Due diligence is the critical period in which you answer the question about the largest purchase of your life: “Is this a smart decision?”
Small business acquisitions can be a catalyst for wealth. However, there can be tremendous risk if a deal is not properly analyzed through multiple dimensions: financial, legal, operational, market, and growth potential. Most buyers create a checklist to work through dozens of factors within each dimension. We’re going to look at the critical elements within each so that you can make a smart, informed decision.
The Buyer Due Diligence Checklist Simplified
Due Diligence Dimension 1: Financial
Financial due diligence should be conducted as soon as a deal is under LOI (when the “Letter of Intent” is signed by both parties). Handling this early can save you long-term because significant financial discrepancies can be handled upfront or can cause you to step away from the deal if too high of a concern.
You may look to hire a financial due diligence partner to handle this for you as even with simpler deals, a trusted third-party that is not emotionally attached to the deal can provide an objective perspective and honest assessment.
Here are key areas you would cover in financial due diligence:
☑ Tax Returns: It is likely you are using a bank to finance the transaction. Beyond your own confidence to compare tax return figures to managerial profit & loss (P&L) statements, the tax return will be required by your lender. This is the true and verified financial data that they will provide an acquisition loan based on, and they will likely want three-years worth to review.
☑ Historical P&L Statements: Profit & Loss or Income Statements should be provided for the past three years, as well as year-to-date. You can request up to five years for a more complete perspective on the business, particularly if dealing with a volatile business. This is less common with SMB acquisitions but most Sellers should have the ability to provide this.
☑ Balance Sheets: As snapshots, you should receive balance sheets to correspond with the P&L Statements you received to see changes over time in inventory, accounts receivable, accounts payable, and debt instruments used by the business. You typically purchase the assets of a small business, not the stock, so the debts won’t transfer to you, but you do want to know what it takes to keep the business afloat.
☑ Top 10 Customer Analysis: This request is to see what the top ten customers contribute to revenue as an indicator of customer concentration. This is a key risk measure to consider. If you lose the top customer, or the top three, what does that do to the business? How at risk are you? What are the implications between not earning an income until you rebuild, or cutting back staff, or even more serious ramifications? Put simply, understanding who is paying you is critical to how a business operates and survives.
There are more items you can request, but are not commonly available because of the nature of operating a small business:
- Cash Flow Statements
- Sellers’ Past Forecasts
- Departmental Budgets
- Expense Analysis
Overall, this stage is about collecting raw data. It will be on you to take the necessary steps to analyze that data to interpret how cash flows through the business, gross margins, fluctuations in expenses, and so forth.
Due Diligence Dimension 2: Legal
The legal stage of due diligence involves some basic verifications and data collection, as well as thorough risk assessments.
Here are key topics to handle in legal due diligence:
☑ Entity Documents: Articles of Incorporation, Bylaws, Letters of Good Standing, Annual Reports.
☑ Contracts & Agreements: Confirming partnerships, supplier agreements, client contracts, subcontractor agreements, employment agreements, and any other formal documentation with other parties. You should be concerned with transferability of contracts in the case of a sale as renegotiating contracts could pose a risk.
☑ Licenses & Permits: It is important to understand what licenses you need to have as part of the business operations, how to receive and renew these licenses, and what the sale’s implications are for those licenses and permits.
☑ Lawsuits & Legal Issues: As they say, any business that has operated for at least a few years is likely to have some litigation against them. However, it’s important to know what legal issues have arisen and if and how they were resolved. Look for trends and inconsistencies. If you have trouble trusting the Seller early on, it’s foreboding about the remainder of the transaction, the transition process, and what else may be uncovered after taking over operations.
☑ Lease: If you are using an SBA loan to acquire your small business, as most in SMB acquisitions do, then you will need a lease that spans at least ten years in place to satisfy the SBA’s requirements. You also need to know how that lease may increase or change in time, as rent increases are typically included. If the Seller owns the real estate but wants to keep it and lease to you, a fair lease agreement will need to be created, and you will need to adjust earnings based on normalized rent if they had previously underpaid or overpaid for their business’ lease.
☑ Insurance: Depending on the industry, insurance can be a significant expense. Furthermore, it is something we recommend you take into account during the due diligence process where you can get new quotes and adjust pricing, which typically will rise with a new owner. From the Seller, you want policy documents, loss runs over the past five years, litigation from employees over the past ten years, loss preventative practices for theft, safety protocols and training, and an explanation of any claims. Additionally, the SBA will ask you to have a life insurance policy in place before the loan closes.
