Due Diligence Checklist – What to Inspect Before Buying a Business

Before you make an offer to buy a small business, you need to do some digging into the company to minimize your chances of mistakenly buying a problematic business or overpaying for a good business. This investigative process is known as due diligence, and it’s every bit as important as hiring an attorney or signing the purchase agreement.

Smart buyers build plenty of contingencies into a purchase offer for a small business, just as they do when buying a home or other real estate. If your financing doesn’t come through or you find some dirty laundry in the business (and you’re not buying a laundromat), contingencies allow you to legally back out of the deal. However, knowing that all your purchase offers will include plenty of contingencies shouldn’t encourage you to make any purchase offer casually.

Making an offer and doing the necessary research are costly, in both time and money, but you’ll be glad you did both after the deal is done and you can rest easy, knowing that you’ve purchased a good business. 

So before making an offer for any business, make sure that you investigate all the important issues that we discuss in this article.

Examine owners’ and key employees’ backgrounds

A business is usually only as good or bad as the owners and key employees who run it. Ethical, business-savvy owners and key employees generally operate successful businesses worthy of buying. Unscrupulous, marginally competent, or incompetent business owners and key employees are indicative of businesses that you should avoid.

Here’s a short list of what to look for and how to find it:

1. Business background

Request and review the owners’ and key employees’ resumes. Are the backgrounds impressive and filled with relevant business experience? Just as you should do when hiring an employee, check resumes and LinkedIn profiles to make sure that the information they provide is accurate. Glaring omissions or inaccuracies send a strong negative message as to the kind of people you’re dealing with.

2. Personal reputations in the business community

The geographic and professional communities to which most business owners and employees belong are quite small. Any business that has been up and running for a number of years has had interactions with many people and other companies. 

Take the time to talk to others who may have had experience dealing with the business for sale (including vendors, the Chamber of Commerce, the Better Business Bureau, and so on) and ask them their thoughts on the company’s owners and key employees. Of course, we shouldn’t need to remind you that you can’t always accept the statements of others at face value. You have to consider the merits, or lack thereof, of the source.

3. Credit history

If you were a banker, you certainly wouldn’t lend money to people without first assessing their credit risk. At a minimum, you would review their credit history to see how successful they’ve been at paying off their loans on time. Even though you won’t be lending money to the business seller you’re dealing with, we recommend that you check his credit records. 

A problematic credit record may help you uncover business problems that the owner has had that he may be less than forthcoming in revealing. The major agencies that compile and sell personal credit histories and small-business information are Experian (www.experian.com), Equifax (www.equifax.com), TransUnion (www.transunion.com), and Dun & Bradstreet (www.dnb.com).

4. Key customers

In most cases, the people who can give you the best indication of the value of a business for sale are its current customers. Through your own research on the business or from the current owner, get a list of the company’s top five to ten customers and ask them the following questions:

  • In general, how is the company perceived by its customers?
  • Does it deliver on time?
  • How do its products or services compare to its competitors’ offerings?
  • Does it have a culture of integrity?
  • What does the company do best?
  • What does it need to improve?

5. Key employees

If the employees of the business for sale are aware of the prospects of the impending sale, be sure to interview them and get their insider’s take on the condition of the business. Also try to find out whether they intend to remain as employees under the new ownership.

Understand why the business is up for sale

As part of your due diligence of a potentially attractive business, you need to try to discover why the owner is selling. Small-business owners may be selling for reasons that shouldn’t matter to you (such as they’ve reached the age and financial status where they simply want to retire), or they may be selling for reasons that you need to think twice about (such as the business is a never-ending headache to run, it isn’t very profitable, or competition is changing the competitive landscape).

Just because an owner wants to sell for some negative reason doesn’t necessarily mean you shouldn’t buy the business. If the business has a low level of profitability, it isn’t necessarily a lemon; quite possibly the current owner hasn’t taken the proper steps (such as cost management, effective marketing, and so on) to boost its profitability. You may well be able to overcome hurdles that the current owner can’t. 

But before you make a purchase offer and then follow through on that offer, you absolutely, positively must investigate many aspects of the business, including, first and foremost, why the current owner wants out.

Here’s how to discover why the current owner is selling (where appropriate, get the current owner’s permission to speak to certain people):

Chat with the owner. Okay, so this isn’t a terribly creative, Sherlock Holmes–type method, and, yes, we know that many sellers aren’t going to be completely candid about why they’re selling, but you need to ask. You can verify the answer you get from the owner against what other sources (like the business’s listing broker) tell you about the owner’s motivations to sell.

Talk to the business owner’s advisors. While evaluating the worth of a business, you should speak to various advisors, including those you hire yourself. Don’t overlook, however, the wealth of information and background that the current owner’s advisors have. These advisors may include lawyers, accountants, bankers, and/or the business’s own board of advisors or directors. Sure, they may not be completely candid, but your job is to read between the lines of what they have to say.

