Episode Host: Henry Lopez is a serial entrepreneur, small business coach, and the host of The How of Business podcast show – dedicated to helping you start, run, grow and exit your small business.

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The following is a full transcript of this episode. This transcript was produced by an automated system and may contain some typos.

Henry Lopez  00:13

Welcome to the How of Business podcast. This is Henry Lopez. This episode is for you if you intend to buy or sell a small business, all from the perspective of buyer due diligence. If you are buying a business, then effective due diligence is essential. And if you’re planning to sell your business, it’s valuable to understand and be prepared for what a smart buyer will be looking for. Buying an existing business can be one of the fastest paths to successful business ownership, but only if you truly understand what you’re buying and what you’re paying for before you sign that purchase agreement. In this episode, I’ll walk you through my due diligence checklist, the key areas you need to investigate, and how to hopefully avoid buying the wrong business. You can find all of the How a Business resources, including the show notes page for this episode, and learn more about my one-on-one and group coaching programs at thehowabbusiness.com. I also invite you to join the How a Business community on Patreon, and please subscribe wherever you might be listening so you don’t miss any new episodes. So buying an existing business can sometimes be a better option than starting from scratch. You get existing customers, cash flow, proven cash flow systems, employees. Ideally, you’re buying a proven, successful business model that has generated consistent profits. But things are not always as they appear. Just because a business is always busy, for example, or is generating lots of revenue, does not necessarily mean that it’s healthy. And you also need to be clear on what you may be inheriting from that business that may not at first be obvious. The process of due diligence is how you find those problems before closing, not after. It’s your opportunity to look under the covers and validate what you are buying. I think the old proverb “trust but verify” comes into play here. A good seller isn’t lying to you, but it’s not their job to protect you either, and of course they’re going to focus on highlighting all that is great about their business, not necessarily the things that may be broken. So verification is your job as the buyer and your advisor’s jobs, the team of people that you’re going to have help you with this, namely perhaps a business coach, a CPA, an attorney, all of those people working together with you. You need to verify that you’re buying what you think you’re buying. So, in this episode, I’m going to share a practical framework that includes a free new checklist that you can download from the show notes page for this episode at thehowbusiness.com, and it’ll walk you step by step through the key elements of due diligence in the process of buying a small business. What is due diligence anyway? Due diligence is a thorough evaluation of all the aspects of the business before finalizing the purchase. The goal is to confirm that the business is what it appears to be and uncover any risks or issues that might change the price or the decision to buy altogether. Due diligence should be a written condition of either your letter of intent, so it should be included in there that that’s going to be an option to conduct due diligence, or sometimes it’s in the purchase agreement. It’s a contingency of the purchase agreement that you have X amount of time to conduct due diligence, and within that period of time, if something you don’t like, anything or whatever, you can walk from the purchase agreement, I prefer to do due diligence during the LOI if the seller is agreeable to it. But often it does happen under the purchase agreement, meaning there’s a period of time set aside. Make sure that your attorney helps you with that, so that you’re clear that you do have a legitimate and legal due diligence period, and you retain the right to walk away from the deal if it doesn’t match what you thought it was. Never waive this opportunity. Never waive this right. It is your primary protection. Due diligence should not be optional, and you should never buy a business as is, like you might buy a used car. We have to conduct some level of due diligence on a business, and it’s not that you’re looking to kill the deal. You’re trying to make sure you understand the deal that you’re getting into.

