Due diligence—the process of gathering as much information and intel as you can before you buy a business—is a critical step in your journey to becoming a business owner. During this period, you should work with an accountant and lawyer to make sure you’ve got all the information you need to move forward.
Before you can begin your due diligence, the seller will most likely ask for a signed confidentiality agreement or nondisclosure agreement. By signing, you agree not to disclose any confidential information about the business that’s uncovered during the due diligence process. This protects the seller in case you decide not to buy after reviewing all the documents.
There are plenty of business documents, files, agreements, and statements that you’ll want to collect and analyze, ideally with the help of a lawyer and accountant.
Here are some of the must-have documents when doing due diligence in the process of seeking to buy a business:
1. Business Licenses and Permits
First up is to make sure that the business you’re looking at has all the business licenses and permits it needs. If you’re going to take over the business, you want to make sure that the current owner hasn’t run afoul of any local business licensing laws. Businesses in certain industries, particularly highly regulated ones like food services and child care, need a valid permit to stay open.
2. Organizational Paperwork and Certificate of Good Standing
If the business you’re buying is a sole proprietorship or partnership, there may not be official “founding” paperwork. However, a registered business entity, such as an Limitted Company , will have organizational documents on file with the state. For an Limitted Company, this is the articles of association. For a corporation, this is the articles of incorporation.
A certificate of good standing for the business you’re interested in. This certifies that the business is approved to operate in the state.
3. Zoning Laws
Check with your area’s local zoning laws to make sure that the business you’re purchasing isn’t violating any restrictions. While some localities allow mixed use commercial and residential zoning, others have tight restrictions on where businesses can be located. This especially goes for businesses like bars and nightclubs that may not be desirable in a residential area.
4. Environmental Regulations
Has this business been secretly dumping chemicals into the nearby reservoir or violating other environmental laws? (We certainly hope not, for everyone’s sake!) Make sure the answer is a firm no before signing on the dotted line. Double-check that this business abides by all of the area’s small business environmental regulations.
5. Letter of Intent
The seller issues a letter of intent (LOI) to the buyer when both sides have agreed on a price point and about which business assets and liabilities will be included in the transaction. The price proposal, along with the terms and conditions of the business sale, should all be included in the seller’s LOI.
The LOI is an indication from the seller that they are serious about seeing the deal through to the end. Once you have it in hand, you can feel more comfortable forging ahead with the remainder of due diligence.
6. Contracts and Leases
Half the fun of the choice to buy a business is all the stuff it comes with. Whether that means a lease for the location, equipment, or something else, you’ll want to make sure the landlord is alright with transferring over these legal documents to your name. Otherwise, you’ll need to negotiate a new lease, which can significantly add to your expenses.
You’ll also want to review any outstanding agreements that the owner has with vendors or customers. This can be very revealing. For example, if your review indicates that 90% of the business’s revenue comes from a single client, you’ll want to think twice before buying. If that client parts ways with the business, it could put a serious dent in the business’s potential.
7. Business Financials
Before you buy a business, make sure to examine its past few years of financials, including:
Double-check that the tax returns and financial statements have passed a CPA audit—don’t accept those financials from the sellers themselves.
Use the business’s financials as an opportunity to analyze its income stream. The business you purchase doesn’t necessarily have to be profitable yet (particularly if it’s a young business), but there should be a clear path to profitability.
Be in the know on whether the business’s debts and liabilities will be included in the transaction or not, and be wary of taking these on. For example, if some of the outstanding receivables the ex-owner was dealing with are too old—90 days or more, for example—then they’ll be pretty tough for you to collect on. You might be better off asking the seller to insure them or contact the customers themselves.
8. Organizational Chart
You won’t want to walk in blind. If you buy a business with employees, make sure you understand how they rank and relate to one another by asking for a business organizational chart. This should also include compensation data, management practices and processes, benefit plans, insurance, and vacation policies.
9. Status of Inventory, Equipment, Furniture, and Building
Make sure to critically analyze these aspects of the businesses, since their values will directly impact the cost of the business.
You’ll want to check:
Sites like Whayne.com can be used to look up equipment and obtain price estimates.
10. Other Important Documents
This list of documents will tell you a lot of information about the business, but there’s probably more you’ll want to examine. Your attorney or accountant should be able to identify additional documents specific to the business you’re interested in.
