Buying a Business: Due Diligence Checklist

There are countless benefits to buying an existing business, including better financing options, an established clientele and reduced start-up time. However, the success of the acquisition greatly depends on a comprehensive analysis of the business, also known as due diligence. For buyers, the due diligence process verifies you are buying what you think you're buying, ensures a fair price, uncovers issues early and increases the likelihood of a successful acquisition. Because it’s a complex and intensive process, it’s ideal to have your attorney and your accountant support you through this process. With their areas of expertise, they’ll be able to identify areas of concern and help uncover any issues. In this post, we’ve compiled a thorough due diligence checklist to serve as a guide.

Transparency

Beware if a seller or broker limits your access to key employees after you have received a commitment for financing. While it’s unlikely a buyer will receive unlimited access to the seller’s team, your team's ability to go in and ask questions of all senior management prior to closing allows you to conduct quality due diligence. It’s important for both parties to determine a mutually agreed upon time to meet with key employees early enough to adjust deal structure if the borrowers team identifies significant risk in the discussions.

Dependencies

During due diligence, it's vital to be aware of potential dependencies. Dependencies can exist from the seller, key employees, vendors, or even customer concentrations, to name a few. For example, a common reliance is for the business's success to be tied directly to the owner-manager or key employees.

People don't have infinite lives, and companies can live longer than their founders. Therefore, owners must consider transition strategies to maximize a company's value and ensure scalability.

Customers

Ensuring the customer retention rate is critical during the due diligence phase. The buyer should unearth how the seller runs the business and the client's expectations. It could be beneficial to schedule meetings with several significant clients to gain insight into their expectations and goals and whether they'll remain a client after the transaction. They are in no way obligated to transfer their business to the buyer. Additionally, make sure you have a clear understanding as to why the owner is selling. Ask the right questions to confirm that you aren't inheriting unsatisfied customers.

In addition to customer satisfaction and retention rate, another consideration is customer concentration. In general, the more diverse the customer base, the better. Concentrations always increase the company's risk, even with top-quality customers. Examine what percentage of sales the top customer accounts for, as well as the top five and 10. Even better, see if you can find out how much each of these contributes in terms of profit. If the top three clients account for more than 35% of the total, run a financial projection if two are lost the day after you close. If the business can still cash flow adequately, it is still a deal worth considering. Have the seller call the top customers with the buyer on the phone to see the relationship's state and their plans to use the company in the future. Consider a seller note tied to retaining a key customer/event for the business. If the customer/event is not retained in the following year, the note should be forgiven to right-size for the loss. 

Stability

Ask for the top 10 customers' sales volume over the past three years. Are most increasing? Are the names the same year after year? If so, it shows the company is providing a good product or service and should have a more stable revenue base to grow from. Conversely, if customers drop off, find out the reasons why. Does the business have new competitors? Are there product quality issues? 

Quality

Some companies may lower their credit standards to increase revenues and profits before a sale. Therefore, examining the Accounts Receivable (A/R) ageing is vital, especially examining accounts aged 60+ past the invoice date. If more than 10% of accounts are over 90+ days, it may indicate a poor-quality customer base.

Seasonality

Get a quarterly historical pattern of revenues. Then, ensure there is enough working capital in the buyer's budget for these normal seasonal fluctuations in the business.

Cyclicality 

How susceptible is the business to an economic downturn? One way to gauge is to ask for financial statements from 2007-2010 to see what impact the last recession had. Can the company survive a similar decline in revenues and profits from the current run rate once the acquisition debt is on it? If the company does not have records from that time, investigate the typical cycles of the customer base.  
 
For example, Live Oak will not finance any business tied to new housing starts. Historically, new residential construction dips to very low levels in a recession. Test the target company's cash flow. How far can revenues and margins decline (typically both drop in a recession) before the company can no longer serve its obligations?

Revenues pulled forward 

Sellers may be tempted to sell very hard just before a sale, especially if they keep the A/R as part of the purchase agreement. They can offer customers discounts or other incentives to book sales before closing. If they do, the buyer may experience a revenue "trough" right after closing. We have seen this behavior in many deals we have financed. Usually, a company recovers from it, but it makes the first few months of ownership very stressful. To prevent this, ask for a monthly sales report each month before closing. If you see a spike, dig in and understand why.

