The Ultimate Guide to Due Diligence When Buying a Small Business
Let's get real about buying a small business - it's exciting but also terrifying if you don't know what you're walking into! As a CFO who's guided numerous clients through growth and due diligence, I can tell you that proper due diligence is what stands between you and inheriting someone else's problems (yikes!).
In this comprehensive guide, I'll walk you through exactly what due diligence means for small business buyers, including:
- Essential financial documents to review
- How to leverage a CFO during due diligence
- Key red flags to watch for
- Why Quality of Earnings (QofE) reports are worth the investment
Small Business Due Diligence Checklist: What to Review Before Making an Offer
First things first - you need to evaluate the business thoroughly. Here's my straightforward due diligence checklist that can uncover most red flags:
1. Financial Health Assessment
Here's what to request:
Complete financial history (not just 3 years)
Monthly statements in Excel (PDFs are nice, but Excel lets you analyze)
Profit and loss statements
Balance sheets
Cash flow statements
Here's what I look for when reviewing small business financials:
Revenue trends (especially any unexplained dips)
Owner compensation patterns
Multiple profitability metrics including:
Free cash flow
EBITDA
Net income
Owner compensation
2. Working Capital Analysis
Working capital is often forgotten in small business acquisitions and can make or break the transition period. I’ve often recommended clients borrow more than the purchase price to cover working capital.
But to get to what you need in cash $$ first you’ll need to review:
Current working capital assessment
Future working capital needs
Cash flow cycle analysis
3. Customer Analysis
Your due diligence isn't complete without diving into the customer base:
- Revenue split (recurring vs. one-time)
- Customer concentration (red flag if any customer is >25% of revenue)
- Market growth potential
- Customer satisfaction metrics (sometimes this is as simple as reviewing google reviews)
How a CFO Partner Strengthens Your Due Diligence Process
Having a CFO during due diligence is like having a really good insurance policy. Here's what we typically help with:
1. Financial Analysis
- Spotting inconsistencies in financial documents
- Validating cash flow sustainability
- Identifying hidden risks
2. Future Planning
- Creating 18-month forecasts
- Planning for post-acquisition dips
- Assessing working capital needs
3. Risk Assessment
- Employee retention analysis
- Systems and technology evaluation
- Market position assessment
Due Diligence Red Flags in Small Business Acquisitions
Here are the deal-breakers I watch for:
- Unexplained revenue fluctuations
- High employee turnover rates
- Pending legal issues
- Outdated systems requiring immediate investment
- Poor financial record keeping
- Unclear customer contracts
The ROI of Professional Due Diligence Services
I get it - spending money on due diligence when you're already writing a big check feels painful. But here's the truth: investing $2,000-15,000 in professional due diligence services could save you hundreds of thousands in unexpected costs.
Consider these benefits:
- Accurate business valuation
- Risk mitigation
- Negotiation leverage
- Post-acquisition planning
- Peace of mind
Next Steps in Your Business Buying Journey
Ready to start your due diligence process? Don't go it alone. Schedule a strategy session with a CFO who can guide you through this critical phase. Your future self (and bank account) will thank you!
Want more insights on buying a small business? Check out these related articles:
[Link to cash flow management article]
[Link to working capital article]
P.S. If you're thinking "this is a lot" - you're right! But that's exactly why we're here to help. Drop me a line if you want to chat more about your business acquisition plans!