Comprehensive Buying A Business Checklist: Due Diligence and More

Not every business offered for sale is worth buying. And that’s not only because a business may have dim prospects; sometimes, it’s just not the right one for you and would be better off in someone else’s hands.

Making the correct choices when purchasing a business is key to reaping optimal rewards while avoiding getting pulled into a money pit. 

Yes, buying a business is an exciting prospect filled with possibilities. Unlike the numerous unknowns that come with starting a new business from scratch, buying a business means someone else has already done a lot of that hard work and tested its viability.

But buying a business can certainly be complex. And you have to plow in substantially more cash upfront than you would if you were starting your own. You must spend plenty of time mastering the internal workings while hoping no major problem is lurking beneath the surface. 

This detailed checklist can serve as a guide in choosing the business that is in your best interest. It is important to note, however, that it isn't a strict checklist. Entries do not carry equal weight. For example, legal documentation and financial statements are much more important than some granular marketing information.

Further, no two opportunities are identical, and no transaction is completely devoid of risk. A key goal of due diligence is to accurately gauge the risk versus the opportunity. 

1. Consider the characteristics of the business you’ll buy

• Is success tied to the owner’s identity? This is important for certain small service-based businesses, such as legal or medical-related businesses. Transitioning clients could prove difficult. 

• Does it match your skills, experience, and industry knowledge? 

• Is it the right size and in your ideal location? 

• Do you want a sole proprietorship, or would you rather oversee a management team? 

• Is demand for the business’s products likely to remain for years to come?

2. Search for a Business to Buy

You can search for businesses for sale in multiple ways. More often, though, you will find one using one of the following channels.

• Online marketplaces for buying and selling businesses, i.e., business-for-sale sites 

• Craigslist 

• Newspaper ads (‘Businesses for Sale’ section in the classifieds) 

• Word of mouth in your social circle 

• Attending industry conferences or professional association meetups 

• Business brokers

3. Understand why the business is up for sale

Plenty of good, healthy, and growing businesses are sold each year. But you want to be certain that the owner is not selling for reasons that could come back to haunt you later on. Some of the questions you should ask include:

• How long has the business been in operation?

• How many owners has it had? You can check the public record at the state, county, or city offices.

• How long has the current owner been in charge?

• What are the biggest challenges they claim to have faced so far?

• What is the overarching trend in the industry? Is the industry growing, slowing, or declining?

Reasons that should give you some peace of mind include the owner’s retirement, illness, relocation, or pursuit of a new challenge.

On the other hand, you should tread cautiously if the reason for selling is low sales, outdated inventory, looming lawsuits, shrinking market share or industry turmoil. A struggling business is not necessarily an unviable business. You just need to have the full picture beforehand.

The owner might not divulge everything about their reason for selling. Therefore, seek out or corroborate the reason by other means. Where possible, talk to customers, employees, vendors, regulators, and nearby non-competing businesses. Run a search of the business and its main products to see if any damaging news shows up.

Either way, include a ’Representations and Warranties’ section in the purchase agreement where the owner guarantees that the information they have provided is accurate and complete.

4. Determine the price of the business: approaches to business valuation

Determining the purchase price for a business is often based on factors such as cash flow, financial projects, assets and expected return on investment (ROI). The following are some of the more common approaches to valuing a business. Note that these techniques are not mutually exclusive. You can use two or more to come up with a price that best reflects the value of the business.

•  Earnings-Based Approach – A multiple of sales or profits.

• Assets-Based Approach – Using the value of tangible assets (such as inventory) and intangible assets (like software, trademarks, patents).

• Market-Based Approach – Using selling price of similar businesses purchased recently. The market value approach is most useful when a lot of data exists on recent business sales.

Remember to take expected ROI into consideration as well. While this varies from one business to the next, you can expect a 10-30% annual return on your investment for an SMB and a 5-10% return for a large business.

You could contract an independent valuation service to help you determine what the business is worth. 

5. Due Diligence Checklist – Financial Information

Once you agree on a price and what will be included in the sale, the seller should issue a letter of intent (LOI) which is a working draft of the final sale agreement. The LOI should contain a price proposal as well as the terms and conditions of the sale. The LOI is a statement that the owner is serious about selling the business and is therefore a license for you to forge ahead with due diligence.

Due diligence is the single most important aspect of buying a business. You will often be required to sign a non-disclosure agreement beforehand just in case you opt not to proceed with the transaction. Financial considerations are the core of due diligence and play an important role in determining the best price to pay for the business or whether to proceed at all.

Elements of financial due diligence include the following (preferably for the last three or more financial years):

• Audited financial statements and most recent unaudited statements – These include cash flow statements, balance sheets, and income statements.

• Growth of revenue and profit

• Accounts payable and accounts receivable

• Federal, state, local, and foreign tax returns

• Debt disclosures such as lines of credit, bank financing agreements and promissory notes. Should include details of any assets used as collateral.

