If you stay in SMB deal flow long enough, you’ll meet the unicorn: fast-growing, clean books, loyal customers, easy handoff, “moving for family reasons,” and priced like it’s still 2016. Tempting? Absolutely. Smart? Not without a tighter inspection. In lower middle market M&A, “too good to be true” usually means there’s risk hiding in plain sight—timing games, concentration under a fresh coat of paint, owner dependency, or working-capital tricks that cash out the seller and saddle you with the bill.
Here’s a practical, buyer-first framework to separate great deals from glossy ones, with simple tests you can run before you burn months and fees.
Fast Checks Before an LOI
Revenue quality in three questions
- Contract vs. hope: Are revenues contracted, at-will, or project-based? Request a top-10 customer list with contract terms and renewal dates.
- Price vs. volume: What’s actually driving growth—price increases, new logos, or larger orders from a single account?
- Owner involvement: Who owns the top relationships? “All me” is not a plus.
If the top customer is >25% of revenue, at-will, and owner-led, you’re not buying stability—you’re buying a negotiation with one decision-maker you don’t control.
EBITDA trust test
- Adjusted EBITDA vs. net income: A big gap isn’t a sin, but it needs receipts.
- Add-back mix: Owner comp replacement, one-time legal, and slashed marketing often “come back” on your watch.
- Seasonality sanity: Pull monthly P&Ls for 24 months; if the deck is stacked with three “perfect” months annualized, recalibrate.
If Adjusted EBITDA depends on add-backs that require you to run the business worse than the seller (e.g., no marketing, below-market wages), it’s not sustainable earnings.
Working capital rhythm
- Ask for TTM monthly AR, inventory, and AP.
- Look for AR >90 days, inventory spikes, and AP suddenly stretched in the last quarter.
- Deals that sparkle while starving payables and pulling forward receivables are asking you to refill the tank on day one.
Simple Tests to Validate a “Great” Deal
Red flag: “Explosive growth with minimal cost increases”
What it often means: Deferred maintenance, underinvested sales ops, or a big customer ramp that hasn’t been stress-tested.
Buyer move: Underwrite gross profit by customer/cohort, not just total revenue. If growth is concentrated, price it with a lower multiple and a retention-linked earnout.
Red flag: “Owner stepping back” without a #2
What it often means: The owner is indispensable and tired.
Buyer move: Quantify decision rights (pricing, hiring, vendor changes). If the owner is the bottleneck, require seller financing and defined transition support. Lower the multiple accordingly.
Red flag: “Recurring revenue” that isn’t
What it often means: Prepaid service plans, punch-card-style packages, or annual billings recognized up front.
Buyer move: Separate billings from recognized revenue. Exclude deferred revenue from the working-capital peg; treat a cost-to-fulfill slice as debt-like.
Red flag: “Clean financials” with weak documentation
What it often means: Cash-basis reports, GL that doesn’t tie to bank, or a CIM built on management’s “adjusted” view.
Buyer move: Calibrate your QoE to value movers (revenue timing, add-backs, working capital). Ask for an issues list in week one so you can reopen terms quickly.
Straightforward Add-Back Check
For each add-back over, say, $10–25k:
- Will you still incur it? If you need to hire a GM, reinstate marketing, or keep “non-essential” family staff to avoid a gap, it’s not an add-back—it’s run-rate.
- Is it truly one-time? If “one-time legal” shows up three years running, it’s recurring.
- Is there paper? Payroll records, invoices, contracts. No doc = no add-back.
The 10-Minute Concentration Snapshot
Ask for top-10 customers by revenue, 24 months. Compute:
- Largest customer % and top-3 %
- Whether each is contracted or at-will
- Who owns the relationship (owner vs. team)
Reads:
- <15% largest / <40% top-3 with contracts = normal guardrails
- 15–30% largest or >40% top-3 = structure required (note/earnout/holdback)
- 30% largest or >60% top-3 = lower multiple, tight structure, or pass
The Trailing Peg Check
- Calculate AR + Inventory – AP by month for 12 months; use the average as your peg.
- Remove dead inventory, haircut aged AR, and normalize stretched AP.
- Write the formula, peg method, collar, and true-up into the LOI. No midnight math fights.
The Deferred Revenue Split
- Get a rollforward: opening DR + billings – revenue recognized = ending DR.
- Estimate cost-to-fulfill on the closing balance. Treat only that cost slice as debt-like.
- Exclude DR from the peg, or you’ll double count obligations.
Seller Stories That Deserve an Extra Beat
“Strategic buyer just walked”
Sometimes real; often code for diligence misses. Ask what changed and get specifics. If it’s vague, assume there’s a material issue waiting for you.
“We didn’t need marketing”
Could be strong product-market fit—or a shrinking pipeline cushioned by price increases and one whale. Rebuild a basic funnel model and see what gross margin looks like when marketing returns to normal.
“No debt, strong cash”
Great—but check if AP is stretched and deferred revenue is inflated. Free cash flow can be a mirage if customers prepay and vendors wait.
“Team is loyal”
Perfect. Now ask for tenure, comp, and backfills. If loyalty equals below-market pay and no bench, plan for turnover or wage resets. Price accordingly.
How “Too Good” Shows Up in the Model (and What to Do)
Case 1: Headline EBITDA depends on reversible cuts
Sellers sometimes cut marketing, maintenance, or headcount to dress up margins. If you’ll put those back to protect revenue, re-run EBITDA with normalized spend. Move the delta into a seller note or reduce price; don’t buy a number you can’t run.
Case 2: One whale and three minnows
If one customer is 30% and two more take you to 50%+, price the fragility with the multiple and protect with structure:
- Lower base multiple by ~0.5–1.0× depending on contracts and transferability
- Add an earnout tied to gross profit from named accounts
- Use a holdback for near-term renewals; release as they stick
Case 3: Pretty books, brittle operations
The P&L looks fine, but the business runs on the owner’s desk and legacy spreadsheets.
- Lower multiple for key person risk
- Require transition hours and delivery of SOPs
- Budget systems upgrades; if cash is tight, trade a bit of price for seller financing to keep day-one liquidity
Negotiating Without Blowing Up Goodwill
You can pressure-test a “too good” package without turning it adversarial.
- Lead with exhibits, not opinions. Show the top-10 revenue table, the trailing peg chart, and the add-back schedule with sources.
- Offer choices. “We can do $X cash at close with a $Y note and a light earnout keyed to Customer A retention, or $X – $Z cash with no earnout.”
- Solve bounded issues with bounded tools. Specific escrow for a tax exposure; earnout only for transfer risk; note for alignment—not “slash price across the board.”
When to Walk (and Feel Good About It)
A pass is a win when:
- The seller won’t document major add-backs or revenue timing.
- Top customers are at-will, owner-led, and the seller refuses transition support.
- Working capital is clearly manipulated pre-close and the seller won’t accept a normalized peg.
- The bank is “fine” but your operating view says the first 100 days will be triage without adequate structure.
You’re not paid to do hard things the hard way. You’re paid to buy cash flows that keep showing up.
A Simple Buyer Checklist to Keep You Out of Trouble
- Top-10 revenue table with contracts and renewal dates
- Largest % / top-3 % and who owns each relationship
- Monthly P&Ls (24 months) for seasonality and one-off dressing
- Add-back schedule with documentation and replacement costs
- TTM AR/Inventory/AP with adjustments for aging, obsolescence, and stretch
- Deferred revenue rollforward and cost-to-fulfill estimate
- LOI mechanics: WC definition, peg method, collar, true-up; note/earnout/escrow concepts
Contact us today or book a free consultation and learn how we can be a trusted partner on your next deal!
