Buying an established company can be an excellent way to become a business owner or expand an existing operation. Instead of starting from scratch, the buyer may acquire an established customer base, trained employees, operating equipment, vendor relationships, and a proven source of revenue.
However, a company that looks profitable from the outside may have financial, operational, or equipment-related problems that are not immediately apparent. Before signing a purchase agreement, buyers should conduct careful due diligence and understand exactly what they are acquiring.
Here are five important steps to take when buying a company.
1. Analyze the Company’s Financial Records
The first step is to carefully analyze the company’s books and financial records. A buyer should generally review at least three years of financial statements and tax returns, along with current year-to-date information.
Important documents may include:
- Profit-and-loss statements
- Balance sheets
- Federal and state tax returns
- Bank statements
- Accounts receivable and payable reports
- Inventory records
- Payroll reports
- Existing loan and lease agreements
The goal is not simply to confirm the company’s reported revenue. Buyers need to determine whether the earnings are sustainable.
Look for unusual expenses, declining margins, inconsistent revenue, excessive owner compensation, personal expenses running through the business, and one-time transactions that may distort profitability. The buyer should also determine how much working capital will be needed after the acquisition.
Whenever possible, have an experienced CPA or financial advisor review the records. The purchase price may look reasonable based on gross revenue but become much less attractive after normalizing the company’s actual earnings.
2. Order an Independent Machinery and Equipment Appraisal
If the company owns machinery, vehicles, construction equipment, medical equipment, restaurant equipment, or other significant business assets, an independent machinery appraisal should be part of the due diligence process.
The values shown on the company’s balance sheet may have little relationship to current market value. Equipment may be fully depreciated for accounting purposes but still retain substantial value. Conversely, recently purchased machinery may be worth considerably less than its original cost due to age, condition, usage, technology changes, or weak market demand.
A qualified machinery and equipment appraiser can help the buyer understand:
- The current Fair Market Value of the assets
- The value of the equipment in a liquidation scenario
- The condition and apparent remaining useful life of major assets
- Whether the equipment list is complete and accurate
- Whether significant repairs or replacements may be needed
- Whether the assets provide adequate collateral for financing
- Whether equipment values support the proposed purchase price
This is especially important in an asset purchase, where a portion of the transaction price may be directly allocated to machinery and equipment.
An appraisal can also uncover problems that financial statements alone may not reveal. A profitable manufacturer, for example, may be operating with aging machinery that will require a major capital investment shortly after closing.
3. Speak With a Lender Early in the Process
Do not wait until the purchase agreement is nearly complete to begin speaking with a lender. Financing discussions should start early so the buyer understands what is realistically affordable and what information the lender will require.
A lender can help determine:
- The required down payment
- Whether the transaction may qualify for SBA financing
- Acceptable debt-service coverage
- Collateral requirements
- Personal guarantee requirements
- The amount of working capital that should remain available
- Whether real estate, equipment, and business assets will be financed separately
Lenders may also require independent appraisals of the machinery, real estate, or business before approving the loan.
Early conversations can prevent a buyer from spending months negotiating a transaction that cannot be financed under the proposed terms. They can also help structure the deal more effectively through conventional financing, SBA financing, seller financing, or a combination of funding sources.
4. Investigate the Company’s Legal and Operational Risks
A buyer is acquiring more than revenue and equipment. The company may also have contractual obligations, regulatory responsibilities, unresolved disputes, and other liabilities.
An experienced transaction attorney should review items such as:
- Customer and vendor contracts
- Equipment leases
- Real estate leases
- Pending or threatened litigation
- Tax liens and UCC filings
- Employee agreements
- Licenses and permits
- Environmental concerns
- Warranties and service obligations
- Intellectual property
- Insurance claims and coverage
The buyer should also determine whether the transaction will be structured as an asset purchase or a stock purchase. The structure can affect taxes, liability exposure, contract assignments, and the assets and obligations that transfer to the buyer.
Operational due diligence is equally important. Tour the facilities, observe the workflow, and determine whether the company follows documented procedures or relies heavily on the owner’s personal knowledge and relationships.
5. Evaluate the Customers, Employees, and Transition Plan
A company’s value can change quickly if its largest customer leaves or its key employees resign after the sale.
Review the company’s customer concentration to determine how much revenue is tied to its largest accounts. A business that derives 50% of its revenue from a single customer carries significantly more risk than one with a diversified customer base.
The buyer should also identify essential employees and determine:
- Who manages daily operations?
- Which employees hold critical technical knowledge?
- Are compensation levels competitive?
- Are key employees likely to remain after the sale?
- Does the business depend heavily on the current owner?
- Are customer relationships tied to the company or personally to the seller?
The purchase agreement should include a realistic transition plan. Depending on the business, the seller may need to remain involved for several weeks or months to introduce the buyer to customers, vendors, and employees.
Noncompete and nonsolicitation agreements may also be appropriate, subject to applicable state law. Without a carefully structured transition, the buyer may acquire the physical assets while losing the relationships and knowledge that made the company successful.
Asking Price is Not Everything
Buying a company should never be based solely on its asking price or reported annual revenue. Buyers need to understand the quality of the earnings, the value and condition of the physical assets, the company’s legal obligations, its dependence on key customers and employees, and the amount of financing and working capital required.
The best acquisitions are built on verified information rather than assumptions. By analyzing the books, obtaining an independent machinery appraisal, speaking with a lender, investigating legal and operational risks, and developing a strong transition plan, a buyer can approach the transaction with greater confidence.
A little additional due diligence before closing can prevent an expensive surprise afterward.
