Due Diligence When You’re Buying a Small Business: What to Look At

Due diligence has one purpose. Find out whether the business is what it appears to be, and find out what changes the day the seller leaves.

Everything you look at serves one of those two questions.

Below is the basic map: financial, legal, and operational. In a small business these overlap constantly, which is why reviewing them separately and never comparing the answers is how buyers get surprised. The seller’s numbers come from the operations. The operations run on contracts. The contracts are held by people who are leaving.

Financial

Start with three years of tax returns, P&Ls, and balance sheets, then reconcile them against each other and against the bank statements. Agreement between those three is the baseline. Gaps are the first thing to ask about.

Look at the earnings number and how it was built. Most small business listings price off seller’s discretionary earnings, which starts with net income and adds back owner compensation, personal expenses, one-time costs, and non-cash items. Go through each add-back and ask what the money was spent on. A health insurance premium for the owner is a clean add-back. A truck three employees drive is not.

Then check whether the earnings support the business you will run. If the seller does the work of two people and takes one salary, you have to add the cost of the second person back in. Same with any family member working under market, and any deferred spending on equipment or software.

Look at revenue by month for 36 months, revenue by customer, and gross margin by service line or product if the data exists. AR aging tells you how fast the business collects. Inventory tells you what is sitting there unsold.

Working capital deserves its own look. Find out how much cash the business needs to operate through a normal month, and whether the deal leaves that cash in the business or takes it out.

Legal and contractual

You are reading documents here to find what transfers, what needs consent, and what follows the business to you.

The core list: entity and ownership records, the lease, customer and vendor contracts, equipment and loan documents, employment agreements, non-competes, licenses and permits, insurance policies, and any litigation or claim history.

Two provisions do most of the damage in small deals. Assignment clauses decide whether a contract moves to a new owner. Change-of-control language decides whether the other party gets a say, a renegotiation, or an exit when the business changes hands. If a customer contract, a franchise agreement, or a lease carries either one, that relationship is conditional until someone signs off.

Also run a lien search, confirm the entity is in good standing in its state, and confirm who legally owns the assets being sold, including vehicles, equipment, and intellectual property such as the business name, website, and phone number.

An attorney drafts the purchase agreement and gives you legal opinions. The earlier work is identifying which documents raise questions, so your attorney spends time on the ones that count.

Operational

This is how the business runs when no one is getting ready for a buyer.

Owner and key-person dependency. Ask the owner to walk through a normal week, hour by hour, then compare it to the org chart. Ask who sets pricing, who handles an angry customer, who the crew calls at 6 a.m. Then ask the same about everyone else, because one indispensable technician carries the same risk as an indispensable owner. If the three most important people left within 90 days of closing, what still works?

Customers. Revenue by customer for three years, who owns each relationship, what is in writing, and when contracts renew. One customer at 40% of revenue is a different business than 200 customers at half a percent. Ask whether a large customer has left in the last two years and why.

Systems and reporting. Sit with the people who enter orders, bill customers, and schedule work. You are checking whether the software produces the numbers you were given, or whether one person rebuilds them by hand every month. When reporting lives in a spreadsheet and someone’s memory, you inherit both.

People. Get the census: roles, tenure, pay, classification. Contractors doing employee work is an exposure that comes with the business. Under-market pay shows up as turnover in your first year. Ask who left recently and why.

Vendors and suppliers. Which are sole-source, what the written terms are, and which prices rest on a long relationship with the seller. A 15-year handshake does not transfer in a purchase agreement.

Licensing and compliance. List every license, permit, bond, and certification the business needs, who holds each, and whether it transfers. Some attach to the entity and some attach to a person who is leaving. Start this early, since the answer can change the timeline or the structure of the deal.

What to do with what you find

Most findings are not deal killers. They sort into four piles.

Fix it. Something you can repair yourself once you own the business. It changes your first-year plan, not the price.

Negotiate it. Something that needs the seller, whether that is a longer handover, an introduction, or a problem cleaned up before closing. It changes the terms, not the number.

Reprice it. Something the price assumed and the business does not deliver. It changes what you are willing to pay.

Walk away. Some findings mean the business is not the one you thought you were buying.

The reason to do this work before closing is simple. Until you sign, every problem is a negotiating term. After you own it, every problem is yours.