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Small Business Purchase - Due Diligence

Updated: Jul 26


Small Business Purchase – Due Diligence


After having an offer to purchase accepted, then the next phase of process begins, which is Due Diligence. This effectively seeks to verify that the business matches the expectations of the sales price negotiated. Depending on the outcome of the investigation the price may need renegotiation, or you may even cancel the process.


Starting the process


Before you start with the actual due diligence you want to table a list of deliverables that will allow you (and any advisor) to quickly gain access to supporting and corroborating information. It is preferable that the buyer is queried whether they can provide the level of information required before tabling the purchase offer. It should be made clear to the seller that the due diligence will not begin until they have the required information requested to hand.


If you do not have all the required information before starting the process of investigation then you run the risk of having your time wasted and the vendor running down the clock (With information they have issues with presenting/releasing/obtaining).

You will almost certainly be required to sign a confidentiality agreement.


Timeline required


The standardized review and analysis time is 4 weeks for a small business, with all requested information to hand. Less time can be undertaken, however, if not everything is covered off within the allocated time, then this will result in more risk of unforeseen issues on acquisition.


Labor resource required


  • Yourself (and assistant where required to assist with aspects such as a stock take).

  • Sufficiently experienced CPA Accountant. Due diligence on small business acquisitions.

The smaller the business the less likely using a CPA accountant will appear to be cost effective. However, they can perform less and more focused checks to provide assurance over material aspects.


Allocating time and resources


Conceivably an unlimited amount of time and effort can be allocated to assurance that the business being bought covers off every perceived risk, however if you take a concept from Project Management of a Risk and Impact Matrix, then this can aid allocating focus. If an element for review is High Risk and High Impact then it must be prioritized, If it’s Low Risk and Low Impact then its lower far lower priority. Effectively place effort where it has the highest benefit in achieving your desired aims.


Your accountant will typically require the following to review the Financial Statements:


  • Access to the clients accounting package if hosted online (Xero etc) view mode.

  • Income Statement (Profit & Loss) and Balance sheets for the business.

  • All End of year journal adjustments to the accounts.

  • Copies of business tax returns.

  • Copies of the owners’ tax returns – especially where it is a sole trader or partnership

  • Bank Statements.

  • Cash journals & cash sales deposit registers/analysis/reconciliation

  • General ledger / Reconciled cash book (where manual).

  • Copies of Sales Tax, VAT, GST (Sales taxes on output/Value added filed on a monthly/quarterly basis) with the relevant government tax authority.

  • Payroll filings with the relevant tax authority.

  • Copies of all leases and contracts in existence. Insurances, Property lease, equipment leases etc.

  • Inventory & Asset list of physically existing items.

  • Schedules of client contracts and work committed for production/supply.

  • Contact details for their Accountant and your Lawyer/Attorney.


4 Main areas of diligence review


1. Financial Statements


Generally, this area is allocated to the professional advisor accountant who’ll perform additional checks to give greater assurance around the validity of the figures presented. For small businesses it is quite unlikely that the financial accounts will have been audited, so they will have been prepared according the information they provided to their accountant.

Hence, one the first questions is, who prepared the accounts? And do they match to filings and consequential payment/receipt amounts in the bank statements? (Tax return liabilities/benefits).


It should also be noted that Audited Accounts are designed to give a level of assurance around the appropriateness of a ‘True and Fair’ view of the financials presented from a historical perspective. They aren’t normally designed to investigate into assessing internal management and processes with regards to future financial performance.


Financial statements requested, should be 3 historical years minimum, and preferably last 5 years. Greater weight should be placed on the most recent information, however historical trends have their inferences. The business being sold should also be able to provide interim statements for any partial year to date. All copies of end of financial year Tax and Account filings should come from their accountant and should be acknowledged as being filed by them on behalf of the client, all payments/refunds arising should be sighted in bank account transactions.


If you want to improve your knowledge of Small Business Financial Statements (Income Statement and Balance Sheet) then there is an article on this site here.


Income Statement / Profit & Loss


As mentioned previously if you want to understand general Small Business Financial statements then please open the link above. In this section we’ll run through the types of tests that will be undertaken against the various elements of the Income Statement / Profit & Loss.


  • There will be sampling of income and expenses and tracing invoices through to collection/payment with appropriate backup.

  • All forms of Tax filings matched to supported documentation (Sales Taxes, GST/VAT, Payroll, Corporation, Withholding taxes).

  • Variability of Income/Expense line items between periods/years. Including trends in cash/credit.

