Questions to ask when purchasing a small business

In the words of Donald Rumsfeld, there are “unknown unknowns” when buying a business for the first time. The goal of this guide of questions to ask when purchasing a small business is to help prospective business buyers make these “unknown unknowns” into “known unknowns”. Once you have a roadmap of the questions you should be asking, you’ll have a better chance of avoiding a dud business acquisition and you’ll feel more confident as you approach financing and potential investor conversations.

Before going into our list of questions to ask, let’s first set the stage. The art of asking questions before buying a business is referred to as “due diligence”. Typically, this period of “kicking the tires” happens before and after submitting an offer for the business. 

You can think of the first round of due diligence as determining whether to make an offer and with what terms. That is, should you submit a letter of intent to buy the business.

The second round of due diligence is much more involved as it will shape (a) whether the deal occurs, (b) what terms are made binding in a purchase agreement, and (c) how you approach transitioning into the owner’s seat.

What does due diligence for a small business look like?

There are a number of ways to break up due diligence, but it typically covers all the areas related to the business.

• Legal due diligence: Is this business in good standing? Is it current on any taxes due? Is it appropriately licensed? Are the employees all above board? Having a good transaction attorney will assist a buyer with completing legal due diligence.

• Financial due diligence: This covers the business’s finances. It can involve analyzing tax returns, bank statements, Quickbooks, and more. Oftentimes, a buyer brings in a CPA or Quality of Earnings provider to assist in modeling out the true historic cash flow of the business.

• Operational due diligence: This approach to due diligence focuses on fully understanding how the business operates. Are there crews? How are routes planned? We recommend to “follow the part,” a common approach in manufacturing to diagnose issues from start to end.

• Owner due diligence: It’s core to understand the current owner’s motivation when selling a business as well as how transferable the business is. A big hack for this is being able to shadow the owner for a day.

• Customer due diligence: The goal here is to understand how customers are acquired, how often they churn, what are the contract terms, and is there any risk for a new owner. Customer concentration is often a core consideration here.

• Transition due diligence: This section of due diligence focuses on the process of transitioning ownership. The ideal outcome is a detailed transition plan with an understanding of any costs or balance sheet changes that will result from a sale.

Who is involved in due diligence?

Although there are exceptions for seasoned acquisition entrepreneurs, a business buyer will almost always be working on due diligence with her legal counsel and lender. 

Often times, other professionals may be engaged (especially for larger acquisitions):

• Quality of Earnings (QoE) provider: These professionals perform due diligence on the financials to uncover any red flags.

• Industry veterans: Some buyers want to engage an industry vet to help them better understand whether the business is performing at or above average as well as to build a bank of due diligence questions that are specific to that industry.

• CPA: Regardless of whether you choose to hire a QoE provider, many buyers will engage their accountant to help them understand the finances.

• Inspectors: For businesses that own a lot of heavy equipment, buyers will often hire a vehicle inspection firm to perform quick pre-purchase inspections. This typically happens after an LOI has been signed but before closing. The same is true of any real estate.

Readiness: Important questions to ask yourself 

These questions should be “go / no-go” questions before proceeding with further due diligence. If you cannot confidently answer these questions, there’s a chance this business is not a good fit.

1. Why buy this business? There are always multiple acquisition targets. What is it about this business that stands out? What is unique about it?

2. Why not build one from scratch? What are the businesses competitive advantages? Although many entrepreneurs are committed to buying instead of building, it’s important to still ask the question.

3. How does this business align with my skills, goals, and requirements? Some businesses simply aren’t a good fit for a buyer. Perhaps the hours are long, hands on, and grueling. Or, maybe the owner’s role requires a lot of sales – something the buyer does not enjoy. It’s important to be honest as buying a business is just the start of a journey that often stretches decades.

4. Am I culture fit for the existing team? Jumping into a small business can be like jumping in the trenches. You’re shoulder to shoulder with your team day-in and day-out. Make sure you like them. 

Legal Due Diligence: Questions to ask an owner when buying a business

While most of legal due diligence will be done by a business attorney, there are some questions that are worth asking the owner and his team.

1. Has the business ever had any liens or been delinquent on taxes? Prior issues with the IRS indicate two things. First, there’s likely an increased chance of an audit in the future. Second, it shows that the owner may not be on top of the ball with the backoffice. If he has been delinquent on taxes to the federal government, he may have other issues under the hood.

2. Have you ever been sued? Or sued someone else? Businesses get sued. That’s a fact of life. However, it’s important to understand how litigious of an industry you may be entering. Are customers often trying to avoid paying? Do suppliers sue if late on payments? Is it an industry like children’s entertainment, which is prone to injury and lawsuits?

3. Do you have any pending litigation currently? Pending litigation is not a deal breaker, but it will often hold up a speedy close of the business acquisition. Get ahead of this sooner than later. 

4. Do you run an I-9 verification process for your employees? This helps you understand the HR processes in place and whether there will be any issues with unauthorized labor.

Financial Due Diligence: Questions to ask about finances when purchasing a business

A lot of financial due diligence will be done in Excel and with the assistance of a CPA or QoE provider, however, there are some questions still worth asking of the existing business owner.

1. Is revenue growing or shrinking? Why? Broad revenue trends are important as they often indicate what’s happening under the hood. Has a new competitor moved into town? Is the owner deliberately declining work?

