Many buyers find themselves fretful over add backs and owner benefits when it comes to due diligence; unfortunately, this concern often overshadows the fundamental objectives of due diligence. During due diligence the buyer’s main goal is verifying the business’ earnings and discovering whether or not the business will fulfill the buyer’s requirements. While there are many helpful
business buying books and articles that provide extensive
due diligence checklists to guide you through the process, the buyer need not be confused about due diligence if they keep three simple ideas in mind:
1. The business’ revenue
2. The cost of goods sold
3. Your future expenses
1.
The business’ revenue is the first and most important number to verify. The most common verification method used is tax returns. Banks and other lending institutions almost always rely solely on tax returns to verify revenues when approving a loan for a business acquisition. There are alternative ways to verify revenue such as bank statements, register receipts, sales logs, etc; however, none of these methods can give you the level of surety that tax returns provide.
2.
The business’ cost of goods sold, which is the seller’s cost of the inventory sold, is the next item to verify. Many buyers will completely skip this step by relying on the numbers provided in the tax returns. This could be a costly mistake because many sellers adjust this number based on their individual tax situation. The number on the tax return may not be the actual cost of the inventory sold. Once you have verified the total annual revenue and the cost of goods sold you are left with the real “gross profit” of the business.
3. The thing to focus on now is
future expenses. It doesn’t matter whether the seller paid his personal cell phone bill or trip to Tahiti through the company. What you need to focus on is what
your expenses are going to be. For instance, find out what the current
lease terms are and whether you should expect any significant increase in your rent expense. If the business has used a certain supplier, verify whether that supplier will still give you the same rate as the previous owner. It is also wise to review the seller’s payroll expense. In many cases, small business owners employ family members without paying them; in other cases, business owners may pay some of their employees in cash. Review the seller’s payroll expense to see if you will need to allot more money for your payroll expense. Review any contracts the seller has with equipment companies, suppliers, or vendors to find out how the current expenses might change after you have taken possession of the business.
Now that you know the three fundamental things to focus on during due diligence, the business’ revenue, the costs of goods sold, and your future expenses, you are on your way to clearly assessing the business’ worth and one step closer to owning the business of your dreams.
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