  • Sales/Purchases segmentation – concentration issues around certain suppliers/purchasers.

  • Margin Analysis – Trends between years, between suppliers, between purchasers. Reflection against the concentration issues.

  • Seasonality and Economic cycles – How the business performs at different points during the year, whether it is the beneficiary of a good economic environment, if there’s specific temporary geographic advantages/disadvantages.

  • Sensitivity analysis – modelling the Income Statement according to various scenarios that could play out. E.g., Loss of a major customer. How the business would perform during a recession. Is some temporary local benefit coming to an end? Etc. Effectively learning how the business would cope with various adverse impacts.

  • Sales pipeline – variability & currently committed, where sales booked/committed in advance. If this has decreased relative to prior periods then this may be the basis for the sale of the business etc.


Balance Sheet


This will follow a more substantive testing approach. Primarily that of physical existence, legal ownership and economic value.


In addition to the above, the following applies to various elements of the balance sheet:


  • Inventory / Stock – Quality issues (Shop spoiled, obsolescence), turnover time. Slow moving items. Trends in total balance. Inventory listing and sales report by SKU (Stock Unit Item).

  • Accounts receivable / Debtors – How long to collect debts, thus impact on working capital and potential for bad debts/write downs (Collectability). Trends in total balance. Where client concentration occurs how do those most material accounts perform? Trace sample invoices to gauge time to pay. Trace last years end of year debtors through to payment in the bank statements, time taken in alignment with sample traced? Are these in alignment with terms and conditions of credit? Are there sales rebates? When are they due and payable?

  • Assets – What are likely maintenance issues? Are the assets up to date with maintenance? How long till replacement is needed, and how will that be financed? Is any of the equipment highly specialized? (Implications for replacement cost and maintenance). Will business continuity be affected if any of the equipment breaks down? If you’re raising finance then the valuation of the equipment. Physical matching of assets to fixed asset schedule in Balance Sheet. Lease and maintenance contracts. Spare parts suppliers and availability where relevant / material.

Any building leases need to be identified and any ‘improvements’ made as generally it is a requirement for reinstatement along with any dilapidations on lease expiry – This needs to be factored into any price as sometimes this can be quite expensive, also there is generally a bond paid at the outset of the lease which should be shown on the balance sheet as an asset.


  • Liabilities – With Creditors/Accounts Payable verify balances with the suppliers and obtained updated statements. Any charges against Assets will require novating the liability to you the buyer or on sale, its repayment (Assuming that is possible with/without penalty) and you the buyer financing through the purchase of the assets outright. Any liabilities that exist will clearly require formalization to how these will be dealt with on business transfer.


Cashflow Statement



A lot of Small Business Accounts prepared by their accountants are not supplied with a Cashflow Statement covering the financial year (by month). However, any business using standardized accounting software can generally prepare one of these retrospectively.


A Cashflow Statement is a good high-level view of the businesses financial position, showing the generation of, and demands on, the cash of the business.


A well prepared forward looking Cashflow Statement Forecast should be one of primary methods of financial control in any Small Business.



2. Internal / External Processes


People

Employees / Contractors / Casual workers


You may need an HR consultant to undertake this whole process if you want to minimize risk of HR issues.


  • Organizational Chart – Effectively a hierarchy of the chain of command and who reports to whom. In many Small Businesses this will be self-evident if there’s only a few employees and likely no physical documentation of any Organizational Chart.

  • Job Descriptions and Job Specifications of all roles. If these are not written / documented then it preferable to document them and have both vendor and employees sign them off.

  • Employment contracts for all the employees.

  • Engagement contracts for Contractors and Casual workers.

  • Vendor to document any benefits / obligations / reprimands to Employees / Contractors / Casual workers not formally documented and those recipients to sign off what they formally acknowledge as additional.

  • Copies of Health and Safety documents, evidence of conformance, evidence of training.

  • Copies of certifications, where required by licence under which the business operates.

  • Non-disclosure agreements / Do not compete, where not formally written in any employment / engagement contract.

Generally


  • How long have the employees been with the business?

  • Which employees are pivotal to short run business continuity?

  • Will they be staying with the business after transfer?

  • What’s the staff turnover? (Especially the pivotal ones)

  • If turnover seems high or most staff have only recently been recruited then why? Remuneration? Workload? Owner expectations too demanding? Poor working environment?

  • Is the firm gaining or losing employees with respect to any competition businesses? (Good businesses tend to gain quality staff from competitors, ones with issues tend to lose good staff).

