It can be exciting to find a small business that meets your criteria for acquisition. But do you know how to evaluate a business before buying it?
There are quite a few steps you’ll need to take on to ensure you make a smart decision. Let’s get started.
How do I evaluate a business before buying it?
First, you’ll need to connect with the seller or the seller’s broker to request some key pieces of information. These will include the business’s financials, tax returns, founding documents, and other documents that’ll help you evaluate the health and viability of the business before buying it.
Often, the seller will ask you to sign a non-disclosure agreement (NDA) that spells out their request for confidentiality and protection of their business secrets, customer lists, processes, and financials before sharing any documents with you.
Next, you’ll work with your accountant and attorney to review the key attributes of the business. You might already know whether the business is well-established, is profitable, has a healthy earnings margin, and is in a favorable location and industry from giving the business listing a quick review. But now, you’ll need to look into other factors to decide if the business is a smart choice for you.
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What should I look for?
You’ll want to assess how well the business fits your preferences and goals and whether there are any risks or red flags you should look into before making an offer.
Here are some questions you can ask during your assessment:
The client base
|How many customers does the business serve?|
How many customers are currently under contract?
Do most of the business’s sales come from a small number of customers?
How many customers have been using the business’s services for at least one year? At least five years?
What is the customer churn rate over the past year?
How do customers perceive the business, and what kinds of reviews are they leaving online?
How many of the customers are personally connected to the business owner?
|By how much has revenue grown in the past few years?|
By how much has market share grown in the past few years?
Are there any new competitors, alternate products, or opportunities that may impact the business’s growth trajectory?
Are there strategic plans in place to bolster growth, and if so, is there any early indication of their success?
|Does the business generate enough cash throughout the year to avoid cash shortages?|
Is the cash flow steady, seasonal, or sporadic?
Has the business had to take on debt to cover cash flow shortages?
Is the cash flow ample enough to support salaries, reinvestment, and growth?
|Has the monthly gross income been steady for the past year? For the past three years?|
How many loans does the business hold?
Do the business’s overhead expenses mirror other businesses in the industry?
Has the business been delinquent in paying taxes, loan obligations, or other debt obligations?
Are there any liens or judgments against the business?
What is the average age of the business’s accounts receivable, and how many are older than 90 days?
Are there any bad debts that the business needs to collect?
Do the business’s financial statements agree with one another, or are there discrepancies in the numbers?
|Which contracts has the business agreed to?|
What are the terms and durations of its vendor contracts?
What are the terms and durations of its customer contracts?
Are there any outstanding legal claims or lawsuits?
Have there been any legal claims or lawsuits in the past, and how were they resolved?
|How many vendors or suppliers does the business depend on?|
How many of those kinds of vendors exist in the market and can be counted on if problems occur with the current vendors?
Do the current vendors offer favorable terms to the business, and if so, are those favorable terms based on their relationship with the current owner?
|How many full-time and part-time employees does the business have?|
Does the business use contract workers?
Where does the business tend to find its best workers?
What is the tenure of each member of the team?
Does the business pay fair wages?
Are there any managers or key personnel who would stay on with the business after the transition took place?
Are any employees candidates for a promotion?
Which employees have critical skills that are necessary for the success of the business?
|Is the site in a favorable location?|
Is the building a lease, part of the offering, or available to buy at an additional cost?
If the building is a lease, what are the terms of the lease, and when does the lease expire?
Are there stipulations about making improvements to the site?
Are building repairs or improvements needed?
Is the building OSHA and ADA compliant?
The strength of its competitors
|How many competitors perform the same kind and quality of work as this business?|
Which competitors have more market share than the business?
Which competitors seem to be growing the fastest?
What compels a customer to choose one business over another?
Is the business on friendly terms with its competitors?
What moves have competitors made that’ll make it difficult for the business to replicate or outmaneuver?
Depending on the nature of the business, you may have additional questions, too. Be sure to find answers to all of your questions as you evaluate the business and consider buying it.
What should I do if a seller won’t share this information?
Some sellers may be reluctant to provide detailed information about the business without a signed letter of intent (LOI). If you are truly considering the business, you should consider drafting a non-binding LOI that’ll affirm your interest in buying it (and provide you with the option to withdraw your offer for any reason without recourse).
The benefit of the LOI is that it establishes a preliminary agreement between you and the seller. If the seller agrees to it, he or she will grant you the exclusive right to examine the business’s statements, records, procedures, and processes. During this period of exclusivity, the seller is unable to entertain other buyers’ offers.
|Sometimes, buyers offer an LOI early in the process, especially if they believe there are other interested buyers. However, you should not offer an LOI unless you fully intend to buy the business based on the information that’s already been provided. Numerous early LOI offers—and backouts that tend to come with them—will tarnish your reputation among the business broker community, and brokers may become less responsive to your requests for information on future businesses.|
How do I draft an LOI?
We recommend two options for drafting an LOI:
- Visit an online legal document site and download an LOI template. We prefer LawDepot’s LOI template.
- Work with an attorney who will draft your LOI and ensure that the terms you propose are non-binding. You can learn more about working with an attorney throughout the acquisition process in our article, The Right Attorney for Your Acquisition.
When sellers are forthcoming with information, the process works a little differently. You, your accountant, and your attorney will evaluate the business and review the concerns that you’ve uncovered. Then, you’ll decide whether the business is worth pursuing. If you decide to move forward, you’ll negotiate the terms of your offer and present the buyer with an LOI to move forward with the purchase of the business.
Ready to learn more? Log into your owner’s portal for free articles and advice on other steps of the acquisition process, including pouring through the business’s financial, operational, and legal concerns and securing financing.