Summary: The due diligence phase is the most critical component of every acquisition. It is the only time you have a chance to examine every detail of the seller's business. A well-planned due diligence helps reduce your risk and increases your chances of success.
This article is broken into two sections. The first section covers everything you should do before looking for companies to acquire. This preparation will help you start the due diligence the right way. The second section covers a detailed list of items that should be reviewed during due diligence.
1. Prepare for the acquisition
The single most important thing you can do to improve your chances of success in your acquisition is to prepare ahead of time. Buyers often jump directly into the search without preparing how to handle the due diligence that comes after making an offer.
Without this preparation, you won't be ready for the most intense and important part of the acquisition. At a minimum, this will delay the transaction. It also increases your risk of buying a troubled business or losing an opportunity to a competitor's bid.
a) Get your documents in place
Most small business acquisitions are financed with a loan backed by the Small Business Administration (SBA). These acquisition loans are provided by banks and finance companies that partner with the SBA. Each finance company underwrites transactions using its own criteria, but most ask for similar information.
You will need to submit information about yourself and the target business as part of your application. Gather your information beforehand so you can immediately apply for financing once the Letter of Intent (LOI) is executed. You need the following:
- Updated personal financial statements
- Debt list
- Three years of tax returns
- Updated Resume
Read "How to get a business acquisition loan" to learn more.
b) Check your credit
Lenders use your personal credit when underwriting an acquisition loan. It works as a proxy for financial responsibility, albeit imperfect. Buyers that use SBA-backed financing for the transaction need a minimum personal credit score of 650 - 690. Other lenders typically require similar or higher scores. Consult with an expert if your credit does not meet this criteria.
c) Get the equity injection
The equity injection are the funds that you will contribute to the acquisition. Equity injections are sometimes referred to as the down payment. The equity injection must come from the buyer's resources and can't be financed by the seller or a lender.
Lenders typically verify that the equity injection is available early in the transaction. They also examine the source of funds. Most lenders will decline to proceed until they can verify the equity injection is in place.
d) Assemble your team
New buyers often try to work out all the transaction details by themselves. They do this in an attempt to save money. This strategy is shortsighted and is one of the biggest mistakes a new buyer can make.
Buying a business will likely be the biggest transaction you will ever make. The right team of experts can help ensure you do things the right way. Hiring the right experts increases your upfront cost but decreases your risk dramatically.
At a minimum, your team should have an attorney and a CPA. Additionally, consider hiring a professional to create a Quality of Earnings (QoE) report on the target business. These reports can be an invaluable tool during due diligence.
Interview your team members carefully. Work only with professionals with small business acquisition experience. Additionally, ensure they have done transactions in the industry of the company you are acquiring.
2. Due diligence checklist
The due diligence phase is usually the most intense part of the acquisition. The teams have a short period of time to evaluate a lot of information and negotiate changes. Unfortunately, the speed, intensity, and volume of issues may overwhelm some buyers. This leads to bad decisions.
The best approach is to plan the due diligence with your team beforehand. You will be better prepared to handle the inevitable problems that arise. This strategy will increase the chances of a successful and ultimately profitable acquisition.
There are 15 areas that you will need to cover during due diligence. Many of these are required to apply for the business acquisition loan. Each transaction and industry is different, so this list is not exhaustive. However, you can use it as a guide to develop a list suitable for your transaction.
a) Will you use a Quality of Earnings (QoE) report?
A Quality of Earnings (QoE) report is created by a professional that evaluates all aspects of the seller's company. They are an essential tool to help minimize the risk of buying a business. The professional should begin their evaluation soon after the due diligence process starts.
The QoE report helps you find potential issues that you should know before buying the business. The evaluation also helps determine the sustainability of the target business's revenues under new ownership. The QoE report can be an essential negotiation tool.
b) Three years of tax returns
The target company should provide you with the last three years of tax returns. Compare the information in the tax returns to what has been reported by the seller. However, don't expect the information to match perfectly. Your CPA can help you examine these in more detail and understand the differences.
c) Three years financial statements (by month)
Ask for the last three years of financial statements, broken down by month. These reports will help you examine the company's monthly performance for the past three years. They also help you identify seasonality, revenue concentration, and expenses. Ask for:
- Profit and Loss Statement
- Balance Sheet
- Cash flow statement
- Accounts Payable
- Account Receivable
Ideally, the target company or their CPA uses accounting software. In this case, ask them to share a copy of the file. Using the accounting file is more efficient and potentially accurate than using seller-provided spreadsheets.