  • Any Labor issues or disputes? Have any turned legal? Employee remuneration competitive with the market? Has it been increasing in line with the market? Is it better paid? Is it just minimum wage?

Sales - Marketing


  • Sales income is the arguably the most important focus in any business, spending funds is easy, winning business is pivotal to staying in business. Hence, an important feature of the diligence process is to assess past sales generation and how future sales will be undertaken, and the risks surrounding it. Having high customer concentration adds risk, as losing an important customer can have a material effect and even to the viability of the business.

  • How are sales generated? How proactive/reactive is the business at generating new sales? How difficult is new sales generation? Who is responsible? How good are they? How long have they been with the business? How much is spent on general/specific marketing to generate sales? Do you think you can increase sales? The likelihood of maintaining sales? How long have clients been retained? Will they stay with the business if the ownership changes?

  • Effectively if the business requires a lot of personalized selling, then a greater level of understanding and assessment needs to be undertaken around the people in that process and the dependencies it generates. Conversely if its passing footfall, or internet driven then a different approach is required. The greatest risk revolves around the current owner having a lot of personalized selling to long time and concentrated customers. For instance, I’ve seen a business with a single customer who had serious issues with managing that relationship and collecting fees.

  • How aware of the competition is the Business? Do they monitor competitor prices?

  • What does the competition do differently to gain custom? Is it all just price competition or are there additional / separate services or a function of location? What advertising they do relative to the business? What would it cost to undertake those additional cross selling / upselling of goods / services? In an ideal business it would have identified all competitors and undertaken a (SWOT) analysis highlighting Strengths, Weaknesses, Opportunities and Threats. By understanding competitors’ offerings, it should be apparent why customers use the Businesses offering, whether based on price, location, size/scale, range, availability, quality. If none of these, then hopefully not simply based on the owner’s relationship / personalized selling.

In summary, does the business have a marketing plan? Did they achieve it? Who is pivotal in generating sales? What risk is attached to future sales on change of ownership?


Processes


Systems


  • What ‘systems’ does the Business use? E.g., Scheduling, Procurement, Accounting, IT, Telephony, HR, Time attendance, Customer management.

  • Do these systems generate the right type of management control information?

  • What management control information is gathered and presented? Do they meet the needs of the organization?

  • Are these systems documented?

  • Do they appear to be properly followed?

  • Are they efficient? What do the employees think about them?

  • How old are the systems? Are they using a recent version update? (Research newer systems to solve your business industry needs, assess cost). Although any change should occur after transfer and once everything else is bedded down.

  • Have employees developed any workarounds for system issues that don’t meet operational or organizational needs?

  • Are they properly licenced where required?

  • Who provides these systems?

  • A copy of all the contracts for provision of systems.

  • Does the Business owner have administrator level privileges to access any systems?

  • Have the CPA give an assessment whether the accounting system is properly being used and sufficient control exists. Identify the person that maintains the accounting system and what experience / qualifications they have. The accountancy fees the Business currently pays to its accountancy firm will give insight into the use of the accountancy systems. E.g., What services are they providing, how high is the resulting annual accounting fee? High? Why? A mess? Etc.


Operations


Legal & Corporate


Some of these elements have been discussed previously in other subsections (Especially when reviewing the Income Statement), but for completeness they will also be referred to in this specific section.


  • Leases


Property lease – Terms, length, renewal, assignability, bond deposit amount, hand back issues with respect to reinstatement (Can be very expensive, E.g., If alterations have been made, engineered wooden floors worn out by office chairs etc). You need a good handle on total monthly outgoings exposure and any additional requirements to pay for the exterior (Sinking funds)/grounds maintenance of/around the building.


Office/Equipment leases – Telephony, Photocopier(s), IT systems, Office desks, Vehicles, Plant, Machinery, Water cooler, Kitchen equipment, office plants & wall hangings.

Effectively most items within a business have the potential to be leased, reviewing the Income Statement expenses should highlight these as invariably there will be at least 1 payment per supplier per year for any item/activity leased.

  • Insurance policies


Premises, Plant & Machinery, Indemnities, Public liability, Employer liability.


Once again, these costs should be observable as payments in the Income statement. The relevant Insurance company(s) will need to be contacted to assess whether they are assignable or whether new cover is required, type, coverage, limits and at what cost. The business may use an insurance broker as an intermediary to negotiate.


  • Customer agreements


Depending on the complexity and timeline of supply then customers may have bespoke agreements. A general retail business for instance would have very standardized terms of trade. Potentially the larger customers (By scale or purchasing value/volume) are more likely to have something nonstandard.


