When you buy a business, the last thing you want to find out is that the business you end up actually getting is different than the one you thought you were buying.  The way around that is to make sure that you dig deep into the operations, financials, logistics, history, and opportunities within the company to ensure that surprises are kept to a minimum.  The key to keep in mind when buying a business is that surprises are bad.  Good surprises might mean that the seller doesn't have a solid handle on the business and where things are at, and bad surprises mean all of that and more, possibly that the seller is hoping to sneak something by you. 

There is inherent risk in buying a business, but there are ways to minimize that risk.  With that in mind,  here is a list of the key things that you want to dig into during the business purchase process.

Financial Statements.   It is obviously important to make sure you fully understand the financial statements of the business to ensure that you've got a clear picture of revenue, margins, income, assets, and liabilities.  The key to keep in mind with financial statements is that many businesses, particularly those that are smaller in size and scope, often implement numerous tax planning initiatives that end up making their financials look different than they normally would.  Also, it is not unusual for small business owners to mix personal and business expenses together.  For example, a $10,000 vacation expense on the books might be for more pleasure than business and under normal circumstances would not be an expense that would be incurred if you owned the business.  On that other hand, many sellers will try to trivialize legitimate business expenses and dismiss them as personal expenses, when in fact, they are critical to the operations.  An example here might be a bonus to employees that the seller says wouldn't be given under normal circumstances, when in fact, if the bonus wasn't given, the employees would leave. 

      Sales Projections.  The more work a buyer puts in understanding where the revenue comes from and if there is any predictability towards that revenue, the better.  It may be entirely reasonable to suggest that a business that has been doing $5 million in revenue for the last 3 years might continue to do $5 million in revenue.  On the other hand, if that revenue was derived from one significant client, and that client is no longer around, then the business may in fact have to scramble to bring in $5 million in revenue the next year.  It is reasonable for a buyer to ask to talk to key clients and ask generally how the relationship has been going and if they intend on continuing to do work with the business. 

Inventory.  Most businesses have a certain amount of inventory that is either obsolete or is generally getting a bit old and won't be able to be sold at normal margins.   A deal may be structured where there is a certain price for the business, and inventory is on top of that.  In those cases, the buyer needs to do a detailed analysis of the inventory and the likelihood that the inventory is in fact, sellable.    The key question to ask is how often inventory generally turns over.  If the business has usually kept inventory for 1 month before it is sold, then it is reasonable to suggest that inventory that has been sitting around for 3 months isn't going to be easy to sell and is going to have to be sold at clearance-type rates.  Buyers should go through inventory reports in detail and be cautious about paying full price for inventory that has been collecting dust for a long time and negotiate accordingly.  

Contracts and On Going Obligations.  Business buyers should spend time going through all sales agreements, distribution agreements, leases, union documents, employment contracts, and anything else that might legally bind the business.  This is particularly true when the buyer is actually purchasing the shares of the business and not the assets.  It would be prudent to have your legal representative go through those documents and ensure that they are transferable and to your benefit.  The last thing you want is to find out that the lease of the company building can't be transferred and the business is officially without a home the day you buy it.

If you put the proper effort into your due diligence, you can greatly reduce the inherent risk of buying a business.  Without it, you are taking an unnecessary risk.  Just remember, just because the seller tells you something, doesn't mean it is true.

Scott Larson has been helping buyers and sellers of small to medium businesses for the last 8 years.  He has recently launched http://www.businesstradeboard.com/  to assist both buyer and sellers of businesses through their mergers and acquisitions.

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