Buyer Due Diligence

Many buyers find themselves focused on the add backs and owner benefits when it comes to due diligence. This concern often overshadows the fundamental objectives of thier due diligence investigation. During due diligence the buyer’s main goal should be verifying the business’ earnings, and discovering whether or not the business will fulfill the buyer’s objectives. I recommend the buyer focus on these three simple ideas:

1. The business’ revenue
2. The cost of goods sold
3. Your future expenses

1. The business’ revenue is the first and most important number to verify. The most common verification method used is tax returns. Banks almost always rely solely on tax returns to verify revenues when approving a loan for a business acquisition. There are alternative ways to verify revenue such as bank statements, register receipts, sales logs, credit card processing, etc; however, none of these methods can give you the level of surety that tax returns provide. Though expenses will vary from owner to owner, you want the seller to prove to you the revenue for ths business.

2. The business’ cost of goods sold, which is the seller’s cost of the inventory sold, is the next item to verify. Many buyers will completely skip this step by relying on the numbers provided in the tax returns. This could be a costly mistake because many sellers adjust this number based on their individual tax situation. The number on the tax return may not be the actual cost of the inventory sold. Once you have verified the total annual revenue and the cost of goods sold you are left with the real “gross profit” of the business.

3. The thing to focus on now is future expenses. It doesn’t matter whether the seller paid their personal cell phone bill, vacations, or health insurance through the company. Understand the business owners are in business for themselves, not to pay as much in taxes to the government as possible. As such, expect to find personal expenses that are run through the business to lower their tax burden. Also, note the non-cash expenses, such as amortization and depreciation. These two line items reduce the tax burden, though don't reduce the true benefit to the seller of owning the business. Focus on what your expenses are going to be. For instance, find out what the current lease terms are and whether you should expect any significant increase in your rent expense. If the business has used a certain supplier, verify whether that supplier will still give you the same rate as the previous owner. It is also wise to review the seller’s payroll expense. In many cases, small business owners employ family members without paying them; in other cases, business owners may pay some of their employees in cash. Review the seller’s payroll expense to see if you will need to allot more money for your payroll expense. Review any contracts the seller has with equipment companies, suppliers, or vendors to find out how the current expenses might change after you have taken possession of the business.

There are surely other items to investigate and verify. Putting your initial focus on these 3 items will get your started on the right path to determine if this is the right business for you, and, what the business is worth to you.