How to Do Business Due Diligence on a Micro-Business
This post will discuss performing business due diligence on a micro-business and its challenges. 75 % of businesses are micro-businesses, according to the U.S. Small Business Administration. A micro-enterprise is a company with nine employees or less with less than 1.5 million dollars in gross sales. These businesses tend to have incomplete financial records, which require special skills to analyze and conduct due diligence.
Working With Minimal Financial Statements
Micro-business owners may only have tax returns with no other “reliable” financial reporting. And the tax returns may not be accurate, so you must use other methods to get a reasonable idea of the business’s financial performance. Many would say walk away, but that excludes too many companies that can provide substantial income and be made more profitable. Buying an existing business is usually a more cost-effective and safer way to acquire a business. Gaining the skills to buy a business will become more valuable as baby boomers retire in large numbers and are forced to sell due to their age and desire to retire.
What Information We Want in a Perfect World To Perform to perform Due Diligence
We generally want to see a minimum of 3 years of financial reporting for the various financial statements below. We also want to see the last 24 financials by month.
- Three years of tax returns
Profit & Loss
Bank Statements
Bank Reconciliation
Account Receivable
Accounts Payable
Statement of Cashflows
Customer List by Sales
Expense by Vendor
Payroll Reports
Journal Entry Adjustments
All Agreements with Customers, Vendors, Employees, Etc.
Timesheets for Employees
Company Debt
Owners of the company
Micro-Businesses Will Likely Be Missing Documents
Most micro-businesses will not have many of these documents, but that’s ok because this post will discuss how to perform business due diligence with less-than-perfect records. The most important part of due diligence is building a relationship with the owner based on mutual respect and trust. Be very observant of what you see and what is said. Does it all add up and make sense? Do you get inconsistent answers? Does anything conflict with representations that were previously made? You are buying the person who is a reflection of the company you acquire. Part of due diligence in a micro-business is being able to trust the owner. An untrustworthy owner is a red flag and should be a sign to walk away.
Information You Must Get for Business Due Diligence
This is the minimum you need to perform due diligence. If the owner uses Quickbooks or some accounting program, you should have most of the data in the files. You may rely on reports from the point of sale (POS) or other sources. Be creative and know that the more challenging it is to get the information, the less competition you will have because most have already walked away.
Tax Returns
Cash Register Tape (Digital or Paper)
Bank Statements
Accounts Payable
Accounts Receivable
Payroll Reports
Company Debt
All Agreements with Customers, Vendors, Employees, Etc.
Timesheets for Employees
Customer List by Sales
12 Questions To Ask The Seller
When you have a target business that warrants a closer look, it is time to move forward with a Letter Of Intent (LOI). A LOI is not an agreement to buy but an acknowledgment that the significant terms of a possible deal are mutually agreed upon. This justifies the investment of time to begin the hard work and commitment of both parties to begin the due diligence process. Use the 12 questions below to gain insight into the company. You can ask these questions at any time, but they should be asked before the conclusion of due diligence. You are not just listening to what is said but how it’s said. Are questions being answered with clarity and factually, or are the answers vague and non-conclusive? You may also repeat the same question phrased differently to confirm that you have drawn the right conclusions. Buying a business is intense, and there is enormous information to analyze.
Why are you selling?
Commonly stated reasons for selling include a well-earned retirement, relocation, partner dispute, failing health, etc. How do you know they’re telling the truth? Well, you don’t, but an examination of the business will give some an indication or confirmation of their reasons for selling.
How have you arrived at the asking price?
Naturally, suppose you move ahead with the purchase. In that case, you’ll be performing your independent valuation process, but it’s worth understanding more about the calculations used by the seller as they might be helpful in negotiations. The seller may be using incorrect methods or assumptions that you may be able to show and argue for a more accurate price.
How would you grow the company?
See if the seller will give you some specific strategies for growing the business. If they share their ideas with you, ask why they haven’t executed the plans themselves. You can gain insights into the business’s potential by quizzing your seller on these points.
What outcomes are you looking for beyond price?
It’s natural to assume that your seller is just after the best price. But you may be wrong, and the seller could have other outcomes in mind that aren’t financial. These may include wanting to see the business develop and grow or continuing to provide a stable workplace for employees. If this is part of the equation, your seller may be willing to be flexible over terms, which could help acquire the company easier.
Are you willing to agree to a non-competition clause?
No buyer wants to acquire a business only to find the former owner is preparing to launch a new one, poaching all their previous customers. In this case, you may as well have started your business from scratch. Ask if the seller is willing to sign a clause to agree they won’t set up a competing business within a fixed period or a specific location. This is a deal breaker if the seller refuses to sign a non-compete agreement.
Who are your key customers, suppliers, and staff?
These factors could be key to the business’s continued success, so it’s worth understanding how dependent the business is on certain customers, supplier relationships, or staff expertise. You can’t count on their contribution unless customers and suppliers are tied into a contract. And if the business’s expertise rests with one or two key employees (possibly including the current owner), you could be at risk.
Are you willing to stay on for a transition period?
This could be quite a significant point. If you have concerns about running the business successfully as the owner’s early days, you may benefit from a longer transition period. It may be worth offering the current owner an incentive for staying on to help transition the business.
How many hours a week do you work in the business?
If you’re concerned about your time commitment to the business, this is an important question. If you plan to run it as a part-time venture – possibly alongside another business – it’s worth finding out how many hours the current owner logs each week. The answer will usually be understated, so find other ways to confirm the facts.
What are the biggest challenges in the business right now?
Most business owners will be prepared to talk about the challenges they face in the current market – and if they’re not, think twice before proceeding. No business is immune from competition or economic conditions, so don’t be afraid to ask questions about your seller’s strategies to stay ahead.
What are you paying yourself?
What the business earns for the owner is the most critical piece of information. Almost all calculations will be based on company earnings. Tax returns tell part of the story but not the whole story. You must also know what addbacks were used. Add backs are any non-financial item that reduces taxable income. It may also include discretionary expenses that are unnecessary to operate the business and is an owner’s benefit. It may be a luxury car or travel that is categorized as a business but was at the owner’s discretion and had little o no impact on the business.
Who is your most profitable customer?
This question allows you to get insight into the sophistication of the seller concerning sales. Do they track detailed metrics on spreadsheets and computers, or is it all in their head?
Who is your least profitable customer?
Some owners will have financial records showing their least profitable customers, but many won’t. This usually leads to excellent follow-up questions or a better look at the customers and the metrics the business is tracking. Don’t worry if the owner has little or no knowledge of these details. Your job is to find the answers and use them to make informed decisions.
Confirming Business Potential
Business due diligence is the process of confirming that the business has the potential you originally thought it had from the initial review. After due diligence, some deals have more or less potential than initially thought. Change the offer or terms to match the findings from due diligence. Negotiation isn’t over until the purchase and sale agreement is signed and the due diligence period has concluded. If the company isn’t what you thought it was, negotiate based on new findings or walk away. Schedule a free call with us if you have any questions about the business due diligence process.
