One of the hardest lessons we’ve learned is that the most important factor in an acquisition is the character of the seller. Warren Buffett famously said, "You can’t make a good deal with a bad person," and we’ve found that to be absolutely true. No purchase agreement, quality of earnings report, or attorney can fully protect you from someone who is determined to be dishonest. Buffett also points out that dishonest people often enjoy conflict and litigation. Most buyers simply want to own and grow a successful business. When you’re dealing with someone who views conflict as a game, you’re already at a disadvantage.
Unfortunately, we learned this lesson the hard way.
The gym in California
One of our earliest acquisitions was a gym in California. Throughout diligence, the seller showed several warning signs. He ran personal expenses through the business to reduce his taxes, openly talked about manipulating the landlord, and generally displayed a willingness to bend the rules whenever it benefited him. Those were all signs we should have taken more seriously. Instead, we focused on what appeared to be a great business generating roughly half a million dollars in annual profit.
After closing, we discovered that nearly 30 percent of the company's revenue was generated through insurance fraud. The gym participated in the SilverSneakers program, which reimburses gyms when eligible seniors visit. Rather than recording actual attendance, the seller simply reported that members visited the maximum number of times each month, regardless of whether they ever came back. During diligence, we questioned the unusually high participation, but the seller had a plausible explanation involving a nearby senior center. The financial statements, tax returns, and bank deposits all appeared legitimate because the fraudulent revenue was flowing through the business exactly as reported.
On the very first day after closing, the seller showed our operating partner exactly how to continue the fraud. He handed him the list of names and explained the process. We refused to continue the scheme, which immediately eliminated a significant portion of the company’s profits. Overnight, what appeared to be a highly profitable business became one that generated almost no profit at all.
At that point, we believed the legal system would make things right. We were wrong.
We pursued arbitration because we thought our evidence was overwhelming. We had documentation, video evidence, the fraudulent records, and even proof that the seller had instructed us how to continue the fraud. Despite all of that, the arbitrator ruled that the decline in the company's value resulted from our decision to change the business's operating practices. In other words, because we stopped committing fraud, the loss in profitability was considered our responsibility. Arbitration is generally final, leaving us with virtually no path to appeal.
The trucking company
We experienced a similar situation in the trucking industry. Throughout the transaction, the sellers were confrontational and argumentative. They berated one of the nation's top SBA lenders, lied about maintenance expenses, and even misrepresented information to both us and the bank. Looking back, their behavior alone should have been enough for us to walk away. Instead, we continued because we'd already invested so much time and effort into the deal.
After closing, we discovered that maintenance costs had been shifted into another business to inflate profitability, and the sellers had voluntarily given up a major customer route just weeks before closing because they no longer cared about preserving the business's value. Although mediation eventually recovered part of our losses, we still suffered a substantial financial hit.
What we do differently now
Experiences like these taught us that there is no quality of earnings report capable of protecting you from a dishonest seller. A QoE can verify the numbers it sees, but it can't uncover intentional deception that's hidden behind seemingly legitimate transactions. Likewise, legal documents are only as valuable as the person on the other side is willing to honor them.
Character is a predictor
Today, one of the first things we evaluate is the seller's character. Often, the financial statements themselves provide the earliest clues. If a business relies heavily on questionable add-backs or routinely runs personal expenses through the company to reduce taxes, that's more than just an accounting issue — it's a reflection of the owner's integrity. If someone is comfortable defrauding the IRS, you should seriously question whether they'll be honest with you during a business sale.
About the author
Mark Fleming, CFA, FRM
Mark Fleming is the co-founder of Owner Actions, where he partners with experienced operators to acquire and grow small businesses. He has participated in more than 40 business acquisitions and has evaluated thousands of businesses across dozens of industries. Drawing on a background in portfolio management, financial analysis, and business ownership, Mark helps entrepreneurs identify high-quality acquisition opportunities and build businesses for long-term success.