Buying a Business Checklist: With Full Due Diligence Considerations

Person considering buying a business reviewing thei

There’s plenty of talk online about buying a business instead of building something from scratch. Why? Because many potential entrepreneurs are seeing the benefits of acquiring an existing company that is in operations vs. trying to start their own. Additionally, trillions of dollars of business value is owned by baby boomers that are all getting ready to retire. Those businesses are going somewhere, and you could buy one.

If you’re exploring entrepreneurship through acquisition (commonly referred to as ETA), there’s a well worn path others have walked that you can follow to buy your first company. This article will outline the complete checklist you’ll need to go from first evaluating a business, going through a purchase process, to eventually buying and transitioning into running your new business.

But before we dive in…

Is it a good idea to buy an existing business? (Possible reasons to buy a business)

The renowned path toward entrepreneurship is to start a company. But with millions of active, profitable businesses out there, there is another often more viable option: buy an existing business. Often, an existing business checklist can help.

The greatest challenge in the early stage of entrepreneurship is finding “product-market” fit - meaning creating a product or service that a market actively wants to buy. When you see stats claiming 90% of startups or restaurants fail in the first few years, they’re failing because they likely couldn’t create something with enough demand to sustain their endeavor long term.

Most businesses that fail early on never find product market fit. Buying a business means you’re usually walking into some semblance of product market fit.

Learn from one of the founders of Baton on why we’re building Baton because buying a small business is more attainable than you think.

Less risky than starting a new business

Think about your local pizza shop, the one that’s been there since you were a kid. People know and love it. Local chains may move into the area, but a great local shop will survive because they’ve long ago established a “product-market” fit. People want good, authentic pizza from a local business near their house. Generations have come to this shop. The shop doesn’t have anything to prove.

Now think about how many small restaurants you’ve seen open and quickly shudder nearby. Donuts and chicken sandwiches sound like an awesome idea, but it’s hard to prove they work until you try it. And maybe they’re awesome…a few times a year, but it’s hard to compete with the consistency of a pizza shop that has been there for 40 years.

If you buy that pizza shop, one of the key things you’re buying is their “product-market” fit. You don’t need to figure out if there is a need for Pizza in the area because they’ve been selling it for 40 years!

Instead, you’ll be utilizing your entrepreneurial energy on optimizing and growing the business. Many entrepreneurs love the idea phase where they’re figuring out how to go from $0 - $1 in revenue. They want to invent crazy chicken and doughnut concepts.

A lot of folks just want the freedom that entrepreneurship provides. They may also have more big company experience that is highly relevant to optimizing an existing business instead of starting one.

Easier to secure funding

Generally, funding an acquisition is easier than funding a new idea. Outside investors and banks often perceive acquisitions as far less risky than startups. Buying an operating company means you’re acquiring an operating history that shows how the business has performed historically - and that is generally a decent indicator of how it will continue to perform. The stronger that operating history, the easier it will be to fundraise.

Operating an already existing business is cheaper

When acquiring a business, you’re generally buying on some multiple of future cash flows. This makes it easier to understand what you’re paying for, and how if the business keeps operating as it does today into the future, how long it will take to generate a return on your investment.

Making those sorts of calculations when starting a new venture is pure speculation: you may guess you can sell hundreds of donuts and chicken sandwiches every day, but the pizza shop can show you how many pizzas they’ve sold every month for years. That level of historical certainty often lowers operating costs and risk.

Possibility of getting more value than you pay for it

Ultimately, if you’re buying a business you want to see a return on your investment. If you can bring fresh ideas and outside experiences to the business you buy and grow, you may be able to generate far better profits than the prior owner. Perhaps the owner of the pizza shop has never tried UberEats. Maybe you think adding gelato to the menu could be a huge revenue driver. Pulling those types of levers is what buying a business is about.

In turn, if you grow the profits of the business, you may someday be able to sell it for more than you paid for it. A pizza shop may be a great business to buy. A pizza shop with a strong delivery and gelato business is likely an even better business to sell.

Easier to run than a startup

If you’ve never run a business before, walking into a business that is already operating can be far simpler than trying to figure out how to do everything yourself. Unclear on which payroll provider to use? Don’t know which insurance policies you need? Never heard of a merchant bank? The owner of the business you’re looking to buy will have figured all this out - so you can step into whatever processes, systems, and tools they’ve been using and then work to improve them over time instead of needing to come up with everything from day 1.

The Process of Buying a Small Business

We buy things all the time: coffee, houses, cars. As we get older, we learn to buy things that are increasingly expensive with more complicated transaction processes. For most people the most complicated thing they’ll ever buy is a car or a house.

