Choosing the Best Business to Buy: Preliminary Due Diligence
If you're searching for the best business to buy, you may have already found several businesses that interest you, but you need a way to narrow them down to a few serious possibilities. Preliminary due diligence is the process of investigating and evaluating these businesses to help you decide if they deserve further consideration.
The goal of preliminary due diligence is to learn just enough about a business to help you qualify (or disqualify) it for purchasing consideration. Unlike formal due diligence, a detailed process that takes place just prior to finalizing a purchase, preliminary due diligence takes place during the search and discovery phase when you determine if the business is a good fit based on your buying criteria.
Your preliminary due diligence for buying a small business should include:
Asking the Right Questions
The process of qualifying a business comes down asking the right questions to get the answers you need about the business. A few questions to consider include:
- Is this an established business or a startup or turnaround business?
- Is it in the right range? (revenue, earnings, and purchase price)
- Is it located in a place you'd like to live?
- Do you have the skills to manage the business?
- Does the business fit your lifestyle?
- Do the earnings of the business provide you with an acceptable living?
- Why is the owner selling?
(To read more on answers you want to seek, see Evaluating a Business for Sale: What to Ask the Owner.)
Visiting the Business
The process of buying a business cannot be accomplished entirely over the phone or via internet. You will need to meet the business broker or owner in person and then pay an actual visit to the business. If the business is being sold confidentially, this may require you to first get permission from the owner.
It's very possible that you will have to repeat this process a few times. Don't be discouraged if you have to meet with many brokers and visit many businesses before finding the right one. It could work to your advantage seeing many types of businesses firsthand. With this process, you'll learn more about what you like and don't like about the businesses you are checking out.
Considering If the Business Is Right For You
Before you dive into the nitty-gritty of the business' numbers, you'll want to be confident that this is a business opportunity that you will be interested in. In most cases, you'll be considering businesses that will require your regular involvement to streamline and extract profits from the business. If the business niche or industry is not appealing to you, the less likely you are to commit to any improvements.
However, lack of knowledge or passion for a business or niche doesn't necessarily mean it should be ruled out. For example, you may find a construction tool manufacturer that doesn't seem especially interesting, but also realize that if you apply your skills and talent, you could turn it into something very lucrative.
Bottom line, look at the business and where you'll fit in. If you don't envision yourself being particularly interested or skilled in a way that can enhance the business, then move on to the next opportunity.
Focusing on Financials
As part of your preliminary due diligence, review the following financial statements:
- Profit & loss (or income) statement
- Cash flow statement
- Balance sheet
- SDE Statement
At first glance, what you see in these statements may seem disappointing. It may appear as though the business you are considering isn't making any money after all. However, keep in mind that most small business financial statements are meant to minimize taxes. In some cases, these documents may actually show a loss for tax purposes.
Yet, many of these small businesses with weak financials are indeed making money; they're supporting someone and their family. You just have to do some detective work to find out exactly how. The first step in determining the owner's benefit is to look at the business's top line (gross sales).
Determining the owner's benefit from a business' gross sales is part art and part science. A good rule of thumb is to estimate that an owner/manager will be able to make anywhere from 10%-20% from gross sales. If the business has a million in sales, $100,000-$200,000 could be going to the owner in some form of compensation. Knowing approximately how much the owner is making will have a huge bearing on your decision to go forward, and the small business's value.
(For more on digging into the financials, see 3 Financial Reports You Need to Look at When Buying a Business.)
Determining Its Potential for Improvement
Again, you may find a business that seems not to be doing very well, but upon further inspection you may discover there's lots of potential for improvement. If you are unable to find out areas of the business you can exploit, such as underutilized assets, then this might not be the opportunity for you.
Though you will not pay for potential revenues but rather past performance in terms of sale price, it's okay to add more weight to the difference you'll make in a business post-purchase. Thirty percent of your decision to buy a business should be based on past performance and seventy percent should be based on what you can do to improve the business.
Overall, try to look past the surface operations, as a visionary who can see untapped potential that the current owner or manager may not be recognizing. This is where the value will be added to your business. If this potential doesn't seem to exist, again, it's time to move on. You may arrive at this point many times before you find an opportunity that could work for you.
Considering An Offer
Once you believe a business meets your buying criteria, it's time to get a little more serious and decide whether or not you'd like to make an offer. This will require a closer look at the value of the business and whether or not the owner is asking a fair price. There are several ways to determine the value of a small business. For more information, read our article How to Value a Business for Sale.