Business Due Diligence
Business due diligence is the examination of a company that you are considering buying. This post is going to discuss micro-business due diligence. 
75.3% 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. 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 different 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 company is usually a more cost-effective and safer way to acquire and grow a business.
What We Want in An Ideal World 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 months 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
Building a Relationship With The Business Owner
Most micro-businesses will not have many of these documents, but that’s ok and the purpose of these posts. The most important thing is to build a relationship with the owner of mutual respect and trust to the extent possible. We must be very observant of what is said, what we see, and whether it all adds and makes sense. Do you get inconsistent answers? Do things conflict with other representations that make one statement “untrue”? We are buying the person who is reflected in the business. Part of due diligence in a micro-business is trust in the owner. A dubious owner is a red flag and should be a sign to walk away.
Information You Must Get for Business Due Diligence
The above-mentioned 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. Alternatively, you may need to rely on getting 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
Due Diligence Questions To Ask The Seller
When you have a business that looks good enough to get a Letter Of Intent, you have not committed to anything, but you will be considered a serious buyer. Start with this list of twelve questions for the seller. It allows you to ask the 12 questions below to get insightful responses. 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 a ton of information, and it can be a challenge to keep track of it all. Take notes!
1. Why are you selling?
Commonly stated reasons for selling include a well-earned retirement, failing health, etc. How do you know they’re telling the truth? Well, you don’t, but most people don’t decide this overnight – if the business has a solid history and a profitable future, the owner should be able to provide you with a timeline for their preparation for sale.
2. 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 if you can, it’s worth understanding more about the calculations used to reach the asking price. The usual valuation methods use asset-based or income capitalization methods, but multiplier valuation methods can be a more accurate gauge of small business value.
3. How would you grow the company?
You could gain essential insights into the business’s potential by quizzing your seller on these points. 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 may want to reconsider your position if the seller has tried many different things without success.
4. 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 several outcomes in mind. 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 payment terms, which could help you to transition the company more effectively.
5. 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 company within a fixed period or a specific location.
6. Who are your key customers, suppliers, and staff?
These factors could be critical to the business’s continued success, so it’s worth understanding how dependent the company 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 on a sticky wicket.
7. Are you willing to stay on for a transition period?
The transition period can be quite a significant point. If you’re nervous about running the business successfully in your early days as boss – or are maybe new to the industry and need some in-job training – it could be worth your while to offer the current owner an incentive for staying on to help transition the business.
8. 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 company – 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. Ask if they take holidays, too!
9. 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.
10. What are you paying yourself?
Assuming you want to take a salary at some point, it’s worth asking just how much the current owner is managing. It may give you pause for thought! Some business owners don’t pay themselves much, so their bottom line looks better than it is.
11. 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?
12. Who is your least profitable customer?
Some owners will have financial records showing their least customers, but many won’t. This usually leads to excellent follow-up questions or a better look at the metrics the business is tracking.
Negotiating & Due Diligence
Due diligence is taking a deep look under the hood and gathering information to ensure the business is the deal that was originally presented. Most deals don’t look as good when you take a close look, so this becomes an opportunity to modify your offer and negotiate based on your findings. In the rare case the deal is better than you thought, it is wise to close it as soon as possible before it gets away. If the company isn’t what you thought it was, negotiate based on new findings or walk away.
Conclusion
Take business due diligence seriously. Make a mistake here, and you may suffer serious financial loss. Many micro-businesses can be like jobs that don’t pay well with long hours. You are looking for what is beyond tax returns and financial statements. The owner usually self-reports tax returns and financial information, so we must verify the information with other sources. Get a professional to help you with due diligence if you have doubts about doing it correctly. Even seasoned entrepreneurs can use an extra set of eyes when doing due diligence. If you want a shortcut to due diligence, read the “do due diligence” bathroom shortcut approach.