• All U.C.C. filings

• Annual reports

• List, condition, and location of tangible assets, including real estate, inventory, equipment, fixtures, fittings

• List of intangible assets such as trademarks, copyrights, patents, business names, trade names, logos, Internet domains, email addresses, website content, social media accounts, phone numbers

• Inventory quantity and quality (quality includes age, state, market viability,and  past performance)

• Bank statements

• Sales records

• Advertising costs

• Business credit reports where available. From entities such as Dun and Bradstreet, Experian, and Equifax

• Schedule of major equipment sales and purchases over the last 3-5 years

• Financial projections

• Any changes in accounting methods used over the last five years

6. Due diligence beyond the financial documentation

Due diligence does not end at financial considerations. Many things could pose an existential threat to the business even though they do not make it to the business’ financial statements. These include:

Customer Information

• Customer list, including highlights of the largest customers by sales over the past 3-5 years. You might want to reconsider buying a business where 85% of revenue comes from just one customer.

• Sales contracts guaranteeing future business.

• Customer retention and churn rates, including information and explanation of major customers lost over the past 3-5 years

• Customer sentiment – Check customer reviews, where available, on websites such as the Better Business Bureau and Yelp. Request to see the most recent survey of customer satisfaction.

Employee Information

• Organizational chart

• Employee retention and churn rates

• Employee resumes, hire dates, contracts, salaries, bonuses, benefits and retirement plans

• Key employees

• Pending employee entitlements such as leave

• Any non-compete agreements with past employees

• List of employee problems over the past 3-5 years, such as allegations of discrimination, harassment, wrongful termination, and worker’s compensation claims

Marketing

• Market share

• Major competitors

• Analyst reports where available

• Marketing plans and budget

• Marketing channels

• Marketing strategies

• Marketing agreements

• Marketing assets like email lists, domains, and display banner

‍Location

• Condition of the premises

• Proximity to competitors

• Visibility for walk-in customers

• Zoning law compliance and variances

• Compliance with environmental regulations such as hazardous substance use and disposal

Legal Documents

• Organization paperwork, including articles of incorporation, articles of organization, bylaws, minutes, resolutions, and any amendments to these.

• A certificate of Good Standing from the state that the business is incorporated, meaning it is up to date on state taxes, fees, and required filings.

• List of company shareholders and the shareholding of each

• List of suppliers and supplier contracts

• List of distribution agreements

• Business and asset insurance policies, including general liability, product liability, and worker’s compensation. List of the business insurance claims over the last three years.

• Business permits, licenses, and consents

• Any documents or correspondence relating to past, current, and threatened lawsuits and government/regulatory action.

• Asset, equipment, and office space leases, including confirmation that payments are up to date

• List of existing products, product information, and products under development, including tests, evaluations, surveys, studies, and other data.

• Intellectual property documents such as patents, trademarks, copyrights, licenses and registrations

• Partnership, joint venture, or subsidiary business relationship and obligation agreements

• Summary of warranty claims

• Non-compete agreements

• Non-disclosure agreements

• All other material contracts

7. Negotiating Phase

It is unlikely that the first price you bid will be accepted. There will almost certainly be some negotiation as you and the seller look to come to a mutually acceptable agreement.

Work with advisors

To make sure all your key bases are covered, have the right advisors on your team during negotiation. At the minimum, you should have an attorney and an accountant. An appraiser and an industry expert would come in handy as well. If you intend to finance the purchase with a loan, get your banker on board, too.

Advisors will cost you, but such fees pale in comparison to the consequences of making a wrong buying decision. If you are considering buying a business, sign up for our Operator Network for access to value-added services, valuation advice, and even bank financing assistance. 

8. Business Purchase Financing

Once you have identified a business you want to buy, you must think about how you will pay for the acquisition. There are multiple options.

Debt financing

• Term loan – A conventional loan that you pay back with interest over a fixed period. Banks often require that you put down 20-25% of the loan.

• Asset-based financing

• SBA 7(a) loan – Unlike term loans, Small Business Administration (SBA) loans require as little as 10% down payment. Of this, only half (5% of the total) has come from your own pocket.

Personal savings or family money  

Seller financing – Paying the business’ owner in installments for a fixed duration

Partnership – Partnering with someone else to buy the business.

9. Finalizing the Deal

Concluding the transaction will typically involve signing or taking ownership of the following.

• Bill of sale, which officially transfers ownership to you

• Adjusted purchase price, which is the final cost of the business

• Intellectual property

• Non-compete agreement

• Building lease

• Vehicle documentation, including, if need be, transfer of ownership

• Consultation agreement if the owner will be staying on to assist in running the business

• Asset acquisition statement for tax purposes

• Compliance with bulk sale laws

• Transition or integration plan with timings, milestones, and responsibilities

• Copies of any correspondence between you and the seller

Conclusion

Buying a business instead of starting your own can be a smart financial decision or a disastrous choice. From the get-go, you need to be clear about what it is you are getting into - from start to finish. The more thoroughly you step through the stages, the better your chances of having made the right decision.

Information posted on this page is not intended to be, and should not be construed as tax, legal, investment or accounting advice. You should consult your own tax, legal, investment and accounting advisors before engaging in any transaction.