In some instances, there are additional areas that you may cover:
- Trademarks & Intellectual Property
- Environmental compliance
- Safety concerns and protocols
Legal due diligence may be the least exciting part of the process. It may also be one of the more concerning, depending on what you find. Aspects like addressing legal issues is best handled early in due diligence to flag major concerns, while some aspects, like insurance estimates, can be handled at a slower pace.
Due Diligence Dimension 3: Operational
You will learn a lot about how the business runs through financial due diligence as you discover how money flows through the business. Operational due diligence is where you get a more practical understanding of running the business.
In operational due diligence, make sure to work through:
☑ Responsibilities to Replace: When the Seller leaves, you need to fill the void in who is handling their responsibilities. The same is true if there is anyone else leaving post-close, such as family members who are employees. Beyond the logistics of making sure these activities are handled, you need to be ready to step into the owner’s shoes, so you should learn early on if you would like to take on what they do in the business. Owning a business is a major commitment–you mine as well pursue something you will enjoy.
☑ Key Employees and Org Chart: Find out who are critical and all-star performers in the business. These are people that you need to retain. Beyond those individuals, you should create an organizational chart for the business so you know the key roles and reporting lines. People are a major part of any business, and knowing those people, how they’re compensated, and how they interact with each other and customers tells a lot about how a business is run.
☑ Tech & Software: Build a list of all softwares and technologies used in the business – from marketing tools to website hosts to phone system providers. Along with what is used in the business, keep track of the costs associated. There are opportunities to save thousands by changing systems. There will also be opportunities to digitize a business, which will take an initial investment. In small business, the technology is often dated and has tremendous improvement potential for a new owner.
☑ Inventory Systems: Identify how they track inventory, when to order more inventory, and how that is handled. Don’t be surprised in a small business if inventory management and when to order is all in the owner’s head. This is something you need to “download” from their brain and systemize, if that’s the case.
☑ Marketing & Sales Processes: Get to know how the business attracts customers. You don’t need to know every step to execute their marketing, but you need to know the steps in the process that your team handles and that customers experience. This is where growth potential can be identified as well by knowing current practices that can be optimized and built upon.
☑ Reputation Review: We recommend that every prospective buyer invests the time to read each and every review of a business. Look to Google Reviews, the Better Business Bureau (BBB), Facebook, Yelp, and anywhere else you can find customer reviews. There is great value and risk in reputation in small businesses. As an additional tactic, review Glassdoor reviews from employees. This can tell a lot about company culture and how the owner operates.
Additionally, you may go into varying levels of depth depending on the target company on topics such as:
- Inventory levels
- Equipment and physical assets
- Standard Operating Procedures (SOPs)
- Assess stability of suppliers
- Review company culture initiatives and employee satisfaction measures
To simplify the operational due diligence phase: what systems are used in the business to manage and run it day-to-day, and how do key stakeholders feel about the company? Answer those questions and you’ll know the quality of the business’ operations.
Due Diligence Dimension 4: Market
The market you operate within involves your target market, the industry, your workforce, and competitors. Knowing these areas inside and out will help you determine where strengths, weaknesses, opportunities, and threats exist in your target business.
For market due diligence, consider the following:
☑ Target Market: Identify your primary, secondary, and tertiary customer segments. Look at rates for customer retention and returning customers. For the big picture, analyze how demographics of the customer base have been changing and project what it looks like in the years ahead based on that segment’s trends in consumer behavior.
☑ Industry: Is the industry facing headwinds or tailwinds? Look to what has changed from ten years ago; and then project how it will change in the next ten years. Ask the Seller for their insight since they’ve lived in the business for so long. For additional insights and data, we use IBISWorld reports to expand our base of information.
☑ Workforce: Observe how their employees are handled and compare with the industry standard. Are staff members properly categorized as W2 employees or as independent contractors? Is the business labor-intensive? What is the average turnover rate? People are a key resource in any business, including small businesses. Consider the current benefits package offered, if any, and see what expectations are in the labor market within the industry.
☑ Competitors: Figure out what the company’s position is in the market, and who the key players are that they compete with. What makes each of them unique? Can you identify the industry leader, the innovator, and the local mover and shaker? Analyze each competitor and the full landscape to understand where the company fits and where it can truly be differentiated.
