Due diligence questions when buying a business

Here’s what you need to know before you buy a company

First of all - rule number 1: Always consult a lawyer before making any substantial purchase.

This guide is not to give you the legal information you need. Rather, this is about doing the business side of due diligence. This guide will focus on the business questions you need to answer before deciding to move forward with an acquisition.

To summarize, look at the table below:

Organization and Good Standing

First, you need to consider the company’s reputation as a customer. Google the company and see what is being said. If the company has a profile on one of the major marketplaces (amazon, ebay, etc.), see what the reviews are.

What you are looking for here is any sign that this organization is not delivering on its promises to consumers.

Now, there’s a level of discretion to be taken here. Every company is going to have bad reviews. If you see that the number of bad reviews is not that high, I would not take it as a big detriment. However, if you find that there are numerous bad reviews, then it can be a sign of poor product quality or service.

In addition, take one or two of the bad reviews and ask the seller about them. See what they say in regards to the reviews. If the seller is very dismissive, or is not providing a great answer, it could mean that the seller did not take very many precautions as it pertains to customer service - which can be a risk

Financial Information

There’s a lot of very fancy numbers and formulas out there to run financial analysis on a business. However, the reality is that often these financial equations are optimizing at a scale that is not there for small businesses.

For most businesses, you need to answer two key questions

First, is this a viable business model?

For this, you want to satisfy a very simple equation.

CAC < 1 year LTV

What does this mean? It means that the cost to acquire one customer is less than the value this company provides over the course of the year.

Why are we using this formula? This formula essentially tests for the health of the business. If this business is not satisfying this month, every month, for the past 12 months, then there is something wrong.

The other formula is the working capital formula

Cash > 3 - 6 month expenses

This formula tests the stability of a business.

Things could go wrong for a variety of reasons. Down time in order for the website to be revamped. Waiting for inventory to be shipped to the warehouse.

Because things can go wrong - it’s so important to ensure that you are able to have enough cash on hand for this period. While this isn't necessarily in the scope of a business’s financials, it should be something you take into account as you think through the loan needed to acquire. Ensure that you have enough money, not just to buy the company, but to also operate it until you are able to start earn income.

Special Sauce

Before you make any purchase, you need to be crystal clear on what the product market fit is. You have to clearly understand what need this business is filling in the marketplace, and why the need is dire enough that people are willing to pay for this product.

To do this, you also need to understand if the business makes sense. Put yourself in the shoes of a customer. See if you can empathize with the consumer, and try to imagine if this would appeal to what you want. One way to do this is to make personas of the different consumer types, and see if this business fits into what the personas are looking for and if it fits in their needs.

Next, try to understand why this business is earning money. Not every business should earn money. There’s lot’s of things that people want, but not everything is needed. Therefore, try to understand why people are willing to pay for this company. Is this company selling a painkiller or a vitamin? Are they curing pain, or preventing potential pain? The answers to these questions will help answer the question of why this company is earning money.

Product or Service Lines

Every company sells a product or service. Once you purchase a business, you will take on the responsibility of recreating the product or service. Therefore, it is key for you to know where the product and service comes from, and know how to bring the product or service to market.

First, understand if you can access the same type of product. Often, there can be a complicated network of suppliers and trade networks for physical products, and you need to ensure that you can pick up that relationship from scratch. Or, it’s a digital product, and you may be required to learn how to add/adapt to the info product. Finally, it could be a tech product, and you may be required to access engineering work to make changes to the product in order for it to be sold.

Try to understand what the investments are needed in order to do this, and see if you can either get guarantees from the seller to help in solidifying the transition, or securing enough working capital to get by the transition period.

Customer Information

Finally, and most importantly, you need to know thy customer. Who is your customer? Where are they? What are they looking for?

There are many things you need to do here in order to better understand your customer. Ask the seller if they have any information regarding the typical customer profile.

The key here is not to get identifiable information or customer data. The key here is to understand who the customer is.

If you’re selling baby carriages - you’re selling to parents

If you’re selling multi-carriaged baby carriages - you’re selling to parents with twins

The smaller the business, the more likely there is a niche consumer group that the business is servicing. In order to ensure that the business is targeting the right consumer group, it’s imperative that you understand who the consumer profile is.

Conclusion

Conducting the right due diligence upfront, will prepare you for any potential headaches down the road.

It's better to spend an extra hour upfront, running the numbers, before jumping headfirst and potentially finding yourself in a problem down the road. Plus you get a chance of understanding the business before you start running it.