Confer with industry sources. Most industries are closely knit groups of companies, each one knowing, in general, what’s going on with the other businesses in the same industry. Most importantly, the vendor salespeople or manufacturers’ representatives who sell products or services to the industry can be a useful source for information. Just remember to take what anyone says with a grain or two of salt.

Seek out customers. The business’s current customers usually have a good idea of why a business is for sale. They can provide you with the information you need to determine whether the current owner is selling from strength or from weakness.

Discuss with employees. Some employees probably know the real answer as to why the business is for sale. Your job: Find out what they know.

In your discussions with and investigations about the current owner, also reflect upon these final, critical questions: How important is the current owner to the success of the business? What will happen when he or she is no longer around? Will the business under new management lose key employees, key customers, and so on?

Survey the company culture

Buying a small business is similar to adopting someone else’s child. Depending on the strength of its already-formed personality and the degree to which it meshes with yours, you may or may not be successful in molding that business into your image.

Thus, another important element of your due diligence is to find out what kind of culture the business has. How, for example, are employees viewed and treated in the company? In meetings, are subordinates allowed (or even encouraged) to challenge the thinking of their supervisors?

Larry was an MBA from one of the nation’s top business schools. He thought he could make a bundle of money by buying a small manufacturing company and running it better than its current owners. Given his blue-chip credentials, he thought running the company would be a snap. So Larry purchased the company with a 35 percent down payment of the purchase price, with the seller carrying a note for the balance.

Larry’s first task was to clean house of the “deadwood,” terminating key employees so that he can replace them with people who would better measure up to his high standards. Larry made his downsizing decisions after just a couple of weeks on the job. He didn’t seem to know (or perhaps didn’t care) that the company had a history and culture of respect for its employees. Even during slow economic times, previous management hadn’t let people go but instead had scaled back hours of operation.

Not surprisingly, after nearly 20 percent of the staff was gone, Larry had earned himself the reputation as the “grim reaper” because many of Larry’s new hires couldn’t do the jobs as well as the previous job holders who had been fired. The original staff that remained, not surprisingly, feared for their jobs; thought Larry was callous, incompetent, and uncaring; and worried about the future of the company. 

Many of the best remaining employees had updated their resumes and were actively seeking employment elsewhere to escape the negative culture that Larry had brought with him. Gradually, most of the good employees who had survived Larry’s initial firings quit as the company went into a financial tailspin. Eventually, Larry himself had to move on.

What’s the point of this story? What should Larry have done differently?

Before buying the company, Larry should’ve taken the time to understand the company’s culture. Changing employees may not be impossible in the company you buy, but attempting to change the culture, especially in such a short period of time, is a too-often-perilous endeavor. Cultures are a sensitive business asset and should be treated accordingly. Larry should’ve spent more time assessing and considering the company’s culture both before he bought the business and after he completed the purchase.

Larry should’ve known that preconceived notions rarely withstand the scrutiny of day-to-day operations. Buying and running a company isn’t as easy as people like Larry may think. An MBA from a top business school and specific work experience don’t come close to guaranteeing success when buying and managing a business. Larry should have maintained the company as it had been run until he studied and learned its real strengths and weaknesses, knew the business well enough to recognize the skills of the employees, and could formulate an informed plan to move the company forward.

Inspect the profit and loss statement

A company’s profit and loss statement, or P&L (also known as the income statement), details its profits (or lack thereof), which are simply revenues minus expenses. Revenues are the money that the company receives from its customers as payment for its products or services. 

Expenses are the company’s costs of doing business. Just as much of your personal income or revenue goes toward income taxes, housing, food, and clothing, company expenses exhaust much and sometimes all of a company’s revenue.

When considering buying a business, take the time to examine the following issues on the company’s profit and loss statement:

1. The owner’s salary and bonuses

Of utmost importance when computing the profitability of any business is the determination of how much money the current owner is (or has been) taking out of it. The profitability of the business may look large at first glance, but the owner may be paying himself little in order to fatten the bottom line. 

Or the owner may be paying himself an excessive salary and bonuses, minimizing the business’s apparent profitability in the process. (In most cases, the owner will be quick to tell you about his penchant to take excessive salary and bonuses and reluctant to reveal if he has been underpaying himself.)

2. Change in revenues over time 

Examine at least the last three years of profit and loss statements. Do you see a steady or increasing rate of growth in a company’s revenues? If a company’s revenues are growing slowly or shrinking, you have to ask the important question, “Why?” Is it because of poor service or product performance, better competitor offerings, ineffective marketing, or an owner who is financially set and unmotivated to grow the business? Before you buy is the time to find out the answer to this question.