Buying a business is a lot more complicated than that. There is far more to consider than when buying a home, there are generally more parties involved, and you’ll have a lot more direct interaction with the seller. A business is a living, breathing thing, and you’ll need to figure out how to value it, convince someone else to sell it to you, and then eventually take it over. This guide breaks down that process, and at Baton, we’re here to support you in your journey.

Buying a small business can be broken up into four parts:

1) Searching

This is where you look for businesses to buy.

2) LOI

A “Letter of Intent” is delivered to a business outlining your intention to buy the business. An LOI is akin to a proposal when acquiring companies.

3) Due Diligence & Acquisition

After you submit an LOI, you’ll go through more formal due diligence and draft the necessary legal documents to acquire the business.

4) Close and Transition

If all goes well, you close on the acquisition and work with the seller to transition into the business as the new owner.

How to Search for a Small Business

Over the last several years, there has been an influx of online marketplaces, business broker and brokerage services where sellers of small businesses can list their companies and buyers can connect with them. At Baton, we help connect serious business searchers to qualified businesses looking to sell. If you’re conducting a search, we’d love to hear about it and will reach out if we think we can help you find the right business to buy.

Some “searchers” have very specific criteria for the types of businesses they want to buy, I buy dog daycares. I look for Dog Daycares of a certain size in specific geographic regions. Some of our competitors look for bigger businesses than we do across the country. I’ve met other searchers looking for almost the exact type of business as us. We’re very focused in our search, as we’re buying businesses like the ones that we already run as a means to grow, but countless other searchers look more broadly.

Many searchers decide on the size of the business they want to buy, largely based on the price they can afford. Others are focused on very specific industries, but whatever your criteria, having some defined parameters around the type of business you want to buy will greatly help you narrow your search. At any given time, there are hundreds of thousands of businesses for sale across the United States.

Some criteria you may want to consider to help you refine your search:

Geography

Do you want to buy a business where you live? Or do you want to move somewhere to operate the business you buy. Consider how geography impacts certain types of businesses and business operations.

Industry/Type of business

When I bought my first business, there was no question we were buying a dog daycare. That was the type of business we wanted to run, so why would we buy anything else? Others think a bit more broadly. They may want to buy a pet business and will consider pet stores, pet focused e-commerce companies, or veterinary companies. That still narrows the search dramatically and helps the searcher learn about an industry as they search.

Size

This is usually based on the purchase price and what a buyer can afford to start. If you’re planning to finance the business with a Small Business Administration (SBA) 7a loan, you’ll need roughly 20% down. If you have $200k to invest, you can buy a business worth $1M. However, there is room to buy a business for less money down if you use seller financing.

SDE

Some buyers want to make sure they’re replacing their income with enough money to live on. They’ll want to ensure that the business they buy is kicking off enough cash for them to remain comfortable. Many small businesses trade for roughly 2-5x SDE, so that $1M example above may generate between $200 - 500k in SDE, allowing the new business owner a comfortable income post acquisition. Keep in mind that SDE usually requires the business owner to work in the business a considerable amount of time. Few businesses that generate $500k in income for an absentee business owner sell for $1M.

What do I need to see before I submit an LOI?

Once you’ve made contact with a potential seller, you’ll want to get a broad understanding of the business. If they’re actively trying to sell the business, they may have most of the information you’re looking for already collected.  If they’re hesitant to sell, you may need to coax them a bit on what it could mean for them and the business if they sold to you (this is where the real art of acquiring companies comes in). Generally speaking you’re want to review:

  • Financial documents such as the last three years of financial statements
  • Any leases the company may have
  • Contracts with both customers and vendors
  • Organizational chart (to understand the staffing of the business) with key employees
  • Any intellectual property, material contracts, licenses or permits that may be required to operate the business
  • Business assets, tangible assets and advertising costs

There are different opinions on how much information to ask of a potential seller before moving towards a LOI (Letter of Intent). Ideally, you gather enough information to get comfortable with putting a value on the business, but not so much that the seller will get tired of talking to you and assume you’re just kicking the tires on an acquisition but you’re not actually serious about buying.

The sooner you can figure out if this is a viable business for you to buy or not, the better. This is where having criteria helps. Having big disqualifying questions really helps, but once you find a business you like, what’s next?

Find out how much the business is worth & Negotiate a price

At Baton, we offer free business valuations to any small business, much like other business brokers. Anyone can explore the rough valuations of any small business in the US via our handy search tool. For buyers, we can also help you understand what comparable deals have looked like for businesses like the one you’re considering buying. You can learn more about how we value businesses here.

