coverage, so line up your own policies before closing day. If you want a second read of the policies and loss runs, Morrow can review them for fit for the new owner and request quotes, though terms depend on carrier underwriting.
How do you decide whether a flag is fixable or a reason to walk?
Whether to ask more questions, change the price, change the structure or walk away is a business decision to make with your deal attorney, accountant and lender. What follows describes how buyers commonly think about it.
Ask three things. Can the problem be measured? Can it be priced or contracted around? Does the seller engage with it honestly? A flag that is measurable, priceable and discussed openly is usually something to negotiate. A flag the seller dodges, or one that cannot be measured because records do not exist, is the kind that ends deals.
A hypothetical example. A listing shows $400,000 of seller's discretionary earnings (the owner's profit plus pay and certain adjustments, defined differently by different advisors), of which $150,000 is add-backs. The asking price is 3.0 times earnings, or $1,200,000 (an illustrative multiple, not a market figure). Three flags appear:
- Add-backs: the buyer's accountant can support only $100,000 of the $150,000, so earnings drop by $50,000 to $350,000. At the same multiple, the price falls by $150,000 to $1,050,000.
- License: the owner holds the only license the company needs. The buyer asks the licensing board and the lender how it will work.
- Loss runs: the seller says the company has never had a claim but has not produced loss runs. The buyer makes them a condition of moving forward.
If the loss runs and license plan come back clean, the deal may proceed on adjusted terms. If the seller will not provide either, the buyer may decide to walk away. Figures are illustrative only.
For the questions that surface these flags, see questions to ask a seller before you buy, and for the full workstream, the due diligence checklist.
Keep reading
- Questions to Ask a Seller Before You Buy a Business
- Due Diligence Checklist for Buying a Small Business
- Was the Seller Underinsured? How to Tell and What It Costs You
- How to Read Loss Runs After You Buy a Business
- 15 Coverage Gaps New Owners Find in Owner-Run Businesses
- All guides for new business owners
Frequently asked questions
What is the biggest red flag when buying a small business?
Earnings you cannot prove. Unsupported add-backs, revenue that does not match the bank or several versions of the financials affect the price directly, because each dollar of earnings is multiplied by the price multiple. Next come heavy owner dependence and a seller who will not engage.
Should I walk away from a business with one big customer?
Not automatically. There is no standard safe percentage. Read the contract, talk to the customer with the seller's consent and ask your lender and accountant how a loss would affect debt service. A condition, a price-linked structure or a transition plan can address it.
What claims history is a red flag?
Frequent claims of the same kind, large open claims, incidents never reported, cancellations or non-renewals, and a seller who will not provide loss runs. A short claims history is not proof of a safe business, so ask what was paid directly and never reported.
Can insurance fix a problem I find in diligence?
Usually not. A new policy generally does not cover losses or circumstances you already know about, so known problems are handled by price, specific indemnities, escrows or closing conditions. Claims from events before closing may still fall under the seller's older occurrence policies, depending on the deal structure and wording. Insurance is mainly for unknown future claims.
How early should I check insurance and claims?
Early. Loss runs, policies and contract requirements are factual and come from third parties. Ask once you have a serious lead and a nondisclosure agreement, so what you learn can still shape price and terms.
References
- Morgan & Westfield: Acquired, Ch. 21, 4 Types of Due Diligence (sell-side advisory firm, 2026)
- Calder Capital: Acquisition Search Is Getting Harder, Takeaways From Stanford's 2026 Search Fund Study
- U.S. Small Business Administration: SOP 50 10 8.1, Appendix 15, Quality of Earnings and Financial Due Diligence (effective October 1, 2026)
- Indiana Department of Revenue: Successor Liability (Notice of Transfer in Bulk)
- NCCI: Experience Rating Plan Manual rules on ownership changes (Item E-1411, as filed in Texas)
- Ballard Spahr: The Art of the (Bad) Deal, Successor Liability in M&A Transactions (June 1, 2020)
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Send Morrow the declarations pages, loss runs and key contracts you inherited. Morrow can review them against the business you bought, flag gaps and request quotes where it makes sense. Any new terms depend on carrier underwriting.
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This article is general information, not legal, tax or financial advice, and not a coverage determination. Coverage depends on the actual policy wording, carrier underwriting, your purchase agreement and your contracts. Ask your attorney and accountant about deal and legal questions.