Henry Lopez  04:05

Your due diligence findings do one of three things: either confirms everything you thought and confirms the deal, or it leads to perhaps a renegotiation of the price or the terms, or the deal ends. You walk away. All three, really, when you look at it, can be wins. At least you didn’t end up buying something that then had unexpected issues later, and you would not have bought it nor paid what you paid for it had you known up front. This is high level here what I’m going to cover, and you want to make sure that your CPA and your attorney are involved in this entire process. You need a CPA to help you with the financials. You might even engage your CPA to conduct a thorough financial analysis, your attorney must come into play before you sign any purchase agreement or contract. Your attorney, not their attorney, your attorney needs to be the one to review it and give you guidance on what you’re committing to before you sign that agreement. Now, if it’s an LOI, a letter of intent. And as long as there’s very clear language in there that you understand, that and that a reasonable person would understand that this is not binding. An LOI should not be binding. As long as it says that, then you’re good to go. But again, if you’re not sure or you’re not sure how to express that, get the advice of your attorney on that. So knowing what you’re buying and what you’re paying for-that’s the key thing here that we’re looking for or looking to uncover during the due diligence process. Before you investigate the details, though, get clear on the reasons and the structure of the deal itself. This is where buyers make the biggest mistake. So I want to understand why is the seller selling now? What what is the motivation? What are the reasons? It could be retirement or burnout, but very different from oh, one of our anchor tenants in our shopping center is leaving. Now they may not volunteer that, but you need to find that out. What are the reasons why they’re looking to sell, and that can lead to clues that you should investigate and as part of due diligence to make sure that you understand what you’re buying. Now, as far as deal structure goes, it can either be an asset purchase or a stock purchase. Most small business deals are asset purchases. We are buying the assets of the business, not the legal entity, not the shares of the corporation or the units of the LLC, and that’s generally safer for us as the buyer. It’s not as advantageous for the seller, and that’s why sometimes you might have a seller that’s asking you to buy the legal entity. This is where your CPA must get involved, and perhaps your attorney as well, because your CPA needs to explain why a stock purchase and what impact that has on your tax liabilities, as well as your ongoing liabilities that you inherit if you buy the legal entity. Validating earnings, of course, is is a big one. This is the big thing we’re looking to make sure that we have based our offer on real numbers. Small businesses are typically priced on a multiple of what’s called seller’s discretionary earnings, which is the seller’s adjusted profit. It’s the profit plus all of those other things, perhaps that the business is covering for the owner. That is really an owner benefit and not necessarily a true quote unquote expense of the business. So that number gets calculated. The seller’s discretionary earning. What is the true compensation that the seller is getting? We don’t typically price a small business based on its revenues or sales, and I I often hear people talking about you know we’re going to pay X multiple of revenues. I suppose there are some small businesses where that makes sense. It doesn’t make sense to me. The revenues are somewhat irrelevant if you’re not generating any profits on that revenue, and I’m not in the business of recommending or buying businesses that are not profitable. I’ll come back to that point. So there are adjustments made to the profit, like the owner’s compensation, personal expensive, one-time costs, and then that number, that seller’s discretionary earning, or that net operating profit that’s been adjusted, gets multiplied by a multiple. And typically, this is just typical.

