Small Business Purchase Due Diligence

Buying a small business has many challenges not the least of which is the due diligence process prior to the purchase. Most small business owners run their business with no thought of selling it. Their record keeping and bookkeeping are done for their needs and there is no thought given to how a buyer would view their information.

When buying a small business Due Diligence has 3 basic areas of focus. Two of the three require the assistance of the seller:

1. Industry Due Diligence: The seller is often the worst source for this information. Many small business owners have no real idea of the industry outside the 4 walls of their business. Get what you can from the seller but be prepared to conduct your industry due diligence with outside resources. Most industries have Trade Associations that can be a good source of information. Here's a link to a Directory of Trade Associations
2. Business Operational Due Diligence: This is where the seller has the most information. They usually can give you, the business buyer, every detail of the business process. During due diligence focus on understanding why the seller does something their way. Also, you will likely find that the business seller has not documented their processes very well or more likely at all. When discuss operations with the seller try to take all the notes you can so that you can get focused on the critical areas you need to understand. You'll have plenty of time later to figure out if you want to change something. Keep in mind that you will be replacing the owner so spending time focusing on what the seller actually does day to day is important. You might want to start a specific list and identify evey seller's duty - daily, weekley, monthly, annually.
3. Financial Due Diligence: This is the wild card. Different seller's are all over the place on this. I've seen million dollar businesses run from a shoe box and $50,000 businesses with perfect accounting. Don't focus on how they keep their books, just focus on how you can determine from their books if the information is reasonably accurate and you can determine how much money the business is actually making. Most small business financial due diligence starts with bank accounts. Do the deposits made at the bank equal the sales reported for the business? If not, why? Once you pull on that thread it will lead you to other questions.

We have a saying in our business, "There are good businesses with bad books, good businesses with good books, bad businesses with bad books and bad businesses with good books".  Make sure your due diligence helps you determine which kind of business you are evaluating. Understand the bookkeeping situation but don't let that automatically disqualify a business for possible purchase.

Keep in mind that your goal is to buy a good business, not just buy a good bookkeeping system.

Related Posts:

• What Do You Buy When You Buy a Business?

Excellent Book about Managing Small Business Finances:

Small Business Financial Management Kit For Dummies

Excellent Document Shredder for Confidential Disposal of Sensitive Materials

   

Options for Small Business Accounting

Over the years I have tried a variety of small business accounting solutions.  A huge leap forward for small businesses is the cloud based small business accounting software. Based on my experience a small business' best option is a "cloud" based solution. A cloud based small business accounting package has some significant advantages and a few disadvantages.

Advantages:

• Your software is always the current version
• You can allow direct access to your outside CPA. This may be the best feature since it allows you to very efficiently book the entries that I used to wait til the end of the month (or quarter, or year, or when the taxes get done). Now when we have something odd to book we simply call the CPA, we login together and the CPA shows us the proper booking, What used to go on someone's "to-do" list is now done correctly the first time.
• You can access your bookkeeping and accounting records from anywhere. Small business owners often complain about being tied down in their chair at the office but you don't need to be.
• You can outsource many activities which a remote user can do part time and at a lower cost because they can access your accounting system. This could save you hiring a full time person or trying to train people to do complex jobs part-time.

Disadvantage:

• There's a monthly subscription fee depending on the level of service you choose.
• Getting your CPA to use something other than Quick Books might be a challenge. But remember, you have to use the system everyday. If you find a system that works better for you than Quick Books have a discussion with your CPA about the benefits to you.

Although Quick Books is the most widely used and certainly a safe choice, I find the Quick Books "on-line" version to be slow and cumbersome. 

There is also the option of outsourcing virtually all of your bookkeeping to a company.  If you want to see what services an outsourced bookkeeping company provides go to GrowthForce they are experts at outsourcing small business accounting services.

Other related posts:

• What Do You Buy When You Buy a Business?
• Using Personal Credit Cars to Finance a Small Business

Here's the Cheapest Small Business start-up Experience You Can Buy

Here's a great book about starting a business. A real life recount of the ups and downs and lessons learned the expensive way.

This book will give you the cheapest experience you can buy. Learning from others start-up business mistakes is always better, and lest costly, than learning from your own.

What on earth is a coverage ratio in financing with an SBA Loan?

When dealing with financing of various sorts you will come across the term "coverage ratio". It my be in the context of "Interest coverage ratio"  or "debt coverage ratio" or some other similar nomenclature.

Here's the basic concept of a coverage ratio. The coverage ratio is designed to determine what margin for error there is in a borrower's ability to pay back the debt.

Let's use an example assuming you are buying a business, here are some basics:

• Business Purchase Price $500,000
• Seller's Discretionary Earnings (SDE) $175,000 (Seller's discretionary earnings is the business earnings before Interest, Depreciation, Taxes, Amortization and Owner's Compensation).
• Down payment Buyer has available $100,000
• SBA Loan $400,000  financed for 10 years @ 7% =  $4,644 per month payment which = $55,750 per year.
• Salary the Buyer needs from business to pay living expenses  $100,000.

Coverage Ration Calculation  

SDE                                       $175,000

Salary needed                         $100,000

Available for Debt Service      $75,000

Amount of Debt service          $55,750

Coverage ratio is                     1.35   Amount available for debt service divided by actual debt service.

Generally speaking when seeking an SBA Loan the coverage ratio required will be between 1.25 and 1.4.

What Price is the Right Price to buy a Small Business

If you decide you want to buy a business you need to prepare yourself for the rather inconsistent pricing methodologies used for setting the asking prices for small businesses.

You shouldn't confuse the asking price for a business with the value of the business or what finance professionals call a Business Valuation or Business Appraisal. There are many ways to compute the value of a small business. The results can be wildly different and all correct. The issue isn't "what is a business worth?" as much as "what is the business value to you?". We'll breakdown the elements and suggest ways for you to go about the process of determining a fair value for a business.


For background it also might be helpful to read  "What do you Buy when you Buy a Business?" . Also, you might want to review this Case Study How to Buy a Business -  Case Study.

In this post we will discuss the elements that create small business value. As Business Brokers we have these discussions with buyers but more importantly we have the same discussions with business sellers.