A buyer can eliminate most unsuitable businesses in a few hours of focused review, well before formal diligence begins. The purpose of this first evaluation is to decide whether the business merits an offer and at what price and structure. Five questions do most of the work: are the earnings real, will they continue, can the business run without the seller, can the price be financed, and am I the right owner for it?
Why the seller is selling
Begin here. Retirement, health and a desire to pursue something else are ordinary reasons, and they are usually easy to confirm. Vague or shifting explanations deserve attention. A buyer should consider whether the seller sees something approaching, such as a lease expiring, a competitor arriving, a key customer leaving or a regulatory change.
Are the earnings real?
Request three years of tax returns and financial statements along with the seller's schedule of adjustments. Then test them.
- Compare the statements with the returns. Differences should be explainable.
- Review each add-back. Accept those that are documented and clearly discretionary. Discount the rest.
- Look at the trend. Three years of rising, flat or falling revenue and margin each tell a different story.
- Examine gross margin by year. Compression may indicate pricing pressure or rising costs that the seller has not passed along.
- Ask about the current year. Results since the last year-end matter as much as the history.
A business whose earnings appear only after extensive adjustment requires more caution than one that is profitable as reported.
Will the earnings continue?
Discuss an acquisition
An initial conversation is confidential and carries no obligation.
Historical earnings have value only to the extent they will recur. Several factors determine that.
Customers. How many are there, how much does the largest represent, and how long have they been buying? Is revenue recurring under contract, repeat by habit, or project-based and won anew each time?
Competition. Who else serves these customers, and what would cause a customer to switch?
Suppliers. Is the business dependent on one source, a franchise or a distribution agreement that can be terminated?
The industry. Is demand stable, growing or contracting? Is technology or regulation changing how the work is done?
Can it operate without the seller?
In small companies this is frequently the decisive question. Identify what the owner personally does: selling, estimating, managing key accounts, holding a required license, performing the technical work. Then identify who will do each of those things after closing.
Review the employees who remain. How long have they been there, what do they earn compared with the market, and is there a manager capable of running daily operations? A capable second-in-command who intends to stay is worth a great deal to a new owner.
What will it need?
Some costs do not appear in historical earnings but will be borne by the buyer.
- Equipment and vehicles near the end of their useful lives.
- Deferred maintenance on facilities.
- Outdated systems that need replacement.
- Below-market wages that will need to rise to retain staff.
- Working capital to fund receivables and inventory from the first day.
Estimate these and include them in the capital required. A fair price for a business that needs $200,000 of immediate investment is lower than for one that does not.
Can the price be financed?
Buyers often begin with a multiple. A more reliable approach begins with debt service.
Take the adjusted earnings you are willing to rely on. Subtract a realistic salary for yourself, since the lender will. Subtract an allowance for capital expenditures. What remains is the cash available to service debt.
Compare that figure with the annual payments on the proposed bank loan and any seller note. An SBA lender will require coverage of at least 1.25 times for a first acquisition, measured on historical earnings. Prudent buyers look for more, because the first year under new ownership seldom matches the last year under the old.
Consider an example. A business shows adjusted SDE of $420,000. The buyer needs a salary of $110,000 and expects $30,000 a year in capital spending, leaving $280,000. At 1.25 times coverage, the business can support about $224,000 of annual debt service. That figure, together with the loan term and interest rate, determines how much can be borrowed, and therefore what price is achievable with the buyer's available equity.
If the asking price requires more debt than that, the price is too high, the structure must change, or the buyer must contribute more equity. Knowing this before making an offer avoids weeks of wasted effort.
Are you the right buyer?
Lenders evaluate the buyer as closely as the business. Relevant industry or management experience matters, and so does liquidity after the down payment. A buyer should make the same assessment personally. Does the daily work suit you? Do you have the skills the departing owner supplied, or a plan to hire them? Can your household manage if the first year is harder than expected?
Warning signs
Certain findings in a first review justify either a lower offer or a decision to move on.
- Statements that cannot be reconciled to tax returns
- Significant claimed cash income that is not reported
- Declining revenue with no clear explanation
- A single customer representing a third or more of sales
- A lease with little remaining term and no renewal option
- High employee turnover
- A seller unwilling to provide financing or a reasonable transition
- Pressure to commit quickly without adequate information
What comes next
If the business passes this review, the next step is a letter of intent that reflects what has been learned: a price supported by verified earnings and financeable under the lender's tests, a structure that addresses the risks identified, and a diligence period long enough to confirm the rest.
The first evaluation is not a substitute for diligence. Its value is in directing a buyer's time and money toward the few businesses worth pursuing.
Twelve31 Advisors assists acquirers with target evaluation, valuation, structure and financing. Buyers can begin by completing the acquirer intake form.