Henry Lopez  08:00

There’s no rules on this, and every industry is different. Every market is different. Of course, every business is unique. But typically speaking, I see small businesses selling between one and three multiples. Now, one or less than one is a business that’s that’s not doing well or has been stagnant. Those are the types of businesses that maybe aren’t even profitable, so I don’t prefer to buy those kind of businesses. But there might be a good reason why you might consider them. Typically, I see businesses selling at around a three multiple of their seller’s discretionary earnings. But again, that’s just a rule of thumb. There are businesses, highly successful businesses, that might sell for more than that-456, times-and then I’ve been part of industries where there’s lots of private equity money moving into that space, and you might see significantly higher multiples. It just depends. I’m just giving you some averages. The key for you, as you’re calculating what it is that you should pay for the business, is you should do some research and get help on this from your coach, your CPA, your attorney, others in the industry doing research online. What is typical for the type of business that you’re buying in your market? What’s a typical multiple, so that at least you have that as a frame of mind, and then you’re investigating during due diligence to validate that that seller’s discretionary number, that profit that you’re basing your multiple on that then determines what you’re going to pay for the business, or at least offer or start negotiations from. That that number is based on real numbers. That’s what you’re uncovering during due diligence. So clarify also during this process what the price covers, what assets, what inventory, or am I paying for the inventory separately, working capital usually is not included. So, what else is excluded? What am I buying? A lot of times, we got to think about things like intellectual property or digital assets. Make sure you’re clear on everything that you are buying as you move into this due diligence period. You’re not buying revenue. Remember. You’re buying verified profits and the assets that produce them. Don’t buy a business that’s not profitable, even if it once was. Unless you’re an expert at business turnarounds or it complements an existing business. But if this is your first business that you’re buying and you’re going into it thinking I’m going to turn this thing around, you may well do so. But I’m here to tell you it’s really high risk, and I certainly can’t recommend paying any kind of a multiple on a business that’s losing money. So be very careful there, and that is, of course, what you’re validating is that it, in fact, is making the profits that had been shared either in the pitch deck or in the summary or in the financial statements that were shared with you. So let’s get a little bit more specific on the areas that you should be investigating as you do your due diligence, and they are the legal areas, financial, operational, the general market, and then other risk considerations. So let’s walk through those at a high level, and the checklist that I mentioned that you can download has all of these in detail, so you can walk through it and check things off as you’re going through your due diligence. So once the deal makes sense, you’re at this due diligence period. Now it’s time to verify it, and there are several areas, as I just said, to work through. I’m going to hit here on just the ones that matter the most, and the full list is in the free checklist that you can download. So let’s touch on legal, but of course your attorney is going to be involved here to make sure that before you sign anything, that you understand completely what you’re committing to, and that language gets added that protects you. But what are you investigating here? You’re investigating the business structure and that it’s in good standing. Make sure you’re dealing with the right person that has the authority to sell and has to sign. To give you an example.

Henry Lopez  11:41

You you might think you’re dealing with the owner, but in fact, maybe there’s a silent partner that has enough majority, or a part of their operating agreement is that person has to sign, and they may not know anything about it. They may not want to sell. There might be some disagreement. So you want to make sure you’re clear on who really has the rights to sell you the business. Your CPA or your attorney should be helping you with this. Another thing that’s critical here legally is leases. This is often gets forgotten or not thought about. If you’re buying a business that’s leasing a space, a commercial space, then it’s critical that you’re able to assume that lease. Often I see people leave this to the last minute, and it can kill the deal. You want to make sure that a the lease has enough life left in it. B that it can of course has to be transferred to you an assignment as it’s called, and that needs to be a contingency in the deal. And more importantly, even is to negotiate an extension before you close on the deal, or make it a contingency of closing on the deal, an extension in your favor. So let’s say there is one year left on the lease, and you’re buying this business. Well, if you don’t negotiate that ahead of time, who knows what might happen to you? Who knows if the landlord is willing to negotiate, or if they don’t double your rent and now your business may no longer work, and you would have to move locations, and that could kill your business. So that’s part of that due diligence is understanding leases and other contractual obligations that you might be inheriting. So that’s the legal aspect, and again, your attorney should be helping you with these things if it’s legal matters that you’re not familiar with. Moving on to the financial area, this is where you need to spend the most time, and again, your CPA can help you with this. But you’re essentially validating that those financials make sense. I recommend looking at three to five years of financial statements, making sure taxes have been filed, making sure you’re aware of any debts or liens that are outstanding, and who’s going to be responsible for those, and by when? Typically, when we buy a small business, we do not inherit any of its debts or other obligations. So those are getting settled at closing, and that’s got to be put in writing. But it could be that we have other contracts for maintenance of equipment, for example, that are expected to transfer to us. So these are critical things. Validate the cash that flows through the business. Reconcile and make sure that things make sense. I like to spot check one or two months, maybe a month from this year and a month from last year, and walk through the cash flow. How did it come into the business? I should see that in the POS system or other system, we should see it going into the bank account. So you’re reviewing bank statements, and you should have access to all of this during the due diligence period. And then you’re seeing it reflected pretty close to the dollar on the PNL. And then if you look at the whole year, that PNL should align with the tax return that was filed. This is for the previous year. So all of those things, the flow of money in and out of the business needs to make sense. And if it doesn’t, anything that doesn’t make sense, in particular, if it doesn’t make sense to your CPA, well, that’s a red flag. And if you start to uncover these things beyond honest errors, which are going to exist. Then that should lead you to question the honesty and the truth about everything else about the business. Now, should you walk from a business if that’s the case? That’s your decision. I know that for me, this is critical. If there’s dishonesty here or a lot of errors, even if it’s not purposeful, well, that tells me this business isn’t being run the way I thought it was being run, and certainly I cannot have any confidence in the numbers, and the numbers are what I’m basing my offer on.

