The due diligence checklist for buying a small business
Diligence is not reading everything. It is checking a short list of specific claims, in an order that lets you stop early when one of them fails.
What is due diligence when buying a business?
Due diligence is the period where you verify, with documents, every claim the seller has made. It usually runs three to six weeks and begins after a letter of intent is signed. The purpose is not to find a perfect business, because there is not one. It is to find out what is actually true, so you can decide whether to proceed, reprice, or walk.
How do you run due diligence, step by step?
Order the checks so the cheap ones that can end the deal come first. Buyers who start with a deep financial review often spend three weeks and several thousand dollars before discovering a lien or a lease that cannot transfer. Run it in this order:
- 1Verify the entity exists as described
Confirm the legal name, registration status, state of formation and good standing. A business trading under a name that does not match its registration is not necessarily fraud, but it is the first thing to understand.
- 2Search for liens and litigation
Run a UCC lien search and a litigation search before anything expensive. An active UCC filing means the assets you intend to buy may already be pledged as collateral to someone else.
- 3Reconcile the financials
Compare three years of tax returns to the profit and loss statements, then compare reported revenue to twelve months of bank statements. Ask about every gap. Then test each claimed add-back against a document.
- 4Test the revenue for concentration and durability
Get a customer list with revenue by account. Establish what share the top five represent, how long each has been a customer, and whether anything is under contract or all of it is repeat goodwill.
- 5Check what transfers and what does not
Read the lease and confirm it can be assigned. Confirm licences, permits, key supplier agreements and software contracts transfer to a new owner. Speak to the landlord directly before closing, not after.
- 6Understand the people
Find out who actually runs the day to day, what they are paid, whether they know a sale is happening, and what happens to the business if the two most important of them leave in month one.
Which documents should you request first?
Three years of tax returns, and nothing else until you have them. The tax return is the only document in the pile that carries a penalty for being wrong. Everything else is prepared by the seller. If a seller is slow or reluctant to produce filed returns, you have learned something important before spending a dollar. The core request list:
- Three years of federal business tax returns
- Three years of profit and loss statements and balance sheets
- Twelve months of bank statements
- Accounts receivable and payable ageing reports
- A customer list with revenue by account
- The lease, plus any equipment or vehicle leases
- Payroll records and a list of staff with roles and pay
- Licences, permits and any regulatory correspondence
What findings should make you walk away?
Books that do not reconcile with the tax returns, and a seller who will not explain the gap. Most problems found in diligence are negotiable. A few are not, and recognising them early saves months:
- Revenue in the profit and loss that does not appear in the bank statements
- Undisclosed litigation, particularly anything involving employees or customers
- A lease that cannot be assigned, in a business that depends on its location
- One customer worth more than about 40% of revenue with nothing contractual behind it
- A seller who restricts access to staff, records or the premises without a clear reason
How long should due diligence take?
Three to six weeks for a small business, if the seller is organised. The variable is almost never the buyer. It is how quickly documents arrive. A seller with clean records answers a request the same day; a seller reconstructing three years of bookkeeping takes a month per request. This is also why diligence speed is a signal in itself about how the business is run.
Do you need an accountant and a lawyer?
Yes, and the cheapest mistake in the process is skipping them to save a few thousand dollars. An accountant tests the earnings you are paying a multiple of. An attorney reads what you are actually signing and what liabilities follow the business into your ownership. On a $500,000 deal, that advice costs a small fraction of the purchase price and routinely changes it by more than it costs.
The full request list in the order to send it, plus the five findings that should make you walk away. One email, no course.
No spam. Unsubscribe in one click.
Common questions
Who pays for due diligence?
The buyer. Expect to spend on an accountant, an attorney, a lien and litigation search, and possibly an independent valuation if your lender requires one. On a small acquisition this usually totals a few thousand dollars, and it is money spent to avoid a much larger mistake.
Can you do due diligence before signing an LOI?
Only the surface layer. Sellers generally release detailed financials after an NDA, and full access after a letter of intent, because the LOI signals you are serious and usually grants you exclusivity for a period. Public record checks such as liens and litigation can be run at any point.
What is a quality of earnings report?
It is an accountant's independent examination of whether the reported earnings are real and repeatable. It goes deeper than a review of the statements and is standard on larger deals. On a small acquisition it is optional, but worth it whenever the add-backs are large relative to the profit.
What happens if you find a problem?
Usually a renegotiation rather than a walk. Common outcomes are a price reduction, part of the price moved into a seller note or an earnout that pays only if the problem does not materialise, or a specific indemnity written into the purchase agreement. Walking is reserved for problems that cannot be priced.
Should you tell employees you are buying the business?
That is the seller's call and it is usually made close to closing. Staff learning about a sale months early tends to cause departures, which damages the business you are buying. Agree the timing and the message with the seller as part of the deal.