When I acquired my first dog daycare, we had a very rough idea of what these types of businesses sold for based on hearsay from other folks in our industry. After working with Baton and diving more deeply into the space, we have a much better understanding of how others value the types of businesses we are trying to buy. Baton can help paint that picture for you.

Once you have that number in mind, some people will have a verbal negotiation with a seller, while others prefer to present their offer in writing in the LOI (Letter of Intent).

The written offer is presented, contingent on further due diligence, into an LOI that normally also stipulates:

Due diligence timeframe

How long it will take you to pull together all the information you need to feel comfortable about the deal and to formalize a purchase agreement.

Closing conditions

Things you’ll need to see to get comfortable buying the business

Financing information

Some closing are contingent on specific types of financing, and you’ll want the seller to be clear on that at this point

Exclusivity

Normally a buyer will ask a seller not to “shop” their company after signing an LOI.

The point of the LOI is really for the buyer and the seller to shake hands, but at the same time leave themselves out if something crops up as they get deeper into understanding one another.

Normally, a buyer doesn’t want to spend the legal and accounting fees necessary to get 100% comfortable with buying a business until they’ve agreed on a price. If everything checks out, they will buy the business. Similarly, a seller doesn’t want to waste time answering hundreds of questions from an interested buyer without a high degree of confidence that they will actually buy their business. The LOI aims to mitigate this.

The LOI is non-binding, but barring any major hiccups, many LOIs turn into closed deals.

Once the LOI is signed, much of the real work begins.

What should I ask for in due diligence when buying a business?

Once the LOI is signed, most buyers operate from the position that they are going to buy the company they’ve been looking at. The goal of further due diligence and the purchase agreement is to get 100% comfortable with what you are buying, and then to actually buy it.

Normally, you’ll want to start by providing the seller with a full list of documents you’ll need to see as part of your due diligence checklist process that often includes:

1) Full financials

  • Three years of tax returns
  • Three years of monthly profit and loss statements
  • Annual Balance Sheets
  • Monthly statement of cash flow
  • Sales Records and Sales Tax Returns

2) Licenses, permits, zoning information

Depending on the business purchase, you’ll need to understand how the licenses and permits will transfer to you as the new buyer.

You’ll also want to ensure the prior business is in compliance with all local laws, regulations, zoning requirements, etc.

3) Full employee list and payroll

You’ll want to deeply understand the costs associated with payroll, whether the employees will likely stay with you when the business is sold, and if they don’t, what kind of risk that represents to you as the new owner.

4) Leases

You’ll want to understand what their leases look like, how dependent the business purchase is on the leases, and how transferable they are. Some things to consider here:

  • If the seller owns the real estate, you may or may not also buy it as part of the transaction. If you’re not buying it, consider what the seller will lease it back to you for. This is often included in the LOI.
  • If the seller doesn’t own the real estate, how long is left on their lease. If the lease isn’t long, you may want to extend it with the landlord as part of the acquisition process. There are plenty of horror stories of people buying businesses only to be put out of business by landlords raising rents shortly after they take over.
  • Is the lease transferable? Most commercial leases are, but you’ll probably want to meet with the landlord to understand what type of relationship you’re walking into here before buying the business.

5) Real Estate Inspections

If you’re walking into a lease, it’s wise to hire a real estate inspector to look at the location of the business purchase. Many Small Businesses lease their properties with NNN leases, meaning the build of the expenses associated with the upkeep of the real estate are the responsibility of the business and not the owner of the real estate. If you’ll need to fix a lot with the physical location the business operates out of, it’s best to know that while negotiating the purchase agreement rather than after you close.

6) Equity Structure and Governance Documents

You’ll need to understand who owns what as part of the business, so that when you do finally buy it, you’re paying the right people.

7) Insurance Policies

It’s likely a good idea to have an insurance agent review these policies and to start thinking about how you’ll transfer them.

8) Inventory List, Accounts Payable, and Accounts Receivable

If the business buys/sells physical goods, you’ll want to have an understanding of how much inventory they have, the cost of that inventory, and how that will impact your ability to run the successful business immediately after buying it.

If they have large accounts payable and/or accounts receivable, you’ll want to understand who is getting paid/paying what based on when you close the business and how that might impact the purchase price.

9) Details of any litigation or threatened claims from customers or employees

10) Proof of PPP Loan Forgiveness

11) Request a list of all debts and loan agreements

These will generally be paid off as part of the purchase process, and oftentimes you and the buyer are paying off the lender directly to ensure that there are no outstanding liens on the business following closing.