d) Three years of bank statements
Your CPA will likely need three years' worth of bank statements. Bank statements are considered a more trustworthy source of information than the seller's financial reports. These statements help confirm the company's financial reports and provide a 'proof of cash.'
e) List of all debts
A list and description of all the company's debt instruments. This list should also include debt due to shareholders and private investors. Items include loans, lines of credit, etc.
f) List of add backs
The seller should provide an itemized list of add-backs. These are items that are 'added back' to the net income and increase the Seller's Discretionary earnings (SDE). Sellers want as many add-backs as possible since a high SDE helps increase the business's sale value.
Verify that all add-backs are found in the financial reports and tax returns. Additionally, add-backs should be legitimate and reasonable. A Quality of Earnings report and your CPA can be helpful resources to determine which add-backs are reasonable and which aren’t.
g) Fixed asset list
Get a list of all of the company's fixed assets. The list should include the asset's age and current value. Examples include:
- Vehicles (with VINs)
This list will help you determine which fixed assets may need to be replaced after the acquisition. Use this information to determine future capital expenditures (CapEx). You may also want to discuss this with your lender since they may be able to bundle additional financing for CapEx.
Lastly, review past repair and maintenance records of essential machinery and vehicles. Some sellers may stop maintaining equipment if they know they are going to sell the business.
h) Copies of all material contracts
Get copies of all material supplier and client contracts. These are contracts that, if lost, would severely impair the value of the business. Examine the contracts with your attorney to ensure you understand them and their business implications.
Look for contracts that include related parties, such as friends or family. These must be identified since the contract terms could change after the acquisition.
i) Employee information
Get a complete organizational chart of the company with a description of each position. Additionally, find out each employee's compensation. Have your attorney review employment agreements, independent contractor agreements, HR policies, benefits plans, etc.
Determine which employees are 'essential'. An essential employee, such as a general manager, could seriously impact the business if they leave. Find out if any employee plans to leave the company after the acquisition. You may need to offer them an incentive if you need them to stay.
Additionally, find out if the seller has made any recent salary or benefits promises you could be expected to keep. These must be accounted for in your offer and budget.
j) Customer information
Review the customer databases, subscriber lists, and sales records. Determine which customers are active and which have not made a purchase in a long time. This information will help you determine active clients and the turnover rate.
Ask the seller to identify major customers and determine their revenue concentrations. Examine the agreements, relationship status, major issues, returns, etc. Consider reviewing the seller company's reputation with their customers through third-party sources. These include:
- Better Business Bureau
- Internet review sites
- Trade associations
k) Insurance information
Review all the business's insurance policies. Speak with a qualified insurance agent to ensure that coverage and costs are adequate for the level of protection this business needs.
l) Licensing information
Review all applicable business and professional licensing information. Ensure you have a plan to cover licensing requirements after the acquisition. Otherwise, you may be unable to operate the business after the acquisition.
Certain industries have legal requirements that at least one employee hold a professional license. For example, companies in the construction trades (e.g., electricians, plumbing, HVAC, etc.) require a licensed person. In most small companies, the licensed person is often the owner. You must plan for licensing continuity after the owner leaves.
m) Business systems
Get an accurate picture of the company's business systems. Ensure you know how they work so you can continue operations after the acquisition. Examples include:
- Customer Relationship Management (CRM)
- Inventory tracking
n) Legal issues
Review the company's past and current litigation with your attorney. Obviously, current litigation is a major risk that must be handled accordingly. Additionally, discuss the potential for future litigation with your lawyer. They should be able to give you an idea of imminent risks based on what your due diligence discovers.
o) Target company-specific issues
Each industry and company has its own practices and nuances. You should add specific items to your due diligence to cover those as well. Additionally, consider what items are important to you but are not in typical due diligence checklists. Include these in your final checklist.
The due diligence period is your chance to learn everything about the company. You should use it effectively to ensure you get the most information.
Consider working with a team that has due diligence experience in the target company's industry. Their experience is essential in helping you discover the potential issues and value of the seller's company.
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