How To Buy A Small Business: Part 2 - Reviewing a Small Business (Due Diligence)

This is Part 2 of the “How to Buy a Small Business” Series. You can read the rest of the Series HERE

The “review” stage of the purchase comes after an offer to buy the business has been made and accepted by the seller. This stage is what the lawyers call “due diligence”. This stage is important for 2 main reasons. First, it can reveal issues in the business which are so fundamentally different from what you expected that you will either decide not to purchase the business at all, or it lead to significant renegotiation of the purchase terms. Second, the review provides information which is key to drafting the Purchase Agreement and providing any additional information needed for finalizing the purchase.

It is key to have experienced advisors assist at this stage to advise on what the potential issues are and how to interpret what is discovered in the review. There are three key advisors to involve at this stage. First (not surprisingly) is a legal advisor. The legal review will look at the existing contracts and relationships of the business. Second, an accountant or other financial professional will review the books and filings of the business to ensure that they are in order and as represented to you. Finally, if you don’t have a business background or industry specific business background, it can be helpful to find someone to provide this insight. This can be a business broker, especially if already involved in the purchase negotiation, or it can be another business professional with insight.

Legal Review:

The legal review will usually start with searches of various government databases, including bankruptcy and litigation. A key review is of the Personal Property Security Act database for security registrations against the business. This provides information on any leased equipment, debt which is secured against the business assets and other debt information. This helps create a list of all debts which the buyer will want paid off before the assets are purchased, or debts which the purchaser is willing to take on as part of the purchase.

The legal review will also include a review of all key contracts of the business. The review will look at what obligations are included in those contracts and whether the contracts can be cancelled if needed.

When a business has staff, one of the most important reviews will be of the agreements with the staff. These agreements may be written down or have developed over time. This review will help identify the risks associated with these agreements and suggest ways to mitigate the risks. This will often be an area of negotiation with the seller.

Financial Review:

A review of the financial statements, tax returns and other books and files of the business will usually be undertaken by an accountant. Most small businesses use a “notice to reader” financial statement format which essentially means that the statements are prepared only taking into account the information provided by the business. This can make it important to have a review of any supporting documentation undertaken as well, to ensure that you have a full financial picture of what you are buying. The tax returns of the business should also be carefully reviewed to ensure that they have been properly filed: if not, this could be an issue to address and mitigate against in the Purchase Agreement.

Business Review:

The business review may be done by you, the purchaser, if you have the experience. However, it can be valuable to have a second set of business-expert eyes on it as well. If a business valuation has been done and is being relied upon for the purchase price and financing, this valuation may need to be reviewed. Other business issues to look for include vulnerabilities to the value of the business. If, for example, a small number of clients or customers make up the majority of the income of the business, you will want to ensure that those relationships are secure and will survive past the sale of the business. If a good deal of the value of the assets of a business is held in dated and potentially unsaleable inventory, this should be identified. The issues to consider will depend on the kind of business and how it has been operated.

Completing the various reviews of the business is usually happening at the same time as the sale documents are being drafted and negotiations for changes are being made. It is a good idea to leave time for the reviews to be completed, but working with an experienced team will help move the process along as they will be able to anticipate some of the common problems and suggest solutions.

HOW MOMENTUM CAN HELP: Get in touch today to receive a FREE CONSULTATION on your purchase. Our experienced team can help you navigate the entire business purchase process from start to finish. We offer flat rates for a small business purchase, which allows you to budget this cost with no surprises. We provide business transition advice and help connect you with supporting services to start your new business with confidence. We can help you complete the legal review of the business, complete the legal paperwork, negotiate any of the missing pieces and close the transaction smoothly.