Henry Lopez  15:24

We may have to adjust the price, or I may need to walk from the deal altogether. Remember that when small business owners share their P&L with you and their balance sheet or any other financial statements, these are not audited financial statements. So there could be honest bookkeeping errors, there could be purposeful errors. There could be things that don’t match. There could be funny business that’s going on to either avoid taxes or whatever else, which is fine. That’s their business, but that’s not the kind of business that you want to inherit nor pay for necessarily. So the financial part of it is key, and following that flow of money, making sure it all makes sense operationally. Investigate the day-to-day operations, the systems, the technology stack. All of those things should be in place. Who who owns that technology? Is that something you’re going to have to transfer into your name? So, what are those software systems that are in place that are essential to running the business, and how will they transfer to you? A big issue to investigate is whether the business runs only because of the owner or maybe one or two key employees. If that’s the case, then of course we’ve got a big problem. If the owner, after they leave, that was the heart of the business. That’s who everybody came to. That’s who the clients trusted, and maybe it’s one or two key customers that make up 80% of the business, those are big red flags that I’m looking for during this due diligence period, as well as key employees. And you might assume that they will stay with you, but they don’t have any obligation nor legal requirement to stay with you. So, if everybody walks out the door and there are no systems in place, and they are the heart of the business, well, then what are you really buying? So you have to be very careful there. We usually negotiate some period of transition where the owner or key employees agree to stay on for a period of time to transition the business. Now again, that’s usually the owner, and we can make that a contractual obligation that they have a transition period. Speaking of workers, employees, the other thing you’re investigating is making sure you’re not inheriting some mess in the way of how these workers are currently classified. If this previous employer, for example, or business current business owner, had been paying people as contractors to avoid paying payroll taxes, but they really, by IRS definition, should be employees, W-2 employees. Well, that’s a problem that now you’re going to inherit, and that can be quite a mess with the IRS. So those are other things operationally that you need to try to uncover during due diligence. I mentioned digital assets, but confirming the ownership of all of these things that are key to running the business, whether it’s online systems or tools or a website-all of these things need to be considered as part of what is going to transfer to you. Now, broadly, let’s step back a moment and talk about the market. I hope that part of your research, as you came to the point of wanting to buy this business, that you’ve researched the broader market. What does the competitive landscape look like. Who are their primary competitors? And I’m assuming that if you’ve gotten to this point, you have confidence that this business you’re buying is well positioned. Or you might argue, well, I’m going to get it there. I’m going to turn it around. I’m going to fix some of the issues that it has customer service wise. Let’s say to get it to be more competitive. I’m good with that. Just be careful that that doesn’t also mean that right now they’re losing money. That’s a really difficult thing to overcome, especially if you’re a first-time business owner. Is to think that you’re going to pay for a business that’s losing money and you’re going to turn it around. That’s a heavy burden and a really big challenge. So I discourage you from doing that if at all possible. But look at the market, look at the customer concentration. Who are those? Analyze the competition and be honest about what it is that you’re buying. Of course, generally you need to also analyze in the due diligence period what is what are the risk factors here.

