Due diligence is the most critical phase of any business acquisition. It's your opportunity to verify that what you're buying matches what was represented. Here's what a thorough DD process covers:
Financial Due Diligence: - 3 years of federal tax returns (personal and business) - Monthly P&L statements for the trailing 24 months - Balance sheets and accounts receivable/payable aging - Quality of Earnings (QoE) report from independent CPA - Revenue concentration analysis (customer and product) - Working capital normalization - Cash flow trend analysis - Debt and liability verification
Legal Due Diligence: - All customer and vendor contracts - Lease agreements and assignment terms - Employee agreements (non-competes, IP assignments) - Pending or threatened litigation - Intellectual property (trademarks, patents, trade secrets) - Regulatory licenses and permits - Insurance policies and claims history - Environmental compliance (if applicable)
Operational Due Diligence: - Employee roster, compensation, tenure, and key-person risk - Customer retention rates and churn analysis - Vendor relationships and concentration - Technology stack and systems - Standard operating procedures (or lack thereof) - Facility condition and equipment age/maintenance
What to watch for (red flags): - Revenue declining for 2+ consecutive quarters - Key customer >25% of revenue - Owner handles all sales/customer relationships personally - Pending lawsuits or regulatory actions - Deferred maintenance on critical equipment - Key employees threatening to leave - Large discrepancies between tax returns and internal P&Ls - Seller resistance to providing requested documents
The QoE Report: A Quality of Earnings report is the most important DD deliverable. An independent CPA firm analyzes the business's financials and produces an adjusted EBITDA/SDE figure. This is what your lender will use for financing. Cost: $15K–$40K. Worth every penny.