2. How did the business perform during COVID? The ‘08 recession? Most buyers want to purchase recession resistant businesses. By looking back at prior dips in the economy, you can see how the business performed when things went sideways. A good follow up is to ask the owner if they would have done anything differently. 

3. What are the company's assets? Some companies own a lot of heavy equipment. If this is the case, you’ll want to know the state of the equipment, how often it needs to be repaired or upgraded, and which service provider the company uses to do that work. The last thing you want to do is buy a business and then spend another $100,000 on capital investments into equipment in year one.

4. What are the company's liabilities? What type of long-term debt does the business have? Why? What type of current liabilities (less than 12 months) does the business have? Does the owner have any lines of credit to assist with working capital? Any equipment or vehicle loans will need to be paid off at a close, which can take time to do.

5. How far back do you have financial statements? Most brokered businesses for sale will provide three years of financial statements along with the current year to date. Many owners may have financial statements that go back more than three years. Getting access to these can help you understand the arc of the company and dial in the valuation which you’re comfortable with.

6. How cyclical is your revenue? Some owners have a strong pulse on their business. For instance, tree services companies in the Northwest often take the last few weeks and first few weeks of a year off. Understanding these patterns will help you identify the best close date.

Operational Due Diligence: Questions to ask about operations and personnel when buying a business

The right questions on operations should leave you with a strong understanding of how the business operates.

1. What’s the first thing you check in the morning? At night? This helps you understand the important systems in the company as well as what is top of mind for the owner.

2. What is the organizational structure? Try to get a sense of each employee, how long they have been there, their role, and how critical they are. You may uncover some employees who will need a promotion, others who may need to be let go.

3. Who do people turn to when you’re out? This is a great question to understand who the natural leader is in the business. You will want to lean on this person and really empower them if you ultimately close on the business.

4. What is the thing your employees complain about the most? As part of any business plan for a new owner, it’s important to invest in the employees. They will be nervous, scared, and stressed when the sale is announced. That’s only natural. By planning a few improvements to their average day, you’ll be able to get some wins and earn their trust that you care about them.

Owner Due Diligence: Questions to ask of the current owner when purchasing a business

These questions will help you negotiate the transaction as well as plan for a potential transition. It’s best to ask them when the current owner is away from the office, as some may be somewhat private.

1. Why do you want to sell now? This gets at the motivations for the seller. Is there a life event that is expediting the sale? Do they feel they’re selling at the top? Do they give an unclear answer, which may mean they’ll drag their feet?

2. Have you considered selling before? Many owners have explored sales in the past – either a transition to another employee or a botched transaction with a third party. Understanding what went wrong will help you from wasting your time or allowing it to be repeated.

3. What’s most important to you in a transaction? The best approach to asking this question is to give the owner a few things to pick between: price, speed, buyer.

4. What do you plan to do with the proceeds? This will help you understand how much they need payment in cash. Some may just want to invest the money, which means you have a better chance of negotiating for some amount of seller financing.

5. What is one thing you don’t want changed? You’d be surprised at how often business sellers assume that a new owner will change the name, fire the employees, and more. This question will allow you to understand how to best reassure the seller.

Customer Due Diligence: Questions to ask about the customers when buying a business

Most businesses being bought and sold are service businesses. When this is true, it’s critical to understand customer concentration and how you can grow revenue through new clients or revenue expansion within your current client base.

1. How has your customer base changed over time? The owner may have deliberately taken on certain clients and that is important knowledge to have.

2. What customer are you most worried about losing? The best answer is none of them, but phrasing the question like this drives to an answer. You can also better understand the common causes for losing customers.

3. If you had to sign on 5 more customers this month, how would you do it? This will give you a sense of the company’s competitive advantage. Would they keep dropping prices? Expand into a complimentary business line? Add to the sales force?

Transition Due Diligence: Questions to ask when taking over a small business

This section typically comes later on in due diligence once a deal has moved from “maybe” to “probable”. The questions here should result in your transition plan, which covers the first 30-60 days of life as the owner of your new business.

1. How often do you take vacations? Walk me through what happened during your last one? This is a great test for how resilient the business will be under a new owner as well as how transferable it is. 

2. What is the hardest thing to teach? This is important. Many owners are involved in responsibilities that require a mix of science and art like estimating or bidding. Working backwards from what’s most difficult will help you build a plan, whether that’s a longer consulting period with the previous owner, hiring a third-party 1099 contractor to handle a responsibility, or asking the owner to train up an existing employee.

3. Are you interested in being involved after the close? We’ve seen instances of a previous owner becoming a rockstar salesperson for the new owner. By better understanding their appetite, you can structure a performance based compensation plan to get them a higher total payout without changing the purchase price.

Frameworks to use when considering buying a business

There are many frameworks to use when performing due diligence on a potential business acquisition. Here are a few that we recommend checking out:

• GWC: Get it, Want it, Capable to do it

• Built to Sell: Teachable, Valuable, Repeatable

• Porter’s 5 Forces

• SWOT Analysis

While this guide to the questions to ask when purchasing a small business may seem overwhelming, rest assured that this process will unfold over many conversations with the owner and your advisor.

Of all the sections, the most important is the readiness section. The success of a business acquisition depends heavily on the searcher buying the business. If you’re not all in today, it’ll be tough to engage when things inevitably go sideways. After all, in small businesses there is rarily a dull moment.

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.