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We get two kinds of calls about business acquisitions. The first comes before the letter of intent is signed: “We’re looking at buying a company. Can you help us review the numbers?” The second comes six months after closing: “The revenue isn’t matching what we were shown. Can you help us figure out what happened?”
Both buyers looked at the same kinds of financial statements. The difference was what they did before signing. If you are somewhere between a handshake and a purchase agreement right now, this checklist is for you.
The seller’s financials are a starting point, not an answer
Most sellers are not trying to deceive anyone. But every seller presents the business the way you would present a house for sale: cleaned up, well lit, and photographed from its best angle. The profit and loss statement you receive is the seller’s version of the story. Due diligence is the process of verifying that story with evidence, and the Small Business Administration’s guidance on buying an existing business says essentially the same thing: review everything, and verify what you review.
Here is where we focus when we do this work for buyers.
1. Verify that the revenue is real, repeatable, and transferable
Start by tying the reported revenue to something the seller cannot easily adjust: bank deposits and filed tax returns, ideally for the last three years. If the P&L shows revenue that never landed in a bank account or never appeared on a tax return, you need to understand why before going any further.
Then look at the quality of that revenue, not just the amount. How much comes from the top three customers, and will those relationships survive a change in ownership? How much is genuinely recurring versus one-time project work? Are customer contracts assignable to a new owner? A business with $2 million in revenue spread across two hundred customers is a very different purchase than a business with $2 million concentrated in three accounts held together by the seller’s personal relationships.
Finally, look at revenue by month, not just by year. Annual totals hide trends. A business that did well two years ago and has declined every month since can still show a respectable three-year average.
2. Test every add-back
Small business deals are usually priced on adjusted earnings: the seller’s discretionary earnings or adjusted EBITDA. The adjustments, commonly called add-backs, are where the price gets negotiated, because every dollar of add-back typically translates into several dollars of purchase price at the deal multiple.
Common add-backs include the owner’s above-market salary, personal vehicles and travel run through the business, family members on payroll who do not work in the business, and expenses labeled one-time. Each of those can be legitimate. Each can also be optimistic. Our standard for accepting an add-back is simple: it must be documented, it must be truly non-recurring or discretionary, and the business must be able to operate without it. In our experience, “one-time” expenses that appear in all three years of financial statements are not one-time expenses. And if the owner’s salary is added back, the cost of replacing the work the owner actually does needs to be subtracted.
3. Do not skip the working capital conversation
This is the most common expensive surprise we see in small acquisitions. The buyer and seller agree on a price for the business, but nobody defines what comes with it. Then the buyer takes over and discovers the checking account was swept at closing, the receivables include invoices that will never collect, and the customer deposits on the balance sheet represent work the new owner now has to deliver for free.
Before you sign, review the accounts receivable aging and discount anything past ninety days. Physically verify the inventory and separate what is salable from what has been sitting on a shelf since the last presidential administration. Identify deferred revenue and customer deposits, because those are obligations you inherit. Then negotiate a working capital target into the purchase agreement so the business arrives with enough fuel to operate. This analysis is a core part of the transaction support work our financial services team performs for buyers.
4. Open the accounting file, not just the PDFs
Here is a step most buyers skip, and it is often the most revealing one. Ask for accountant access to the seller’s actual QuickBooks file, not just exported statements. A PDF shows you what the seller chose to present. The file shows you how the business actually keeps score.
Inside the file, we look at whether the bank and credit card accounts are reconciled, whether there are large manual journal entries clustered near period ends, whether the undeposited funds account has been quietly accumulating, whether inventory quantities go negative, and whether the file’s numbers tie to the filed tax returns. None of those findings automatically kills a deal. But each one tells you something about how reliable every other number is, and reviewing accounting files is work our technology team does every day. If a seller refuses reasonable access to the books, treat that as information too.
5. Look for the liabilities that are not on the balance sheet
Some of the most expensive problems in an acquisition never appear in the financial statements. Review the lease terms and any personal guarantees attached to them. Ask about sales tax exposure, especially if the business sells into multiple states, because uncollected sales tax can follow the business to a new owner. Examine how workers are classified, since a team of contractors who should have been employees is a payroll tax liability waiting to be discovered. And ask directly about warranties, customer commitments, and any pending disputes. The purchase agreement’s representations and indemnification language should reflect what you find, which is a conversation for your attorney, informed by your accountant’s findings.
6. Settle the structure and tax questions before you sign, not after
How you buy the business matters almost as much as what you pay for it. An asset purchase and an equity purchase have very different consequences for the liabilities you assume and the tax treatment of the price you pay. In an asset deal, the buyer and seller must also agree on how the purchase price is allocated among the assets and report that allocation consistently to the IRS on Form 8594. That allocation directly affects your depreciation deductions for years to come, which makes it a negotiating point, not paperwork.
The right entity structure for the acquisition, the financing, and the allocation should all be settled while you still have leverage: before signing. Our tax planning team works alongside buyers and their attorneys on exactly these questions.
Right-sizing the work
A full quality of earnings report from a national firm can cost more than some small businesses themselves. That is not what most closely held acquisitions need. What every acquisition needs is a diligence effort proportional to the deal: for a smaller purchase, a focused review of the revenue support, the add-backs, the working capital, and the accounting file can usually be completed in a few weeks and priced accordingly. The goal is not a four-hundred-page report. The goal is to know what you are buying before you own it.
If you are evaluating an acquisition, contact us or call (314) 845-6680. We will scope a due diligence review that fits the size of your deal, and if the numbers do not support the story, you will know while walking away is still free.
Frequently asked questions
What is financial due diligence when buying a business?
It is the process of verifying a target company’s financial story with evidence before you commit: confirming revenue against bank records and tax returns, testing the earnings adjustments the price is based on, evaluating working capital, and identifying liabilities that do not appear on the balance sheet.
Do I need a full quality of earnings report for a small acquisition?
Usually not. Formal quality of earnings reports are designed for larger transactions and lender requirements. For most closely held deals, a right-sized diligence review covering revenue support, add-backs, working capital, and the accounting file provides the protection you need at a cost proportional to the purchase.
How long does due diligence take?
For a typical small business acquisition with reasonably organized records, plan on two to four weeks from receiving the financial information. Build that time into your letter of intent, because compressed diligence is where expensive mistakes happen.
This article is for general information only and is not tax, legal, or investment advice. Every transaction is different; consult your advisors about your specific situation before acting.
