Due diligence before buying a business: nine cross-checks that expose a weak sale

Sellers aren’t generally liars. But every seller presents the business in its best light, and the information memorandum that arrives from the broker is a marketing document. Due diligence is the step where you stop reading the brochure and start checking the plumbing.

The most useful habit is simple: never rely on a number until a second, independent record agrees with it. The checks below are built on that idea. Work through them with your accountant and solicitor, ideally before you have committed money, and keep a copy of everything, since your lender will ask for much of it. The roadmap in how to buy a business with finance shows where this step sits.

Check 1: does the profit and loss match the BAS?

Ask for the profit and loss statements and the lodged BAS for the same periods. Sales on the P&L should be broadly consistent with the sales reported on the BAS once GST is accounted for. A business that reports one level of sales to the ATO and a higher one to a buyer is telling you something, whichever figure is true.

Timing differences explain small gaps. Large or growing ones don’t. Learning to read the P&L helps; see how to read your profit and loss statement.

Check 2: do the bank deposits support the sales?

Request twelve to twenty-four months of business bank statements. Total the deposits and compare them with reported turnover. Card-heavy businesses are easy to test because merchant settlements are traceable; cash-heavy ones are harder, which is why a cash business needs a deeper look, such as stock purchases against sales and a few weeks of observed trade.

Lenders do the same exercise. How lenders read your bank statements shows what stands out to them, from dishonours to round-sum transfers.

Check 3: what is the owner’s wage really worth?

Most small-business profit is partly the owner’s salary in disguise. If the seller works 60 hours and draws nothing, the “profit” includes pay you would otherwise have to give a manager. Replace the seller’s labour with a market wage and see what remains. If that adjusted profit can’t service your loan and leave you a living, the business is overpriced or the debt is too big. The next guide, how to value a small business, covers this adjustment.

Check 4: are there claims over the assets?

Search the Personal Property Securities Register for the seller’s name, ABN and ACN. It shows security interests registered over vehicles, equipment and stock. A finance company with a registered interest may be entitled to follow the asset into your hands, so settlement should include discharge of anything you aren’t taking over. See the PPSR glossary entry.

Search ASIC’s registers too, to confirm who the company’s directors are, that the entity is registered and who holds its shares. If the business is sold by a trust, ask for the trust deed to confirm the trustee has authority to sell.

Check 5: what does the ATO account say?

Ask the seller to show you the ATO online account or statement of account for the business: any outstanding tax, BAS or super debt, and whether a payment plan is running. Debts of the selling entity don’t automatically become yours when you buy assets, but they can cause trouble if the seller can’t pay and the business is a single-purpose entity, and they warn you about cash pressure on the seller’s side. If you are buying the company itself, the debts come with it.

Check superannuation for employees too: unpaid super is a liability someone will have to meet.

Check 6: does the lease survive the sale?

For a shop, café or clinic, the lease is the asset. Read it for:

• remaining term and renewal options, since a lease with eighteen months left makes a five-year loan much harder
• rent review method and any recent increases
• assignment clause: will the landlord consent, and on what conditions?
• personal guarantees or bank guarantees the new tenant must give
• make-good obligations at the end

Make the contract conditional on the lease being assigned or a new one granted. Business Queensland lists leases as a core part of its buying checklist, and other states say the same.

Check 7: are the licences, permits and contracts transferable?

Liquor licences, food premises approvals, tradie licences, franchise agreements and customer contracts often don’t transfer automatically. Some need the regulator or the counterparty to approve the new owner. A contract with the council or a supermarket may allow the other side to terminate on change of control. Ask for every material contract and read the clauses on assignment.

Check 8: how much trade walks out with the owner?

Customer concentration and owner dependence are the quiet killers. Ask for a sales breakdown by customer for the past two years. If the top customer is a fifth of revenue, find out how that relationship works and whether it is personal. Talk to key customers and suppliers during the handover if the seller allows it. A reasonable deal gives you a transition period, say two to three months of the seller working alongside you.

Also ask about staff: who are the key people, what are their contracts, what leave and entitlements have accrued, and would they stay? Under the Fair Work Act’s transfer of business rules, taking on the seller’s staff for the same work within three months can carry service across, so accrued entitlements affect your price.

Check 9: is the equipment as good as the list says?

Have a qualified person inspect plant, vehicles and machinery. Compare the asset register with what you can see. Lenders want to know the condition and age because it affects what they will lend against, and a worn-out key machine is a near-term capital cost that belongs in your price.

Want an opinion on whether your numbers would support a loan? Send us the basics; a minute is all it takes, with no credit enquiry.

Putting the findings to work

A diligence report that turns up problems isn’t a failure. It’s the point. There are four sensible responses:

1. Renegotiate the price to reflect the issue, such as lower adjusted profit or an expiring lease.
2. Restructure the payment so that risk is shared. Holding back part of the price, or using vendor finance with the right to offset claims, protects you if something surfaces later; see vendor finance when buying a business.
3. Require warranties and indemnities in the contract on the financials, tax and employees.
4. Walk away. There is always another business.

A short worked example

This is an illustration. A buyer is shown a plumbing company with $1.2m of annual sales and $240k of profit. The checks reveal three things:

• Bank deposits over twelve months total $1.08m once GST is considered, about 10% below the claimed sales; the seller explains that a large job was invoiced just before year-end but not yet paid.
• The owner draws no wage and works full time. A market wage for a manager would be about $110k, which brings real profit to $130k.
• One builder contributes more than a third of sales.

The buyer asks for the aged debtors list to confirm the unpaid job, renegotiates the price on the adjusted $130k, and negotiates a six-week handover to meet the builder. The bank sees a cleaner picture and the loan is smaller and safer.

When due diligence is done, finance is the next question

A well-run diligence process makes the loan application easier, because you can hand the lender the same evidence you’ve already tested. Banks should be your first call when the business fits their criteria; their pricing is often the best available. If a bank has declined, or the settlement date is coming faster than a bank can move, talk to us.

It takes about a minute to fill in, and enquiring doesn’t leave a mark on your credit file. Your details aren’t broadcast to a list of lenders, so your phone stays quiet. A real person reads the specifics of your purchase and rings you to discuss options. Enter the figures carefully, as the right structure rests on them.

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