Due diligence. It is the same whether you are buying a home, a car, or your own business. When evaluating an existing business for a potential purchase, completing your due diligence is absolutely critical.
Due diligence, as seen in the recent post, Buying an Existing Business: 12 Factors to Consider, means a deep exploration into the financials, assets, obligations, and customers of the company under consideration. Yet for those who have never been involved in such a transaction, the thought of doing such an assessment can be daunting. Here is a closer look at how to evaluate the potential of an existing business before you buy.
Once you have agreed in principle to purchase a business, you need access to the confidential files, data, and information that will help to determine whether (or not) to proceed with the transaction. Here are the components to evaluate within a due diligence process:
- Assets. Understand the equipment, supplies, and products that the business has and owns outright. These should be prepared on a checklist and verified. What items still have outstanding amounts owed or are under agreement for a lease, loan, or rental? The financial terms of these agreements should be incorporated into the sales contract.
- Financials. This is the bread-and-butter of due diligence and includes reviewing the certified financial statements, cash flow statements, balance sheets, and tax returns for several years prior to the sale. Be sure to gauge owner income versus business profits and whether the profitability data is in keeping with industry norms.
- Legal. You will want to look at any documents related to how the business is incorporated and other formation documents, including partnership agreements and other binding contracts. The legal review also includes all warranties, guarantees, and product liability documentation, not only those that cover the company, but also the guarantees which is provided to customers. Any regulatory obligations should also be reviewed and any litigation where the company or its owners were plaintiffs or defendants should be reviewed.
- Employees. You will want to see organizational charts, job descriptions, and personnel files for all senior-level employees. Any employment contracts should be considered, as should information on professional advisors (accounting, legal, financial, insurance). Classifications of independent contractors should also be considered.
- Products and services. If the company sells products, you want to be sure you can still sell them, meaning you need catalogs of products and services available, prices paid, and how those goods are delivered.
- Customers. In addition to reviewing accounts receivable, you will want to get a full rundown on the company’s major customers, including what percentage of revenue they account for, how critical they are to profitability, and what they have purchased in the past. Are the relationships with the existing owner or are they loyal to the company/brand?
Once this due diligence is complete, you will want to create your own valuation for the business to determine if the sales price is fair. There are three basic valuation models, the most common of which for small businesses is a market-based valuation, which looks at the industry and compares the value to similar companies. Other models are asset-based, which is usually used when the business is no longer profitable, and income-based, which evaluates the company’s potential for future income.
At Benetrends, we help companies with the funding that will be necessary once an agreement for purchase is made. Our unique model for funding small business leverages existing 401(k) and IRA funds to provide penalty- and tax-free funds that can be used to purchase or operate a company. To learn more about how Benetrends can help provide access to funds for your small business purchase, schedule a consultation today.