  • Supplier contracts


Once again this depends on the complexity of the relationship with the supplier and generally is driven by the level of customization / lead times involved with supplies. Businesses involved in distribution, licencing use, franchise have particularities that require assessment, from assignment, to termination rights, to margins, volume characteristics (rebates) etc.


Otherwise in generic small businesses they will tend to be simple standard terms of trade. Although there can be volume rebates and so forth (Any gained in the previous year will be observable in the Income Statement as a credit, although incorrectly a simple netting off may happen so they don’t appear unless you look at all the invoices, although supplier statements will highlight them).


Note: As discussed with Customer and Supplier concentrations any business whether purchase or sale that is a material amount to the business requires increased focus and attention. There is no certainty on continuity, so you need to be cognisant that the sale of the business may be motivated by an impending loss of a major buyer/supplier.

  • Licences and regulations compliance


Different industries require different licences to operate, and some are required to give assurances as to the quality and conformance to regulations of their product or service. Where these are required, they need to be valid and current, for any insurances to be active.


  • HR & Payroll/Accounting & Software


Businesses over a certain size of employee headcount will increasingly tend to outsource HR and Payroll. If this the case, then this will need reassignment upon business transfer. Outsource providers are highly likely to meet any regulations/laws requirements.

If things are done in house, then it needs to be assessed by whom and do they have the appropriate skills.


Accounting system will be checked by your accountant to ensure it is sufficiently accurate and has the appropriate levels of controls. Who maintains it and their level of expertise, you’ll need appropriate administrator level logons upon business transfer.


Software/IT may also be outsourced, so like with HR/Payroll the same approach can be taken. Where in house then all software licences need to be listed and checked against licence fees paid in the Income Statement.


  • Legal


Any documentation relating to legal disputes (Pending or Historical). If it’s a large customer or an important supplier then it can have substantial implications.


Your lawyer / attorney should cover off most potential pitfalls. That your business is not liable for anything prior to acquisition, or the activities of other tenants, that it is in full conformance with laws/regulations/codes.


Your lawyer / attorney should also advise whether they believe you should incorporate a new entity and have it purchase the assets and operations.

  • Company secretarial


Where it is a company then Incorporation documents / Articles of association. If you are acquiring the actual legal entity (rather than purchase of the assets and ‘Operational business’) then you will require everything including the minutes. Generally, most company documents are filed with the appropriate government agency and are publicly accessible for free or a small fee.


3. External factors


  • General Economic conditions


Where are we in terms of the general economic cycle? Are you buying during an economic boom and paying for those easy economic conditions? or buying a profitable business in the middle of a sustained recession? Has the business been through a previous recession? If it hasn’t, then what gives you confidence it will make it through the next? You are primarily buying and paying for future performance.


If the product or service being sold is less discretionary income based then it will be impacted less by any economic downturn (relatively).


  • Business / Competitors


Is the business in a declining industry? Changes in Fashion, Taste, Technology, Channels can impact the future business sales/viability. E.g., Main/High Street travel agencies, Mobile phone shops etc.


Is competition increasing? If the business was an early mover then additional competition can be entering the market until it is saturated and thus decreasing margins and therefore profits. E.g., Coffee shops that are continually appearing. Assess if any competition has recently appeared or has been in existence for a number of years.


  • Why is the Vendor selling the business?


The seller has far more knowledge of business issues and potential impacts. If the owner has had the business for years and is obviously retiring then that is a different risk proposition to a recently started businesses during a economic boom and the owner is not of retirement age.


You cannot accept the words of the Vendor as to sale, you must independently and objectively reason the sale.


4. Innate factors / qualities


  • Skills, interests, strengths, experience.


The purchase of any business requires a lot of effort, focus and capital over an extended time period.


Hence, it is important that any buyer has sufficient skills in the most important element that drives value in the business. E.g., If the business is highly dependent on personal selling, then the buyer needs to be a born salesperson, alternatively if the business requires excellent project management, coordination and operational skills then the owner will need to be sufficiently able in them. Often the owner in a small business will be the subject matter expert in the operations of the business.


Furthermore, do you have sufficient interest in the activities of the business to input considerable effort over a long time period? Once you lose interest, the business will suffer.


Finally, the old saying of ‘Stick to what you know’ has credibility. You know the industry practices, you’ve been performing similar business activities, and you’ve been interested enough in the business to become sufficiently experienced.

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