You might also look to:
- Employee reimbursement policies
- Assessment of employees and Sellers’ ratings of each
- Job market trend reports
- Recent laws passed around wages and benefits offered
Market due diligence covers the four critical stakeholders: those you hire, those you sell to, those you compete with, and those engaging in your industry. This stage of due diligence involves a tremendous amount of knowledge gathering and can build a picture of what the Seller has developed throughout their career. Use this to accelerate your learning as you near the close date on your acquisition.
Due Diligence Dimension 5: Growth Potential
While risk reduction is certainly important, no one buys a business for constant anxiety about risks. They buy because of the inspiration of what could be. Growth Due Diligence is performed to clarify the potential of the business and to help set the stage for how to increase earnings from the business to be used as you see fit: reinvest in the business, increase your take-home income, or pay down the loan debt faster.
Here’s what we look at in Growth Due Diligence:
☑ Marketing Optimizations: Start with quick wins. How do we do what we’re doing now, but better? Existing marketing may simply need new energy and perspective to improve upon. After close, you should continue running the business as it has. If it wasn’t profitable as-is, you wouldn’t be buying it. However, you can start to make small adjustments that compound without massive changes or investments.
☑ Untapped Opportunities: Look for new marketing channels and approaches that can be leveraged in the business. Consider what the industry and competitors have proven successful. Incorporate digital marketing strategies that modernize the company’s marketing strategy.
☑ Expansion to New Markets: Your target markets can be growth by looking at new geographic targeting or different segments altogether. Expanding locations is a logistic challenge, considering where you can go to find the right people while remaining profitable. Expanding to new segments means understanding how to differently position and communicate, where those people are, and how to reach them. Either strategy can provide an exponential increase in the business.
☑ Modernize Sales Processes: We have seen many times a small business that became successful on a sales strategy from a decade or two ago, or longer. Buying behaviors change with the times. An outdated sales style can require training, updated process, tech support, and an integration with marketing. When handled properly, it can also dramatically transform how many leads turn into customers with a direct impact on top- and bottom-line.
☑ Product/Service Portfolio: Looking at the existing portfolio of products and/or services, identify what sells well and what doesn’t. Explore why that is the case for each, whether it’s customer demand, awareness of what is offered, or positioning. If you want to grow, rework your existing portfolio, or even expand to new services you can offer to your existing customer base.
☑ Growth through Acquisition: Post-close, you can say that you have successfully completed an acquisition. You can do it again. Inorganic growth can add fuel instantly to an existing business through an add-on or bolt-on acquisition. An add-on might be through a company acquired that does what you do while expanding your base of customers and employees, while a bolt-on may incorporate a company that may continue under its own banner and may provide a different array of products or services. This is an often overlooked strategy in small business, but if integration is properly handled, it can be an unmatched growth lever.
Other things you may look to can include:
- Industry trends
- Buying behaviors
- Customer acquisition costs
- Automation and systems
- Pricing strategies
- Brand Messaging
Growth due diligence is the most exciting part of due diligence. It isn’t about the risks and concerns–which are vital but not typically optimistic. Your acquisition journey is likely to be one of the most stressful times of your life, and building a bigger picture of what could be ahead of you is one of the ways to balance that stress level with positivity and creativity.
Due Diligence Is As Much About Learning and Identifying Potential as it is Risk Reduction
While most buyers will look at due diligence as reducing the downside and avoiding a bad decision, it’s also a tremendous learning opportunity and a time that you can clarify what the real opportunity is. The optimist, as any business buyer, needs to find within themselves to observe the issues that can be resolved, the untapped opportunities that can be pursued, and the options ahead of them.
Buying a business is a tremendous undertaking, mainly if you have never done it before. It also can unlock a new stage in your life with limitless possibilities ahead of you while being able to leapfrog past the arduous and expensive pursuit of starting a new business from scratch. We absolutely believe in the “entrepreneurship through acquisition” model and love supporting others in their quest for a new, exciting challenge.
About the Author
David is Bbg, Inc.’s managing director. He focuses on driving strategic growth and operational effectiveness. Passionate about helping others be at their best and fostering collaboration, he ensures excellence is seen in the clients we serve and the businesses we operate. Follow David on LinkedIn