Due Diligence Checklist for Buying a Small Business

Due diligence for buying a small business means proving four things before you sign: the profit is real, the customers will stay, the business runs without the seller, and nothing legal is waiting to land on you. Match the seller's figures to their tax returns and bank statements, pay an accountant for a quality of earnings review on larger deals, check customer concentration, and read every lease and contract.

You found a business you like. The seller is friendly, the books look clean, and the broker says another buyer is circling. This is the moment buyers stop checking, because checking feels like doubting a person you have started to trust.

Diligence is how you keep the trust and still protect your savings. The checklist below is the order we would work in, with the documents to ask for and the red flags that should end a deal. BizBuySell puts the due diligence phase at 30 to 60 days, and an SBA loan takes 45 to 90 days alongside it.

What does due diligence actually cover?

Five areas, in this order, because each one can kill the deal more cheaply than the next:

Work through financial first. If the profit on the tax returns does not support the price, you have saved yourself the legal bills for everything after it.

How do you check that the profit is real?

Start from the tax returns, not the broker's summary. A listing shows SDE (seller's discretionary earnings): profit with the owner's salary, perks and one-off costs added back. Every add-back is a claim. Ask for three years of business tax returns and match the net profit on them to the profit and loss statements the seller gave you. If they differ, the tax return is the number the seller swore to.

Then match the revenue to the bank. Add up 12 to 24 months of deposits from the business bank statements and compare them with reported revenue. Cash businesses (laundromats, restaurants, car washes) are where sellers most often say the "real" income is higher than declared. You cannot borrow against income the seller did not report, and you should not pay for it either.

Challenge each add-back. A one-off roof repair is a fair add-back. The owner's car, phone and family on the payroll may be, if they will really disappear when you take over. "Owner works 60 hours a week and takes no salary" is not a saving: you will have to pay someone to do those hours, which is why the business acquisition calculator subtracts a market salary before anything else.

Get the tax transcripts yourself. On an SBA-financed deal the lender must verify the seller's figures against IRS transcripts, which it requests with Form 4506-C or Form 8821, under SOP 50 10 8.1. Do the same even without a lender. The seller signs the request, the IRS sends the transcript, and nobody gets a chance to retype the numbers in between.

Pay for a quality of earnings review on larger deals. A quality of earnings (QoE) report is an accountant's independent rebuild of the seller's earnings: which add-backs hold up, how revenue is recognised, what the business really needs in working capital. Morgan & Westfield puts a review of a simple business with under $10 million of revenue at $10,000 to $20,000, with $5,000 at the low end. SBA lenders must now get one on any first acquisition priced at $3 million or more, and it has to include a proof of cash and a look at customer concentration. On a deal under a few hundred thousand dollars, a CPA's narrower review of the returns and bank statements is often the proportionate step.

Who are the customers, and will they stay?

Ask for revenue by customer for the last three years. Then look at three things.

Concentration. There is no official limit for small businesses. Public companies must disclose any single customer that brings in 10% or more of revenue, which is a sensible point to start asking questions. If one customer is a quarter of sales, you are buying a contract with that customer, and it may walk when the owner does.

Contracts and churn. Are the big accounts on written contracts, and do those contracts survive a change of ownership? Many have a change-of-control clause that lets the customer leave or renegotiate. For subscription and online businesses, ask for monthly churn and check it against the billing system rather than a spreadsheet.

Why customers buy. Read reviews, call a few customers with the seller's permission late in the process, and ask what they would do if the owner left. If the answer is "follow him", that is owner dependence.

Does the business run without the owner?

This is the most common reason a fair-looking deal disappoints. The seller is often the best salesperson, the person suppliers trust and the only one who knows how to fix the main machine.

Ask the seller to list every task they did last month and how many hours each took. Then mark which ones a current employee could take over, which ones need a new hire, and which ones only the seller can do. The last group is what you are really negotiating over.

Ways to protect yourself:

• A transition period in writing. Paid help from the seller for a set number of months, with named duties.
• A seller note. If the seller is owed part of the price over several years, they have a reason to make the handover work. The financing guide covers how seller notes sit next to a bank or SBA loan.
• Key staff. Find out who the business cannot lose, what they are paid against the local market, and whether they know about the sale. Retention bonuses are cheaper than replacing a manager in month two.

What legal checks matter most?

Get an attorney who does small business acquisitions to run these. Our list is what to ask for, not legal advice.

• The lease. For a shop, restaurant or workshop, the lease is often worth more than the equipment. Check how many years are left, renewal options, rent increases, and whether the landlord must consent to an assignment. A business with 14 months left on a lease the landlord will not extend has 14 months of value.
• Licences and permits. Some transfer with the business, many do not. Check which ones you must apply for in your own name and how long that takes.
• Lawsuits, liens and tax debts. Search court records and UCC lien filings in the business's state, and ask the seller to disclose pending claims in writing.
• Asset purchase or share purchase. Most small deals are asset purchases, so the buyer takes the assets and chosen contracts but not the old company's unknown debts. Buying the shares means buying its history too. Your attorney and accountant should agree on the structure before you sign the purchase agreement.
• Employees. Check that staff are correctly classified as employees or contractors and that payroll taxes are paid. Misclassification claims follow the business.

What about assets, inventory and working capital?

Walk the floor with an equipment list and note age and condition. Ask what needs replacing in the next three years, because that is money the SDE figure does not show. Count inventory close to closing and agree that the price assumes a set level.

Agree on working capital in the letter of intent. The buyer needs enough cash, receivables and stock on day one to pay staff and suppliers before customer payments come in. In larger deals this is a "working capital peg": a target level, with the price adjusted up or down at closing if the actual figure differs.

Which red flags should end the deal?

Walk away, or reprice hard, if you find:

• Tax returns that show far less profit than the listing, with "cash" given as the reason.
• A seller who will not give bank statements or tax transcripts, or who delays them past the diligence window.
• One customer, supplier or platform behind a large share of revenue, with no contract that survives the sale.
• Revenue falling for the last two years while the asking price is based on the best year.
• A lease that ends soon, with no written renewal from the landlord.
• Add-backs that grow every time you ask about the profit.
• Key staff who do not know the business is for sale and are about to retire or leave.
• Pressure to skip steps because "another buyer is ready to sign".

Walking away from a deal after spending a few thousand dollars on diligence is a good outcome. Buying a business that cannot pay its loan is the bad one, and the risks guide shows how far that can reach when you have signed a personal guarantee.

The checklist, in one place

Week 1: the documents.

1. Three years of business tax returns and profit and loss statements.
2. 12 to 24 months of business bank statements.
3. The general ledger and a list of every add-back with evidence.
4. Revenue by customer, by month, for three years.
5. The lease, every customer and supplier contract, licences and permits.
6. Staff list with roles, pay, start dates and contracts.
7. Equipment list, inventory report and receivables ageing.

Weeks 2 to 4: the checks.

1. Match tax returns to the P&L and bank deposits to revenue.
2. Order tax transcripts and start the quality of earnings work.
3. Map owner tasks and key-person risks.
4. Attorney reviews the lease, contracts, liens and lawsuits.
5. Rerun the business acquisition calculator with the verified SDE, not the listed one.

Before you sign the purchase agreement.

1. Renegotiate the price or terms for anything diligence turned up.
2. Put the transition period, non-compete and working capital level in writing.
3. Confirm the lender has everything for its own checks.

The rest of the series starts at how to do private equity. If you have not yet found a business to check, read how to buy a small business first.

This is general information, not financial, legal or tax advice. Every deal is different, so have a qualified accountant and an attorney in your state or country review any business before you buy it.