Henry Lopez  19:16

You need to investigate what insurance coverage is in place and that you’re going to need to continue. Have there been any claims filed that might impact you at that location? You’ll want to talk to an insurance broker about this. Are there any regulatory or government changes or anything that’s being imposed or will be imposed that maybe the previous business grandfathered but now might get triggered you as a new owner? So you need to be aware of those types of things, and again, an attorney can help you with this. And in other things that might need to be looked at, for example, if you’re getting an SBA loan, there are certain things or certain conditions that that bank is going to expect. If you’re buying a franchise, that franchisor has to approve you. There might be a transfer fee, so who’s going to cover that transfer? So all of those things are things to uncover during due diligence. So those are kind of the general areas to look at in due diligence. Again, I spell this out in a lot more detail in the checklist that you can download. Some common mistake that I’ve touched on, but I want to repeat here: skipping or rushing due diligence at all is critical. Just because you want to keep the deal moving, or you’ve fallen in love with the business, so you’re just going to take it at face value, or you know the seller and so you trust that everything is good. Big mistake often not making it a written condition of the LOI or the purchase agreement. It has to be part of that language. If it’s part of the LOI, a lot easier because the LOI is not binding. But if it’s part of the purchase agreement, the language has to be just so, so that it makes it a contingency that within certain period of time, if certain things aren’t cured that come up during that due diligence period, you can walk from the deal, and that’s where your attorney has to be very involved and help you make sure that that language is clear and in your favor in that purchase agreement or contract. Another big mistake is to take the seller’s add backs. You know those numbers that are being added back on to increase the compensation number to the owner, which is what you’re then basing your price on. You got to validate those those numbers make sense, not just take them at face value. And then another mistake is going it alone. I’ve mentioned it now multiple times. You need a team, a coach, a CPA, an attorney. Maybe your lending officer can help you as well if you’re getting a loan. What are those things that you need to investigate that you need help with? And then of course the lease we talked about, making sure that the lease transfers. And the mistake I see there is waiting until the last minute, or not even thinking about having to negotiate that. And then the biggest common mistake to avoid is buying an unprofitable business or a business that depends mostly, if not exclusively, on its owner. There, you’d be buying a job, and if it’s not making any money, you’re buying a lesser-paying job than what you have now, so don’t do that. Don’t buy a business that you can’t confirm as part of your due diligence that it’s making money and enough money to justify the compensation you’re expecting from that business. When it comes to due diligence, I want you to slow down, take your time. There’s no hurry here. Usually, we negotiate 3060, days, something in that range. The seller must provide you complete access. If they’re blocking you or not giving you access to certain systems or telling you that’s not available or that’s confidential, then you’re not being allowed to do due diligence. That’s not due diligence. Due diligence is an agreement that the seller is going to give you access to everything and anything you ask for, bank statements, POS systems, the financial systems, any any and every system that has data or that has a piece of how the cash flows through the business, you have access to that. Otherwise, you’re not really doing due diligence.

Henry Lopez  22:56

And to me, that would be an immediate red flag if I’m not allowed access to that information, as they say, a no that you discover in due diligence is far cheaper than a yes you regret. So remember to trust but verify. So as I said, I’ve created a new. This is a new version of the buyer due diligence checklist. You can get it at the show notes page for this episode at thehowabusiness.com. It covers all of the seven areas. It’s a practical guide that I hope helps you as you go through due diligence, or if you’re a seller, look through it and be prepared for what again a smart buyer is going to be looking for and asking for. Buying a business can be a great path to ownership. I’ve bought several businesses myself, and many of my clients I have helped buy businesses. But the deal that you clearly understand is the only deal worth doing. The theme again is trust but verify. Do that work up front, that due diligence work, and you’ll close with confidence instead of crossed fingers. This is Henry Lopez, and thanks for joining me for this episode of the How of Business. I wish you the best as you buy and grow a successful and profitable small business. I release new episodes every Monday morning, and you can find the show anywhere you listen to podcasts, including the How a Business YouTube channel and at my website, thehowabusiness.com. Thanks for listening.