Checklist for buying a business

Buying an existing business may have advantages over starting from scratch, such as existing operations, customers, and cash flow. But the due diligence process can be quite involved. Here’s a checklist to help you do it right. 

Buying a business can be an exciting and deeply engaging experience. Here are some of the main steps to follow:

• Decide on the type of business. Where do your interests lie? Which industries align with your skills and experience? Do you want it to be home-based? Do you want to keep it small or run a large team of people?
• Assemble a team. Before you start seriously looking for an acquisition target, it’s smart to have some professionals around you. Your team might include an accountant to help you analyze the businesses, a lawyer who can draw up offers and contracts, a financial advisor to help with your personal finances, a banker or lender who can assist with financing, and potentially a business broker who can help you source deals.
• Select a potential acquisition. Based on the criteria you set and any input from your team, start by identifying a business for sale that you believe is worth investigating more closely. 
• Write a Letter of Intent. Your lawyer can help you draft a Letter of Intent that tells the seller you are interested in their business. This letter will typically include a non-disclosure clause and some parameters around a due diligence period, during which time you will be allowed to examine the business in detail, including its financial statements, and other private information. 
• Perform due diligence. The due diligence process is outlined below. Essentially, this is your opportunity to verify that everything matches the seller’s representations and lives up to your expectations. This process may also help you arrive at the price you are willing to pay for the business.   
• Obtain financing. In order to make a firm offer, you need to know how you will finance the acquisition. This can be a combination of equity that you and/or your investors put up, debt that you obtain from a lender, and potentially a portion of the purchase price that the seller is willing to receive at a later date through a vendor financing arrangement. 
• Finalize the offer. There may be some back-and-forth with the seller on various financial and contractual details of the offer. Once you are in agreement, your lawyer can write up the final offer, and you can proceed to close the deal.

Perform due diligence

Finding a business that looks appealing to buy is one of the first steps. But before you can ink the deal, you will need to perform due diligence, which is a deep dive into the details of the business. Due diligence is your chance to make sure there are no red flags or hidden risks to avoid. Here is a non-exhaustive list of the sorts of things to look for:

• Organization. Make sure all the proper legal documents are in place, including Articles of Incorporation, bylaws, organizational chart, and lists of shareholders.

• Financial information. Audited financial statements for three years, company credit report if available, any projections and strategic plans, a schedule of inventory, a schedule of accounts payable and receivable, details on fixed and variable expenses, and the company’s general ledger.

• Physical assets. A schedule of all fixed assets, all leases of equipment, copies of all real estate leases, deeds, mortgages, title policies, surveys, zoning approvals, variances, or use permits.

• Intellectual property. A schedule of all patent applications, trademarks, and copyrights. A description of any important technical know-how or trade secrets.

• Employees. A list of employees including tenure, positions, salaries, and bonuses.

• Licenses and permits. Copies of any governmental licenses, permits, or consents.

• Taxes. Federal, state, local, and foreign income tax returns for the last three years. Plus, details on any recent audit and revenue agency reports, tax settlements, employment tax filings, excise tax filings, or tax liens.

• Contracts. Copies of all contracts, including subsidiary, partnership or joint venture relationships; contracts between the company and any officers, directors, or shareholders; loan and credit agreements, mortgages, or similar agreements; sales or distribution agreements; letters of intent; and any other material contracts.

• Customers. A schedule of the company’s largest customers, any supply or service agreement, a schedule of any unfilled orders, and the details of any current marketing plans.

• Legal. A schedule of any pending or threatened litigation and documents relating to any injunctions, consent decrees, or settlements to which the Company is a party.

• Insurance. Copies of all policies, including general liability, personal and real property, product liability, errors and omissions, key-man, directors, and officers.

Get an independent business valuation

There is more than one way to calculate the purchase price for a business. In many cases, you can obtain a fair estimate by analyzing the company’s assets minus any liabilities, its revenue minus any expenses, and looking at the current environment surrounding the business. For example, you might evaluate the health of the business’s industry and the recent selling prices of similar businesses.

As part of your due diligence process, you can retain an independent business valuator with the knowledge and experience to come up with a reasonable range of values. You can then use that insight to negotiate firmly but fairly with the seller.

1. Earnings-based methods

Perhaps the most fundamental valuation metric used by stock market investors is the price-to-earnings (or P/E) multiple. In short, this is the ratio of the price per share versus the company’s earnings per share. For example, if a company earns $1 per share and its stock trades 15 times higher than that at $15 per share, the P/E ratio is 15. In other words, investors are paying $15 for every $1 of current earnings.

This format allows an apples-to-apples comparison of different businesses. Imagine that companies in your industry have a P/E ratio of 15, as in the example above. Now let’s say you are analyzing two businesses that both have $1 million per year in sales. If one has net earnings of $200,000, this method implies that it might be worth $1.5 million ($100,000 x 15). If the other business has net earnings of $50,000, it might be worth only $750,000 ($50,000 x 15).