3. Revenues by product line

For companies with multiple divisions or product lines, ask for the revenue details of each product line. Find out what’s spurring, or holding back, the company’s overall growth. One red flag is if the business has acquired other businesses that don’t really fit with the company’s other business units. Some larger small companies that are struggling to build revenues sometimes try to “enter” new businesses through acquisition but then don’t manage them well because they don’t understand the keys to success in those businesses.

4. Revenues by individual stores

With retail stores, such as a picture-framing enterprise that has multiple locations, examine the revenues on a store-by-store basis. If the business has been opening new sites, also determine the change in revenues from opening new locations versus the change at existing locations. A company can show overall revenue growth by simply adding new stores while the existing locations may actually be experiencing declining revenues.

5. Expense details

To help you identify which expense categories are growing and which ones are shrinking over time, take a look at the expense categories for the past three years and calculate what percentage of the company’s revenue each category makes up. As a well-managed and financially healthy company grows, expenses as a percentage of revenues should decrease. 

Not all expense categories necessarily decrease. Research and development, for example, may be expanding in a company awash in revenues and seeking to create and offer new products and services.

6. The bottom line

The net result of revenues that increase faster than expenses is a fatter bottom line (the last line of the profit and loss statement that indicates net profits or losses after taxes). 

When you examine how a company’s profits change relative to total revenue received, focus on operating income, which is the net income from operations before one-time write-ups or write-downs. (Sometimes companies experience one-time, revenue-enhancing or revenue-reducing events that can change profits temporarily.)

Even healthy, growing businesses can get into trouble if their expenses balloon faster than their revenues. Well-managed companies stay on top of their expenses during good and bad times. Don’t be fooled into thinking that all is well financially just because a company’s revenues have been increasing. It’s easier for companies to get sloppy during good times.

Thoroughly examine other expense items — such as automobile expenses and travel and entertainment — for insight as to how the business has spent its money in the past. You may unearth some excessive, unnecessary expenses that, if you’re successful in cutting, can immediately improve your bottom line.

A term you may come across when you’re dealing with attorneys, accountants, business brokers, or sophisticated buyers is EBITDA. EBITDA is an acronym that stands for Earnings Before Interest, Taxes, Depreciation, and Amortization. Many business sales are made based on EBITDA earnings rather than net income. Be aware of which of the two methods you’ll be using in determining the value of the business.

Review the balance sheet

A balance sheet is a snapshot-in-time summary of a company’s assets and liabilities. This financial report is typically prepared as of the last day of the company’s fiscal year-end, which for most companies is December 31. (Some companies have a fiscal year that ends at a different time of the year.)

The assets section of the balance sheet summarizes what the company holds or owns that is of significant value. The liabilities section details what the company owes to others. Here are several key line items to look for when reviewing a company’s balance sheet:

1. Accounts receivable

Also known as receivables, this line item is money that’s owed to a company for products or services already sold but not yet paid for. As companies grow, so, too, do their receivables (unless the business deals only in cash, in which case the business shouldn’t have any receivables at all). 

Be on the lookout, however, for accounts receivable that are growing at a faster rate than the company’s revenues (in other words, receivables that are becoming a larger portion or percentage of the company’s revenues). Bloated receivables may indicate that the company is having problems with the quality of its product or pricing. 

Dissatisfied customers pay more slowly and/or haggle for bigger discounts. Out-of-proportion receivables may also indicate that the company’s customers are having financial problems of their own. Be sure to ask for the business’s accounts receivable aging — a listing of the monies owed to the company accompanied by the length of time the bills have gone uncollected.

Throw a red flag if the business doesn’t maintain an aging of receivables — unless all its customers are paid to date.

2. Property and equipment

All companies require equipment, such as office furniture, computers, and so on, otherwise known as fixed assets. Manufacturing companies also own machinery for making their products. Equipment becomes less valuable as it becomes more obsolete over time. 

This depreciation of fixed assets is charged against profits by the company as a cost of doing business each year. Thus, even if a company ceases buying new equipment, its balance sheet will continue to show fixed asset charges — not for purchases but for depreciation of the value of property and equipment. As depreciation is subtracted from the value of the equipment, the amount shown for fixed assets on the balance sheet will gradually decrease.

If a company hasn’t been periodically upgrading its equipment, you can get stuck buying a company that needs a lot of costly new equipment. When a company’s balance sheet indicates a continual decline in the bookkeeping value of the company’s equipment, beware that the company may simply be deferring new equipment purchases. 

Inspect the company’s equipment and talk with others who are familiar with the type of business so that you can understand how outdated the equipment really is and how much you’re likely to have to expend on replacement equipment if you buy the business.

3. Inventory

The balance sheets of manufacturing and retail companies should detail inventory, which is simply the cost of the products that have not yet been sold. As a business expands over time, inventory should follow suit. 

