What does due diligence actually examine?
Due diligence is the work a buyer undertakes to confirm that the business is what the seller represents it to be. Ours concentrates on the financial and tax dimensions: whether the earnings are genuine, whether they will continue under a new owner, and what liabilities may accompany the purchase.
It is distinct from the other reviews already under way around the transaction. A business broker markets the business and typically presents the seller’s figures, while a lender underwrites the loan to decide whether it will be repaid. Both serve a purpose, but neither is working for you on the question that matters most: is this business worth this price?
What is quality of earnings, in plain terms?
A quality of earnings analysis asks a single question: how much of the reported profit can a new owner reasonably expect to continue earning? It removes one-time events, corrects accounting that does not reflect how the business actually operates, and separates the owner’s personal costs from the cost of running the business.
For smaller businesses, the asking price is usually based on seller’s discretionary earnings, or SDE, which is profit before the owner’s salary, interest, depreciation and personal expenses paid through the business. SDE is a reasonable starting point. The difficulty lies in the add-backs, because each one raises the price, and each one is a claim that should be tested against invoices, payroll records and bank activity.
How do the tax returns, books and bank records fit together?
We reconcile three sources for each year under review. The tax returns show what the seller reported to the IRS, the books show the figures the seller manages from, and the bank statements show what was actually received. When all three agree, you can rely on the numbers. When revenue in the books exceeds what the bank received, or a seller explains that some sales “never made it onto the return,” there is no sound basis for paying for earnings that cannot be documented.
What else can you inherit?
- Working capital. How much cash, receivables and inventory the business needs to operate on day one, and whether the transaction leaves enough of it in place.
- Customer concentration. If one customer accounts for a large share of revenue, the earnings are only as durable as that relationship.
- Payroll exposure. Workers paid as contractors who may in fact be employees, late payroll tax deposits, or unpaid wages.
- Sales tax exposure. Uncollected or unremitted sales tax. In Colorado, a buyer of a retail business can become liable for sales tax the prior owner owed but did not pay, according to the Colorado Department of Revenue.
Asset purchase or stock purchase?
The structure affects both your taxes and your risk. In an asset purchase, the price is allocated across classes of assets, from cash and inventory to equipment and goodwill, and buyer and seller generally each report that allocation on IRS Form 8594. The allocation determines how quickly you can deduct what you paid, so we model the options and you negotiate with the after-tax result in view.
If you plan to finance the purchase with an SBA 7(a) loan, changes of ownership are an eligible use and the maximum loan amount is $5 million, according to the U.S. Small Business Administration. The lender’s underwriting serves the lender; our report is prepared for you.
A scenario: what happens when the add-backs do not hold up?
For example, a buyer is evaluating a service business advertised with $400,000 of SDE and an asking price of $1.2 million, three times SDE. The figures are illustrative.
In diligence, three add-backs fail. A $35,000 “one-time” equipment repair turns out to recur every year. The owner’s spouse, paid $40,000 and added back as a family expense, in fact handles scheduling and billing that someone will have to be paid to do. And $25,000 of cash sales the seller describes cannot be traced to deposits or the tax return. Supportable SDE is therefore $300,000, and at the same multiple that is a $900,000 business, not a $1.2 million one. The buyer can renegotiate, restructure part of the price as an earnout or withdraw, but only because the figures were tested before closing.
What will you receive, and how long does it take?
You receive a written findings report that sets out what we tested, what held up, what did not and what each finding means for price and structure. We then review it with you on a call, so you understand every finding before you decide.
Most small-business engagements take a few weeks from the time the seller produces the documents. For first-time buyers, we also explain the process as it unfolds, so you complete the transaction with a clear understanding of the business you are acquiring. If you proceed, our accounting, payroll and tax planning teams can establish the business’s systems from the first day of ownership. Our checklist for buying a business in Colorado and our broader mergers and acquisitions work are useful next reads.