2. Market-based methods

Market-based methods of business valuation share similarities with the housing market. To determine the valuation, you look at comparable home sales in the same neighborhood – or business sales in the same industry. Just as the price per square foot varies drastically between Des Moines and Manhattan, so will the likely business valuations in mature, lower-growth industries like farming or dry cleaning versus younger, higher-growth industries like robotics or ecommerce. 

Market-based methods can also involve more qualitative and speculative aspects, such as estimating how evolving industry trends or consumer behaviors will impact the future growth of a business. Again, you could liken this to real estate, where certain demographic, cultural or economic trends make some areas grow more appealing and the homes there start to attract higher prices.

3. Asset-based methods

A company’s assets are generally the most predictable part of its valuation. If a company owns a building or a fleet of vehicles, it’s pretty straightforward to determine their present value minus loans or mortgages that are secured against them. The value of the assets, net of any debt, can generally be added to the valuation.

Non-physical assets can be a bit trickier. Imagine a company that owns the patent for a medical device that it has not yet manufactured or brought to market. To understand the value of that asset, it is necessary to model out what it will cost to manufacture and to market — and what the resulting revenue stream will look like.

Assess the company’s assets

In assessing the real estate, fixed assets, and inventory of a company, you want to know more than just what each item is worth today. Here are some of the factors to include in your research:

• Where is it? It may sound silly, but one of the principles of due diligence is putting eyes on any and all assets to make sure that they exist and that they match the seller’s description. 

• What is it worth? Used equipment depreciates. In order to compensate you for its eventual replacement cost, you need to know its current appraised value, not what the seller paid for it originally. 

• What is its age? You need to know if equipment is approaching a major service interval or the end of its life. In the case of certain inventory, it could become unsellable past a certain age.

• What is its condition? Similar to the age question, the goal here is to understand how soon something might need to be replaced or repaired.

Finally, you will want to understand the type of ownership and maintenance attached to each asset. For example, is it owned outright, is there a loan outstanding, or is it leased? Is there a warranty or service contract or would any repairs be out-of-pocket? Answering these questions might help you anticipate potential expenses and factor that into your valuation of the assets and the company.

Equipment assessment checklist

Equipment is part of a company’s assets, so it’s important to know what it is worth to you as a buyer. As you evaluate an itemized list of equipment, here are some of the questions to consider:

• What is it worth today?
• Where is it located?
• What is its age?
• What is its condition?
• Is there a warranty or service contract for it?
• What are the likely maintenance costs?
• How much useful life does it have remaining?
• What is its replacement cost?
• Is there an outstanding loan or lease relating to it?

It is a good idea to have a look at the seller’s equipment and any documentation relating to it as part of your due diligence. 

Inventory appraisal checklist

Inventory is another key component of a company’s assets that you much take into account as part of your due diligence and to calculate a valuation. Here are the steps to take when appraising inventory:

• What is the full list of items, including descriptions, and item numbers?
• Where is the inventory stored, and are there any leases or other costs associated with storage?
• When was the inventory acquired, and what did it cost?
• What are the considerations around inventory aging, spoiling, or obsolescence?
• Are there any inventory reserves and/or write-offs?
• Is any of the inventory held on consignment?

Ideally, you will inspect the inventory in person as part of the due diligence process. If this is not practical or possible, you might ask the seller to fully update their inventory records before closing the deal.

Accounts receivable assessment checklist

Accounts receivable are monies owed to the company, so it’s important to see not just how much money is reflected on sales reports or invoices, but how much is actually collected as revenue. Here are a few questions to ask while reconciling accounts receivable with a potential seller.

• Do the accounts receivable look right, given the company’s revenue trends?
• If there are accounts past due, is it a widespread issue, or does it pertain to only a small number of clients?
• Why are these amounts past due?
• Has the company had to write off unpaid invoices in the past?

If you are concerned about delinquent client accounts, you might ask the seller to let you speak with the client or clients as part of your due diligence process. It’s important to understand if the business has trouble collecting all of the amounts that are owed to it. 

Examine any liabilities

If the business has any mortgages, loans, or other debts, it’s wise to examine the documentation pertaining to them, and ideally, to have your lawyer also take a look. You want to understand all the terms and conditions that might affect the business. You don’t want any surprises, such as a debtor having the right to demand early payment or covenants that might limit your choices in the future, such as your ability to seek additional financing or to sell assets that have been pledged as collateral. 

Decide whether to acquire the entire business or just buy shares

After you have completed your due diligence and arrived at a valuation for the business, you might decide that you would like to invest in it without owning it outright. If this is something the seller is willing to consider, a deal like this could allow them to extract some capital from the business while continuing to run it. All the while, you could participate in its future earning potential, either at arm’s length, or with some type of advisory or co-executive role. This is just another option for you to consider when figuring out how to buy a business in a way that will best meet your personal and financial goals.

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