However, beware if you see inventory increasing faster than revenues because it may signal several problems, including customers who are scaling back on purchases, poor management, or an obsolete or inferior collection of goods. Inventory is the most dangerous asset of all because a swollen inventory often represents cash that can’t be redeemed.

4. Accounts payable

When companies purchase supplies, equipment, or products for resale for their business, they generally have a period of time (typically 30 days) to pay the bills. Similar to inventory and accounts receivable, accounts payable (which appear on the liability side of a company’s balance sheet) usually increase in tune with a company’s increasing revenues. Accounts payable that are growing faster than revenues may or may not indicate financial trouble. 

The increase may simply be good financial management (the slower a company is with paying bills, the longer the funds can be drawing interest in corporate accounts). On the other hand, if the company is struggling to make ends meet, an accumulation of accounts payable can occur and can be an early warning sign of financial trouble.

5. Debt

Debt, both short term and long term, is money that the company has borrowed and must someday pay back. Footnotes to the financial statements (assuming they’re audited) generally detail the terms of the debt, such as when the debt is to be paid back. 

If the financials you’re working with haven’t been audited, be sure to either ask for a thorough explanation of the debt or, better yet, leave the debt out of the purchase. The vast majority of buyers don’t want to assume the seller’s debt; unless there are extenuating circumstances, you shouldn’t want the debt either.

6. Other assets

This catchall category is for the other assets of the company and can include stuff that will make your eyes glaze over. For example, companies keep a different set of books for tax purposes (yes, doing so is legal). 

Not surprisingly, companies do this because the IRS allows, in some cases, more deductions than what the company is required to show from an accounting standpoint on its financial statements. (If you were a company, wouldn’t you want your shareholders, but not the IRS, to see gobs of profits?) The benefit of deferring taxes is treated as an asset until the IRS gets more of its share down the road.

Even if you’re competent in reading financial statements, never purchase a business without involving a good tax advisor to help you evaluate the value of the business and the financial terms of the transaction. Buying a business isn’t the time to rely on your own trial and error; be sure to involve someone in the buying process who can bring her financial/tax expertise to the table.

Consider “Off-Balance-Sheet” Assets Worth

The value of a company’s assets includes not only tangible items, such as inventory, accounts receivable, furniture, fixtures, and equipment, but also soft assets, such as the firm’s name and reputation with customers and suppliers, customer lists, patents, and so on. These soft assets are also known, in accounting jargon, as goodwill. In many cases, the value of this goodwill is greater than the value of the hard assets.

If you’re seriously interested in making an offer to buy a particular business, take time to investigate the worth of the company’s goodwill. 

As part of your investigation, be sure to assess whether the current customers of the business will continue buying from the business after you take it over and to evaluate the quality of the key employees. And don’t forget to look into the business’s relationships with suppliers — are they good or bad? In addition, check out the competition — does it seem formidable?

Ask key employees these questions:

  • What do you like the most about your company? What do you like the least?
  • How do you see the future of the company?
  • Can the products or services be improved?
  • What would be the first improvement you’d make if you owned the business?

Ask suppliers these questions:

  • Does the company pay its bills on time?
  • Do you get an inordinate amount of returns from them?
  • Compared to other companies in the industry, how does the company treat its suppliers — as partners or as a necessary evil?
  • If you could change one thing about the company, what would it be?

Some final points about goodwill: Companies work hard to attract and retain customers through advertising, product development, and service. Companies can’t put an exact value on the goodwill they’ve generated, but when they purchase (acquire) another firm, some of the purchase price is considered goodwill. 

Specifically, if a company is acquired for $100 million yet has a net worth (assets minus liabilities) of just $50 million, the extra $50 million is considered to be goodwill. This goodwill then becomes an asset on the balance sheet, which, similar to equipment, is amortized (depreciated) over the years ahead. (Goodwill is amortized over ten years.)

Uncover lease contract terms

A soon-to-expire lease at a low rate can ruin a business’s profit margins. With a retail location, the ability to maintain a good location is critical as well.

Check comparables — that is, what similar locations lease for — to see whether the current lease rate is fair and talk to the building owner to discover his plans. Ask for and review (possibly with the help of a legal advisor) the current owner’s lease contract. Pay extra-careful attention to the provisions of lease contracts that discuss what happens if the business is sold or its ownership changes.

Final Words

Every business buyer or seller should remember this saying: “You name the price, I’ll name the terms.” What this saying means is that the terms can be more important than the price in making the deal work. 

What if, for example, you buy a business that’s somewhat overpriced, but you have to pay only 10 percent down, the interest rate on the balance is 2 percent, and you don’t have to pay off the note for 30 years? In this example, the terms are much more important to the deal than the price.

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