Following requesting all these documents, the first thing we would recommend doing is running a UCC lien search with the help of an attorney. At this point, you may want to start engaging an attorney that has supported transactional work before (ask them if they have specifically helped clients buy and sell small businesses). That lien search is a great way to start understanding how honest the seller is - do they have outstanding loans and or liens on the business they’re not being upfront about? If so, what and why are they hiding it?

Additionally, it’s smart to run a background check on the seller at this point. What comes up may or may not be relevant to the business, but the more you know about who you’re potentially buying a business from, the better off you will be as the negotiations get tough.

I wrote another article here about preparing for the sale of a business that should be helpful to understand want the owner might be going through.

How Do I Know the Financials Are Accurate?

When I bought my first business, I was staring at a ton of spreadsheets and bank statements and thinking, “how do I know any of this is real”? I’m good with photoshop…I could make all this up if I really wanted to. Few, if any, small businesses will have audited GAAP financials, so it will be up to you and your team and your purchase agreement to get you comfortable with the numbers you see. Keep in mind, making up financials and selling a business based on them is fraud, and luckily in America, we have a legal system that helps protect us if fraud does occur, but ideally you do everything you can to ensure you’re buying an honest business.

While your attorney is running these searches and background checks you or your accountant should be working to “tick and tie” the financials. You’ll want to look at the bank statements, and the key financial statements, to ensure that the cash inflows and outflows of the business lineup with what is being reported on the cash flow statements and financial statements. If you don't have any accounting experience, I highly recommend working with an experienced CPA to help you with this.

Once you’re comfortable with the financials and the initial information provided by the seller, it’s wise to start working with your attorney to start drafting a purchase agreement. A good transactional attorney will be able to work with the LOI you have in place with the seller, make some additional suggestions that you’ll want to consider as part of the purchase agreement, and get to a draft that is then shared back to the seller.

Normally there are a few weeks of “redlines” where the attorneys go back and forth arguing the finer points of the purchase agreement. I’d recommend trying to humanize this process as much as possible - if the attorneys are arguing over something, decide if it might not make more sense to talk to the seller directly and try to come to some kind of agreement that can then be translated back into the legalese.

You can learn all about my experience buying my first company here. Regardless of how much business experience you have, if you’ve never bought or sold a company, it is a completely unique experience and I’d highly recommend working with experienced advisors who can help guide you through the process.

What else do I need to consider as part of the due diligence process?

Beyond the documents listed above, you’ll want to start thinking about what the transition process between the seller and you will look like. This will have financial, contractual, and operational complexities to it. Some things to consider:

  • How are you transferring contracts, both from customers and vendors?
  • How are you transferring employees?
  • When are you meeting the management team? How and when are you announcing to both employees and customers that the business is under new ownership?
  • How will you transfer ownership of existing technology systems?
  • Do you require any training from the seller? Make sure to negotiate that into the purchase agreement so that you don’t pay off the seller and then you’re left with no obligation on her part to continue helping you in the first few weeks or months of owning the business.

You’ll also want to connect with an insurance broker to get policies in place immediately following closing - you don’t want to own a business that is uninsured. Many brokers are familiar with the M&A process and can look at the existing policies in place from the seller and help guide you towards getting similar or better policies.

What happens once the purchase agreement is signed?

Depending on the type of business you’re buying and the seller's relationship to their employees, you may or may not have access to the business before you close on it. I’ve bought businesses where we met the entire management team and planned our transition with them before we closed on the deal. I’ve acquired other businesses where the seller was terrified their staff would quit if they found out they were selling, so the first time we ever walked into the business was on the day we closed.

Regardless of how much direct access you have to the business you’re buying, you can have a plan walking in. The key things to consider are how are you going to transition:

  • The employees
  • The customers
  • All the systems
  • All of the expenses

If you can list out all those specific needs with the seller prior to closing and build an action plan similar to the one we shared here, you’ll be well on your way to successfully transitioning the business to your new ownership.

How Baton can Help

If you’ve made it this far, you might feel a bit daunted by the process of buying a business. Never fear - Baton can help you both find and close on your first ever business acquisition. Personally, buying businesses has changed my life and the life of my family. I’ve been able to move away from working for others towards working for myself in a way that is sustainable, fun, and consistently challenging and exciting. The first time I bought a company, I didn’t know ANY of what has been outlined in this guide, but with the support of great advisors, I’ve done this a few times now. It is a process, but if you work through it diligently, you can change your life and your career by buying a great company.