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Thinking of Buying a Business? Don’t Skip These Crucial Steps!
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If you’re on the hunt to buy a business, you need to read this before you sign the dotted line.
There's crucial homework you need to do first to make sure what you’re looking at is actually a good deal.
On average, would-be business seekers look at 100+ deals before pulling the trigger. That’s because there are a lot of companies that seem enticing on the outside, but have a rotting foundation that only an experienced eye will find.
In this article, I’m going to walk you through the key areas of performing due diligence, highlighting what to look for, and how to avoid common pitfalls.
Understanding Due Diligence
What is Due diligence?
It’s nothing more than fancy corporate-speak meaning to do investigative work into a business.
It’s digging deep into their financials, operations, legalities, and general business functions. It’s you’re your opportunity to get a good look under the hood, ensuring you know exactly what you’re buying and preventing any surprises.
Think of it as the home inspection you got before buying your house. You’re protecting your investment from hidden risks and costly mistakes.
Financial Due Diligence
First, let’s talk numbers. Financial due diligence is where you scrutinize the business' financial health – probably the most important step.
Begin with the financial statements from the past three years.
You’ll be looking at income statements, retained earnings statements, and balance sheets.
Nothing happens in a business without a money trail. If you start seeing numbers that aren’t adding up, these should be immediate red flags that requires answers or you need to walk away.
Here’s a quick MBA overview of these documents:
1. Income Statement: this shows Revenue, Expenses, and Net Income. You will see it as:
Revenue – Expenses = Net Income
(with each line item listed)
2. Retained Earnings Statement: this is important because you get to see how much money remains in the business. Retained Earnings is the money still in the bank after expenses and distributions. These statements show the previous Retained Earnings, Net Income, Dividends, and current Retained Earnings.
Beg. RE + NI – Dividends = End RE
3. Balance Sheet: this provides the business’ Assets, Liabilities, and Equity. You’ll see it as:
Assets = Liabilities + Equity
- Assets are typically cash, land, and capital equipment – things that carry value and can be converted to cash if sold.
- Liabilities are a legal obligation to repay an amount borrowed or to perform a service for money already received.
- Equity is stocks sold and profits retained.
When analyzing the revenue and profit trends, look to see if the revenue is growing, stable, or declining. Steady profits suggest a healthy business. On the flip side, declining profits might be a red flag.
Don’t forget to check the debts and liabilities. You need to know what kind of financial baggage you’re inheriting. Too much debt can spell trouble.
Legal Due Diligence
Legal due diligence is all about ensuring there are no hidden legal landmines.
Start by examining all contracts and agreements. This includes leases, supplier agreements, and customer contracts. You want to ensure there are no unpleasant surprises in the fine print or hidden obligations you’ll be left on the hook for.
Next, check the intellectual property rights.
Make sure trademarks and patents are in order. This protects you from future disputes and ensures you’re getting all the assets you’re paying for.
Lastly, investigate any pending lawsuits.
Ongoing or past litigation can be costly and time-consuming. You don’t want to purchase the rights to continue the previous owner’s legal battles.
Operational Due Diligence
Operational due diligence is about understanding how the business operates on a day-to-day basis.
Assess business processes – are they efficient? Are they standardized? Are they documented?
It’s critical to look for documented processes and procedures. When buying a business, the goal is to minimize your day-to-day involvement. This requires standard operating procedures that employees and managers can follow to maintain standards and efficiency.
Evaluate the customer base. Who are the customers? What percent are repeat buyers? What’s the acquisition cost and lifecycle?
Having a diverse customer base is a good sign. You don’t want too much of your business reliant on a small number of clients.
Finally, review vendor relationships. Strong relationships with suppliers, manufacturers, and other vendors mean reliability. Check for long-term agreements and the history of service.
Reliable outside relationships equal a stable business.
Market and Competition Analysis
Understanding the environment the business is operating is crucial. Look at industry trends. Is the industry growing or shrinking? Is the market saturated? Are the customers looking for better options?
Analyze the competitive landscape using what’s called a SWOT analysis. This stands for Strengths, Weaknesses, Opportunities, and Threats, and is separated into two categories: internal and external.
Internal: Strengths and Weaknesses – where does the business excel and what are its shortfalls.
External: Opportunities and Threats – where are areas in the market that are underserved you could capitalize on and what is the competition and marketing doing that may cause problems for you in the future.
Human Resources Due Diligence
This last section forces you to get personal.
People are a company’s greatest asset and largest liability, so you need to make sure the culture, leadership, and team are sound.
Start by reviewing employee contracts and benefits. Check for key employees and retention plans. And most importantly, talk with the employees to hear first-hand what they think of the business, how it’s run, and what the issues are.
Having these detailed and intrusive conversations at all levels of the organization will pull back the curtain to give you insight you’ll never see on a spreadsheet.
Ultimately, doing your homework before buying a business is crucial.
By looking closely at financial records, legal papers, daily operations, the market, and the staff, you make sure you know exactly what you're getting into. This’ll help you spot hidden problems and avoid bad surprises that pop up at the worst possible times.
The biggest thing to remember is that buying a business takes time. Many business searchers look at 100+ options before they find the one that’s right for them.
Between location, industry, price, and deal quality, don’t expect this process to take less than 18-24 months.
Happy hunting and I hope this helps you find the perfect business for you to buy.
This week's Harder Not Smarter Podcast episode:
EP 024 of the Harder Not Smarter podcast with Mike Sarraille. Fresh from the incredible Triple 7 Legacy Expedition where they made 7 skydives across 7 continents in 7 days. Mike, a retired Navy SEAL, shares gripping tales from his military service and transition to the business world. He delves into the meticulous planning and challenges faced during his recent adventure, highlighting the unbreakable mindset of veterans. Discover the invaluable skills veterans bring to the civilian workforce, from discipline to process optimization. Don't miss this episode filled with lessons on resilience, leadership, and the power of collaboration.
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