Due Diligence and You—When it Comes to Business Acquisitions, it's NOT Just for Your Lender

So you’ve found a business you’d like to buy.

You’ve done a basic surface check, and everything looks fine. Now, it’s time to dig deep and make sure everything looks good before you sign the papers. If your business was a used car, this would be the “I’m checking to make sure I’m not buying a lemon” part. In the SBA world, we call this process “due diligence.”

Due diligence is the time and effort you and a business broker or other financial advisor take to scrutinize your purchase and determine exactly what you’re getting. It isn’t glamorous; a lot of due diligence consists of double-and-triple-checking paperwork. But it’s worth it.

To start the process, you need two forms: the letter of intent, and the confidentiality agreement. The letter of intent outlines the proposed price and purchase terms, as well as the conditions of sale. The confidentiality agreement ensures that you, as the buyer, won’t use the company’s private and financial information for any purpose other than determining whether or not to buy the business. With those in hand, you’re ready to dive into the seven areas of investigative work.

One: Financial

Start by reviewing the past three to five years of financial statements for the business. Look for profitability, trends, and positive cash flow patterns. Your SBA lender wants these forms prepared by a professional, reputable CPA firm—not the business itself.

Next, examine tax returns for the past three to five years to determine revenue and any outstanding tax liability. Accounts payable and receivable schedules, credit reports, and general ledgers can also help you determine the business’s overall financial health.

Two: Organizational

Ask for a copy of the business plan. For SBA lenders, a strong business plan is an indicator for success. Review it carefully, paying close attention to the management, operations, and financial structure of the business. Look for weak spots. Create a written plan for addressing those weak spots, and be ready to discuss those changes when you sit down with your loan officer. Since business plans play a key role in SBA loan approval, you want to make sure this is airtight.

Aside from looking at the business plan, there are other documents to review which outline the company’s organization. These docs include:

  • Articles of incorporation
  • Bylaws (and any attached amendments)
  • Minute books
  • Organizational charts
  • Shareholder lists and breakdowns of shares for each
  • Certificate of Good Standing from the Secretary of State
  • Locations and states where the business is located
  • Previous names (if any) and copies of registrations

Three: Collateral

Many SBA lenders require the borrower to provide collateral for each loan, so it’s important to know what your business can offer as collateral. Start by calculating the value of any real estate. Review copies of real estate deeds, leases, and mortgages.

As you evaluate the property, you’ll also want to review the zoning or environmental requirements for your location. Are you subject to any environmental audits, and are there any special permits or licenses required? Review any title policies, surveys, and zoning approvals for the location.

You’ll also have to value any smaller physical assets. Look at all fixed assets, equipment leases, and other major equipment purchased. Evaluate the worth of the furniture, fixtures, and inventory that come with the business.

When you know what assets your potential business has, you’ll be able to better gauge what you have to offer as collateral on the loan before offering up any personal assets, like a home.

Four: Intellectual

Ask for a schedule of all domestic and foreign patents, trademarks, and copyrights. Trade secrets, agreements, and any claims regarding intellectual property should also be given for evaluation. Depending on your lender, they may require separate documentation showing the transfer of intellectual property to the new owner.

Five: Customers

SBA lenders want you to know your market. Request a list of the largest customers and their sales records—as well as any supply agreements connected with them. Examine the company purchasing and credit policies, any outstanding orders, and any recent major losses.

Evaluate existing strategies for bringing in new customers and familiarize yourself with any advertising campaigns, marketing plans and materials. Know your competitors, and have strategies to strengthen and grow your customer base in spite of the competition.

As you meet with your SBA loan officer, showing that you’ve done your research and you know the market gives you an advantage. If there are weak spots in your acquisition, knowing how to address those weak spots speaks to your leadership and management abilities and increases a lender’s confidence that you’ll run a successful and resilient business.

Six: Human Resources

Finally, review the staff and employee resources you’ll have once you own the business. Know your employees and their positions, salaries, and years of service. Review the current employee handbook, benefit programs, and existing retirement plans. Be aware of any employee problems that have occurred during the past three years (harassment, discrimination, labor disputes, grievances, wrongful termination, etc). Again, the more you know, the better you’ll be able to make a smart purchasing decision and defend that decision when you apply for your SBA loan.

Having done a thorough “mechanic’s check” for your business, you now know exactly what you’re getting into. You’re ready to make an offer. Which means you’re ready for the last stage in your investigative process: price.

Seven: Price

Valuing a business is crucial, but tricky since different businesses lend themselves to different methods of valuation. Your lender will chose an independent third party to perform the appraisal—encouraging objectivity—but it’s okay for you to ask the appraiser what methods they used to value the business so you know where the price came from.

While there are many different methods to valuing a business, the three most common are asset-based valuations, discounted cash flow valuations, and comparable company valuations.

Asset-based. Asset-based appraisals take the physical assets of the business and subtract any debts or liabilities to get a total value. This is great for companies that have large facilities or expensive equipment (restaurants, factories, car washes, etc), but they fail to take in non-physical assets, sometimes referred to as “good will” assets. These could include things like reputation or branding which add to the company’s success and value.

Discounted Cash Flow. Discounted cash flow appraisals look at the projected cash flow for the next few years and make an offer at a discounted rate—accounting for risk and the time value of money. This method is used for many legal, auditing, and other professional services that have few physical assets but steady cash flow and income.

Comparable Companies. You can always compare the price of the company to other similar companies that are publicly valued or have sold recently. While this can be a good starting ground for price negotiations, keep in mind that most companies—even within the same industry—vary greatly in their actual worth. A small local hardware store is going to sell at a different cost than a nationwide chain, and even similar small businesses can have very different net worths.

Recognize that most often, business owners will overvalue their businesses. Similarly, buyers may not fully realize the value added by certain non-physical assets of the business and try to undervalue it.

Since SBA lenders have strict parameters about the use of funds, they want to know what their money is going toward. Knowing exactly where your price comes from, and the value behind your business, can help you justify your loan amount. Once you have your appraisal in hand, be ready to negotiate a reasonable asking price so that you don’t just get a good business—you get a good business at a good price.