Acquiring an existing commercial business offers a compelling path to growth, characterized by established revenue streams, a built-in customer base, and often more favorable financing conditions compared to a startup from scratch. However, the actual value and potential pitfalls of such an acquisition are only revealed through a rigorous due diligence process. This meticulous examination ensures you're investing wisely, paying a fair price identifying any challenges that could impact post-acquisition success. Engaging legal and accounting professionals is paramount during this intensive phase, as their expertise can pinpoint critical areas of concern and uncover hidden issues. If you are considering financing the acquisition, reaching out to a trusted lending partner early in the process to assist in evaluating different financing options is another important early step to take.
 
Here's an expanded due diligence checklist tailored for commercial business acquisitions:
 
Unveiling Transparency and Operational Dependencies
 
Access to Information: Be cautious if a seller or broker restricts your access to key personnel, particularly after a financing commitment has been made. While unlimited access might be unrealistic, your team's ability to interview senior management before closing is crucial for thorough due diligence. Both parties should agree on an acceptable timeframe for these meetings, allowing for adjustments to the deal structure if significant risks are identified.
 
Operational Dependencies: It's vital to identify and assess all significant dependencies. These can stem from the seller's continued involvement, reliance on specific key employees, concentrated vendor relationships, or even a limited customer base. For instance, if the business's success is heavily tied to the owner-manager or a few key individuals, a robust transition plan is essential to ensure continuity and mitigate "key person" risk. Commercial entities thrive beyond their founders; therefore, owners must strategize for seamless transitions to maximize long-term value and scalability.
 
Client Base and Revenue Stability
 
Customer Analysis: Thoroughly assess customer retention rates and the seller's operational approach to client management. Schedule meetings with a diverse range of significant clients to understand their expectations, levels of satisfaction and likelihood of remaining after the acquisition. Customers are under no obligation to transfer their business. Additionally, understand the seller's motivations for selling to avoid inheriting a pool of unsatisfied customers.
 
Customer Concentration and Diversification: A diverse customer base generally indicates lower risk. Analyze the percentage of sales and more importantly, profit contributed by the top customers. If the top three clients account for over 35% of total sales, model financial projections assuming the loss of two of them post-closing. If the business remains adequately cash-generative, it might still be a viable deal. Arrange joint calls with the seller and top customers to assess the strength of the relationship and gauge future intentions. Consider a seller note tied to the retention of critical customers or specific business events, with the note potentially forgiven if these conditions are not met, thereby adjusting the purchase price to account for the loss.
 
Revenue Stability and Trend Analysis: Request sales volume data for the top ten customers over the past three years. Are sales increasing for most? Are the customer names consistent? Consistent customers indicate a stable revenue base and a high-quality product or service. Conversely, investigate customer attrition to identify potential issues, such as new competitors or concerns about product quality.
 
Financial Health and Operational Efficiency
 
Quality of Receivables: Beware of businesses that may have relaxed credit standards to inflate revenues before a sale. Review the accounts receivable (A/R) aging report, paying close attention to accounts that are 60 days or more past due. A significant percentage of accounts older than 90 days could signal a poor-quality customer base or lax credit policies.
 
Seasonality and Cyclicality: Obtain historical quarterly revenue patterns to understand seasonal fluctuations and cyclicality. Ensure your working capital budget accounts for these variations. Assess the business's susceptibility to economic downturns by examining financial statements from past recessionary periods. If such records are unavailable, research the typical cycles of the customer base to determine the most suitable approach. Test the target company's cash flow resilience to revenue and margin declines during an economic contraction, ensuring it can still meet its obligations post-acquisition.
 
Revenue Pull-Forward and "Coasting": Be alert to sellers artificially inflating sales before closing, especially if they retain accounts receivable (A/R). This can manifest as aggressive discounting to pull future sales into the current period, leading to a revenue "trough" post-acquisition. Request monthly sales reports and investigate any sudden spikes. Similarly, a seller losing focus on sales generation before closing can also create a revenue deficit. Monitor historical sales pipelines and future order tracking to detect sharp declines in activity.
 
Revenue Verification: At a minimum, have your CPA reconcile business deposits from bank statements over the past year to reported cash revenues. This helps mitigate the risk of overstated revenues. While IRS tax transcripts verify tax returns, further due diligence is often needed to confirm accuracy.
 
Inventory Assessment: Verify the salability of all inventory included in the purchase. Ensure it's not obsolete or slow-moving. Understand the company's typical cash conversion cycle, inventory days, and turnover rate. Identify and mitigate any potential supply chain vulnerabilities or vendor dependencies that could disrupt operations.
 
Human Capital and Financial Performance
 
Employee Dynamics: Understanding the Seller's Role within the Company. If their involvement has been passive, their replacement might be straightforward. However, if they hold key relationships or critical operational knowledge, a well-structured transition plan, along with a contingent seller note, is vital. Investigate required licenses for business operations. Be cautious if a relatively young seller is departing for "other interests" without clear justification.

Key Employee Considerations:

• Identify key employees who hold customer relationships.
• Do non-compete or non-solicitation agreements bind these employees?
• Are they aware of and supportive of the sale?
• Are there any pending retirements or recent key employee departures?
• Do any employees possess essential licenses or technical knowledge? Consider incentives to retain these individuals.

 
Margins and Cash Flow Analysis: Most commercial businesses are valued on a multiple of adjusted EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization). Rigorously verify all "adjustments" made by the seller to normalize operations. Valid addbacks must be quantifiable and verifiable (e.g., seller's salary if they are leaving).
 
Trend Analysis of Margins and Sales: Investigate any significant or sudden improvements in margins or sales in recent periods. If the reasons aren't transparent and verifiable, base the valuation on an average margin over several years. Delayed bill payments can artificially inflate reported profits; examine accounts payable carefully. Analyze market trends, local demographics, and competitive landscape to understand how external factors influence business trends.
 
Asset Verification and Financial Structure
 
Equipment Inspection: Conduct a physical inspection of all equipment. Confirm its working order and ensure a detailed equipment list is included in the purchase agreement.
 
Working Capital Considerations: Typically, the seller retains all cash and pays off all funded debt. In a stock purchase, working capital should be set at a normalized level. A "target level" is often agreed upon, with adjustments to the purchase price based on the actual working capital at closing. Generally, the seller should not retain A/R in a stock transaction. In an asset purchase, if the seller maintains A/R, this effectively increases the purchase price, as you'll need cash to cover the initial gap in the balance sheet. Factor this into your purchase price negotiations.
 
Upon the conclusion of due diligence, you should have a comprehensive understanding of the target business's strengths, weaknesses, opportunities and threats. This crucial phase allows you to identify and mitigate risks, negotiate a fair purchase agreement and ultimately pave the way for a successful ownership transition. While a "perfect" deal is rare, thorough due diligence equips you to make informed decisions and set your business acquisition up for long-term success. To learn more about financing opportunities please contact Brad Neigel at info.liveoak.bank/lender-page/brad-neigel.