 
Coasting to the finish line

The company feels a similar impact to the revenues pulled forward if the seller loses focus on driving sales in the period leading up to the sale. The buyer can experience a revenue "trough" due to the lack of leads and sales activity. To monitor this, ask for the historical sales pipeline of the company or how the company tracks future orders. Ensure you don't see a sharp decline in the months leading up to the sale.

Verification of revenues

To verify revenues, at minimum, we suggest that the buyer's CPA conduct a reconciliation of the business deposits over the past year (from copies of the bank statements) to the reported cash revenues for that same period. This is one of the most common complaints we hear about early problem loans. The buyer says that the revenue/customers represented by the seller were overstated. We get tax transcripts from the IRS to verify the seller's tax returns, but more due diligence is needed to confirm that those numbers are accurate.

Inventory

Verify the inventory being purchased is salable. If the seller is willing to sell a large portion of inventory as part of the transaction, ensure that the inventory is not obsolete and has not been sitting on the shelves for a significant period. Study the company's normal cash conversion cycle and inventory days/turnover. Also, verify that the industry has no supply chain issues and that you can get all inventory needed to run the business. Finally, remember to look for any vendor dependencies or concentrations that could cause problems down the road.  

Employees

What has the seller's role been with the company? If the seller has been passive, they can be replaced. However, the transition becomes vital if they hold key relationships or specific essential knowledge of the product or service. Consider a contingent seller note to ensure their continued interest during a transition period if they are important to the business. For example, are there special licenses required to do business? On a side note, explore why they are selling. If the seller is still relatively young and is leaving to pursue "other interests," beware. 
 
Additional questions to consider regarding employees:

• Who are the other key employees?
• Who holds the relationships with the customers?  
• Are these people tied to the company through non-competes/non-solicitation agreements?
• Are they aware and supportive of the sale?
• Are there pending retirements?
• Have any key employees left in the past year?
• Does the seller or any employees hold licenses that are required for business operations?
• Who possesses the technical knowledge to run the business? The buyer should consider incentives to keep these employees with the company.

Margins & cash flow 

Most companies trade on a multiple of earnings before interest, taxes, depreciation and amortization, referred to as EBITDA. In most cases, the reported EBITDA is "adjusted" by the seller to reflect "normalized" operations. Therefore, a vital piece of due diligence is verifying any adjustments.

Addbacks

Many adjustments to the reported EBITDA are valid addbacks. However, to be valid, they must be quantifiable and verifiable. For example, the seller's salary (assuming they are leaving the company) is a valid addback. It can be quantified and verified through the company's tax return, payroll journal or W-2.

Trend analysis

Seek to understand significant changes in margins or sales. Beware of situations where the margins (or sales) significantly improved in the most recent period. If the reasons aren't well-defined and verified, consider basing the valuation on the average margin over the past few years. Remember, in cash basis accounting, not paying your bills can lead to higher reported profits. Make sure you examine the company's accounts payable to guard against this. 
 
Many of the business trends will be driven by market trends, so it is important to understand the demographics in the area and industry trends. What are the demographics of the area? What competition do you face in your local community? Is the local population growing? 

Equipment

Do a physical inspection of all equipment. Is it in working order? Is a clear equipment list included in the purchase agreement?

Working capital

In almost all cases, the seller retains all cash in the company and pays all funded debt of the company. In a stock purchase transaction, the working capital (accounts receivable (A/R) + inventory – Accounts Payable and other current accrued liabilities) should be set at a normalized level. A "target level" is sometimes set, and the difference in working capital at closing can lead to a slight increase or decrease in the purchase price. Typically, the seller should not retain the A/R in a stock transaction. In an asset purchase, the A/R may or may not be retained by the seller. If the seller retains A/R, this will effectively increase the overall purchase price since you will need cash to fill this initial hole in the balance sheet after closing. Make sure you factor this in when agreeing upon a purchase price. This is an area where a seller may attempt to get more than what their company is worth by tacking on A/R. 

Once the due diligence phase concludes, you should have a clear understanding of whether this business is a good investment or one that you should walk away from. It’s a critical component of the acquisition process and allows you to fully understand your target business. While you may never find a “perfect” deal, due diligence allows you to identify any risks and properly mitigate those risks before buying. Your due diligence can help you negotiate the purchase agreement and set yourself up for a smooth ownership transition process.