For example, ask the seller for property documents, equipment/asset listing, brand assets for advertising materials, an account of intellectual property assets, insurance coverage, employee policies and contracts, incorporation information, and customer lists.
Once due diligence comes to a close, you’ll need to make your final decision about whether to buy the business. If you decide to go ahead, the sales agreement is what ties it all together.
The agreement will enumerate the final purchase price and everything you’re purchasing, including:
Have a lawyer help you put this document together—or, at the very least, review it before you sign.
Before you finalize the move to buy a business, there’s one very important step—the buyer and seller have to agree on a price. This is where many deals fall apart because buyers and sellers often place very different values on the same business, and several factors affect a business’s value.
Buyers and sellers usually use some kind of pricing model to get a ballpark number and frame negotiations. During this process, it can be very helpful to call in an independent business valuation professional to make an objective determination of value. Valuation services, which can be found online or through word of mouth, cost around $3,000 to $5,000, but they can save you thousands more in the long run by coming up with a good estimate of value.
Whether you do this yourself or hire someone, it’s helpful to have some knowledge about how businesses are valued. To get some insight, we spoke with Mike Bilby, CPA and certified valuation analyst.
Bilby said small businesses should understand three main approaches to valuing an existing business:
Best used for: Businesses that are already turning a profit or have a positive forecast of earnings.
The earnings approach values a business based on its historical, current, and projected profits. Specific methods you may come across that fall into this approach include the capitalized earnings method and discounted cash flow method.
For businesses with a history of fairly stable profits, that history can be used to anticipate future earnings and value the business. Even if a business hasn’t generated a profit yet, earnings models can be used to predict how much the business might earn in the future. The disadvantage of the earnings approach is that it relies on a prediction of future earnings, which may not be accurate.
Best used for: Capital-intensive businesses, such as manufacturing and transportation businesses, and businesses that aren’t profitable yet.
The asset approach measures the value of a business’s tangible and intangible assets minus debts and liabilities. Tangible assets include things like equipment and real estate, and intangible assets include things like patents, trademarks, and software. The asset approach considers the current fair-market value of the business’s assets but also the future return on investment that the owner could get from those assets.
Best used for: Accounting for local factors or confirming a price that you arrived at based on one of the other two approaches.
The market approach measures the value of a business based on how much comparable businesses have sold for. It’s a good way to get a ballpark range for a business’s value and to account for local factors that the other approaches may miss, such as the business’s location in a particular neighborhood.
It might be confusing to get all these approaches straight in your head, but the point of all of them is to assess the current financial health of the business, as well as its growth potential. In reality, Bilby says, none of these methods exists in isolation. All three of these approaches can be used to arrive at a fair price for a business, and the final price will always be the one that both the buyer and the seller agree on.
Buying a Business: Getting the Cash
Once you and seller agree on a number, the next step is to get the money. There are a few different ways you can gather up the capital you’ll need to purchase a business—some specific to buying an existing business, others pretty standard.
Here are some of the ways to finance a business acquisition:
If you’re able to cover the costs of buying an existing business, that’s always an option. This is more likely if you’re buying a small business rather than a chain. Of course, you’ll want to consult your accountant before ponying up a large lump sum of your own cash. Also, make sure that you’re not using all your money because running a business takes capital, too.
Many businesses are also funded with money borrowed from family. If you go this route, you should understand the tax implications for gifts and family loans. Make sure that you and your family member put the exchange of money in writing and follow IRS rules for family loans.
Some sellers will agree to holding a note, or accepting staggered payments—sort of like a lender. This way, they get guaranteed income for the coming months (or years, depending on your plan).
There are rules around seller financing, particularly if you plan to use another form of debt financing as well. For example, sellers have to be on “standby” if you’re also getting an SBA loan, meaning they have to agree that they won’t be paid back until you pay off the SBA loan.
Some sellers might also be willing to trade in some assets, like some furniture they really loved or the company car, for a lower price.
By turning to a partnership instead of buying a business solo, you can divide the payments you’ll be making while still owning that company.
Taking on a partner isn’t only useful to cut costs, though: you can also bring someone on board with more specific experience or a different skill set. Just don’t forget to draw up a partnership agreement, so co-ownership doesn’t cause any problems down the line.
By selling company stock to its employees, you can get a big discount—making up 50% or even 90% of the business price by some measures. You’ll probably want to sell non-voting stock, if possible, to retain ownership over the business. In order to issue stock, you’ll have to organize the business (or re-organize it) as an S-corp or C-corp.
