Business acquisition: 6 red flags in the accounts of a founder led company
The six red flags to check in the accounts of a founder led SME or startup are: an EBITDA that only holds up because the owner underpays themselves, a swelling shareholder loan account with private costs booked as business expenses, a gross margin that drifts without explanation, working capital buried in the balance sheet, a lasting gap between reported profit and actual cash, and missing provisions that hide latent liabilities. Any one of them is negotiable through a price adjustment, an escrow holdback or a warranty; it is their accumulation, and the seller’s reaction to your questions, that should stop you. Always rebuild EBITDA on a market salary and reconstruct three years of cash before you commit to a price.
When you are weighing the purchase of a founder led business, the accounts you are handed are almost never false. They simply answer a different question than yours. They are built to pay as little tax as possible, not to show true earning power. Due diligence on an SME or startup starts with reading those same numbers through a buyer’s eyes, separating a healthy company from a well disguised job. Here are the six red flags that each deserve an hour of your attention before you put a price on the table.
1. An EBITDA that rests entirely on the owner’s salary
Start by normalizing the founder’s pay. An owner who pays themselves 60,000 euros a year, while the market rate for a managing director to replace them is 180,000, mechanically inflates EBITDA by 120,000 euros. The reverse is just as telling. A founder pulling 350,000 euros out of a company with 1.5 million in revenue is probably hiding a profit distribution dressed up as salary. In both cases, rebuild earnings on a market salary for the role actually performed. If the normalized EBITDA melts away after this single correction, you are not buying a profitable company, you are buying your own future salary.
An EBITDA that cannot survive a market rate salary for the owner is not an EBITDA, it is an accounting illusion.
2. The shareholder loan account and private costs
On the balance sheet, study the shareholder loan account closely. A balance that swells year after year signals one of two things. Either the founder draws more than the business earns, or they fund operations out of their own pocket to mask a cash squeeze. Then hunt for private costs sitting in the income statement: premium vehicles, travel, thinly documented entertainment expenses, salaries paid to relatives with no real role. Every euro of private cost you strip out lifts reported earnings, but its mere presence tells you how rigorous the accounts in front of you really are. In a business where the private and the professional blur together, no number can be taken at face value.
3. A gross margin that drifts without explanation
Lay three financial years side by side and track gross margin as a percentage of revenue. A margin holding steady at 42, 43, 42 percent is reassuring. A margin that slides from 48 to 41 to 38 percent tells a story the seller will not volunteer: competitive pressure, lost pricing power, or customers won at a discount to prop up the top line before the sale. The opposite pattern is just as suspect. A margin that jumps in the final year, right before the deal, deserves the closest scrutiny. Ask for the monthly breakdown. A margin spike concentrated in the last few months is often window dressing, with costs pushed out or revenue pulled forward to flatter the exit picture.
4. Working capital buried in the balance sheet
Many buyers think in earnings alone and forget the balance sheet, which is exactly where the most expensive trap hides. Calculate the cash tied up in operations over several years: inventory plus receivables minus payables. An SME or startup with 4 million in revenue that ties up 800,000 euros of working capital needs another 200,000 euros every time revenue grows by 1 million. Buy on a flattering EBITDA without setting aside cash for this working capital, and you will find the hole three months after closing. I have seen it happen more than once: the earnings were fine, nobody had sized the balance sheet, and the buyer had to put cash back in to fund their own growth.
- Lengthening receivable days. A drift from 45 to 60 to 75 days is often a sign that struggling customers are being kept on to support the top line.
- Payable days stretched to the limit. Paying suppliers at 90 days can mask a cash strain that EBITDA never shows.
- Inventory growing faster than sales. This points to latent obsolescence, and so to a write down still to come that you will carry.
- Old unprovisioned receivables. Check the aged balance: an 18 month old invoice will rarely be paid and should already have been written off.
5. The gap between profit and cash
A company reporting 400,000 euros of profit a year for three years should, all else equal, build up cash or pay down debt by a comparable amount. If cumulative profit is 1.2 million but cash has not moved and debt has not fallen, the money has gone somewhere: distributions, the loan account, investments never flagged as such, or a profit more theoretical than real. Rebuild a simplified cash flow statement over three years. It is the most honest test there is. Profit can be shaped by the way entries are booked, but the cash collected does not lie. When profit and cash diverge for any length of time, believe the cash.
6. Missing provisions and hidden liabilities
Founder led businesses almost always set aside too little in provisions, because every provision cuts the profit available to distribute. Look for what is missing: no allowance for doubtful debts despite a heavy aged balance, no warranty provision in a trade that clearly generates claims, unrecorded overtime and holiday balances, a live dispute absent from the notes. Check VAT and social security compliance over five years, along with the risk that contractors are reclassified as employees. Each of these is a hidden liability you inherit unless you have it covered by a quantified warranty in the contract.
From diagnosis to decision
No single one of these signals is a deal breaker on its own. One red flag is negotiable: it becomes a price adjustment, an amount held in escrow, or a warranty. It is the accumulation that should stop you, and above all the seller’s reaction when you raise the question. A founder who calmly explains why the margin fell and opens the aged balance to you is a credible partner. A founder who shuts down, plays it down, or sends you to an accountant who gives you nothing has told you what matters without saying a word.
The classic mistake buyers of SMEs and startups make is to fall in love with the company before rebuilding its normalized numbers. The right order is the reverse. First establish the adjusted EBITDA, the real working capital and the cash actually generated, derive the valuation and the debt capacity the deal can carry, then settle on a price that reflects the risk you have measured. A buy side business acquisition analysis, done before the letter of intent, turns a gut feeling into a defensible investment thesis and hands you the numbers to negotiate the price the business is genuinely worth. This is exactly the work Mercova runs alongside buyers.
Key points
- Normalize EBITDA on a market salary for the role actually performed: if it melts away, you are buying a job, not a business.
- The balance sheet hides the most expensive trap: size the working capital over several years before you validate a price built on earnings alone.
- Profit can be shaped, cash much less so: when earnings and cash diverge for any length of time, believe the cash.
- A single red flag is negotiable (price cut, escrow, warranty); it is the accumulation and the seller’s reaction that make you walk.
- Rebuild the numbers before you fall in love with the company, never the other way round.
Frequently asked questions
When should this analysis be done, before or after the letter of intent?
Ideally before. A letter of intent signed on an unadjusted EBITDA locks you into a price the numbers may not support, and reopening it later makes you look like the one backing out. Put the normalized EBITDA, the real working capital and the cash actually generated on the table first, and you negotiate from a thesis rather than a gut feeling.
What if the seller refuses to share the aged receivables or the monthly detail?
Reluctance alone is not proof: some founders are simply poorly equipped and have never pulled that report. But a flat refusal, or a constant deflection to an accountant who never answers, tells you a great deal about what there is to find. Openness on old receivables costs an honest seller very little; its absence gets priced into the deal or into the warranty.
How long does a first pass at rebuilding the accounts take?
Across three years, a serious first pass takes a few days, not weeks, provided you have the general ledger and the aged balance. Most of the work sits in three adjustments: the market salary, the normative working capital, and the reconciliation of profit against cash. That is enough to tell whether the file deserves a letter of intent or a quiet exit.
Is one red flag enough to walk away?
No, you deal with it rather than run. A single flag can be quantified: a slipped margin becomes a revised price, a latent liability becomes a warranty or an amount held in escrow. What should make you walk is a cluster of flags and a seller who closes up the moment you dig.
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