It might be possible for you to lease the business instead of buying it outright—with the option to make the big purchase down the road once you’re able to afford it.
Understandably, not all sellers will be open to this option, since they more likely than not want to wash their hands and walk away from the sale. However, if leasing is something you’d be more comfortable with—even though it may cost more money in the long run—you might as well ask.
Choosing to buy an existing business will give you tons of documents to approach a bank or alternative lender with: financial histories, tax returns, employee records, cash flow analyses, inventory and equipment valuations, and much more. This wealth of data makes business acquisitions a good candidate for loans because lenders aren’t working with a risky blank slate.
If you’re looking for a small business loan, here are a few potential financing options that might help in buying a business:
Term Loan
With a traditional term loan (or a short-term loan if the purchase price is relatively low), you’ll borrow a set amount upfront, then pay it back—plus interest—over a predetermined amount of time.
This is a pretty ideal format for buying an existing business: you’ll get the cash you need to make your purchase, then pay the lender back over time as the business generates revenue.
Although rates and terms vary depending on your financials—like your personal credit score—as well as on the lender, you can usually expect a term of 1 to 5 years and interest rates between 7%-30%, for amounts ranging from $25,000 to $500,000.
Asset-Based Financing
For asset-based loans, you’ll borrow capital against a certain asset, which acts as collateral in case you default on your payments.
When buying an existing business, you’re taking on all of its assets—which means you have a lot of potential collateral to help finance your purchase. These loans will be much smaller than the cost of a business purchase, of course, since you’re only financing a part of the buyout (based on the value of the collateral), but they can still be very helpful.
You can use three different kinds of assets as collateral for financing:
Choose one—or all three!—to help you finance the right amount for your business acquisition.
How Debt Financing Is Different When Buying an Existing Business
As we mentioned before, getting a business acquisition loan is typically easier because the lender has a history to assess.
But just like with any business loan, lenders will scrutinize all of the following:
For term loans and SBA loans for when you buy a business, banks typically require buyers to put down a 20%-25% down payment on acquisition loans. However, the SBA recently made some changes that make it easier for buyers to obtain SBA 7(a) loans for buying a business. Now, the SBA requires the buyer to put down just 10%, and only half of that (5%) has to come from the buyer’s own cash. The rest can come in the form of a seller’s note as long as the seller agrees to be on full standby—meaning that the seller won’t be paid back on their note until after the bank is paid.
When getting a loan for buying an existing business, you’ll also have to provide a formal business valuation (like we discussed before), explain your relevant experience, offer an updated business plan, and show financial projections for the business under your command.
In short, you’ll want to tell a story of how you will improve the business.
When you’ve finally found the right business, done your due diligence, agreed on a fair price, and gathered the capital you need, make sure you (or a broker) have all 10 of these documents, notes, and agreements in place:
This document will prove the actual sale of the business, officially transferring ownership of the business’s assets from the seller to you.
This is the final count of the cost of your purchase, including all prorated expenses—like rent, utilities, and inventory.
If you’re taking over the business’s lease, make sure your future landlord is in the know. On the other hand, if you’re negotiating a new lease, double-check that everyone understands its terms.
Does the business come with any vehicles? If so, you might have to transfer ownership with the local DMV—make sure to get the right forms complete by the time of sale.
Similarly, all patents, trademarks, and copyrights might require certain forms to get transferred to you, the new owner.
Check the available Consumer Guide to Buying a Franchise to see if you’ll need to file any franchise documents.
It’s standard practice—and generally a good idea—to ask for a non-compete from the former owner. This way, the previous owner won’t set up a competing shop right across the street!
This document is in case the seller is staying on as an employee. Make sure to file this agreement if so.
You will need to list the assets you’ve acquired, and for how much. This document is pretty important for your tax returns, so don’t forget it.
Bulk sale laws have to do with the sale of business inventory and are designed to prevent business owners from evading creditors by transferring ownership of the business to someone else. To comply, prospective buyers usually have to notify the local tax or financial authority about the pending sale.
You should now have all the information you need to buy a business safely, smartly, and successfully.
Some pointers to remember:
Although there’s a lot involved in buying an existing business, you’ll be rewarded when you’re finally at the helm. You will be able to revitalize what might have been a stale company with fresh ideas and fresh leadership. Good luck!