Five Non-Negotiables To Understand Before Closing
January 28, 2025 | Issue #113
Big Deal Small Business: 5 Non-Negotiables To Understand Before Closing
January 28, 2025 | Issue #113
This is a newsletter written by Kaustubh Deo // Guesswork Investing about acquiring & operating small businesses. If you are a new reader / new searcher, please start here.
I find it personally fulfilling to support searchers in buying small businesses. I see how it can positively impact their lives.
But there are plenty of moments where I feel truly worried for potential buyers. I don’t mean to be patronizing or paternalistic, but I can’t help but feel some anxiety for buyers that seem unprepared for the reality of their acquisition.
The cliche in search is that “the only thing worse than never buying a business is buying a bad business.”
That is true, but the more nuanced view is that there are a lot of businesses that are buyable by searchers, but only after the searcher knows what they are buying. They need to understand the ground truth of the small business BEFORE they close, and price the deals or create transition plans accordingly.
Today’s post covers five non-negotiables — if you cannot confidently state you understand each of these five items, you are not ready to close on a multimillion dollar loan and acquire the business.
1. Understand what the owner and their family does.
When asked what they do in the business, most small business sellers will say something along the lines of “Oh, I probably work 40-50 hours per week in the business, so you can definitely just replace me if you’re going to be an owner-operator.”
Look — this will occasionally be true, but on average, this is the real answer: “I spend 40-50 hours per week in the office, and another 10-15 hours per week driving around to meet clients/vendors or just thinking about the business. Also my spouse handles the bookkeeping, website, and tax filings on the weekends.”
The seller isn’t being intentionally misleading — they just have run their business for so long, they really do think of it as a fairly manageable 40-50/hour week job. Your job is to get into the nitty gritty of exactly how they spend their time.
So for each person that is leaving — the owner, the owner’s kid, the owner’s spouse, whoever — you need to have a very clear idea of what functions they are serving.
2. Understand how the business delivers its product/service.
In order to do the above, you need to map out every process step involved in serving your clients. That process map needs to include WHO is in charge of each step. In my opinion, this is what constitutes operational due diligence when it comes to small business acquistions.
This starts at the very beginning of the customer journey, with client acquisition — what are the lead channels? If Google Ads is one of them, who is managing the Google Ads? Oh, turns it it’s the owner’s spouse who loves to tinker in Google Ads and is constantly fine-tuning their ad campaigns? Now you know that’s another thing the ownership team does.
Who answers the phones when the client calls? Is it going to the owner’s cell phone or someone in the office?
Who processes client questions that are sent via email? Is it the owner answering emails at 8pm each night, or is that time baked into an employee’s job description? Who processes purchase orders that come in via fax?
The last step is often invoicing, and that’s easy to overlook — but who actually finalizes each invoice? Many small business owners want to have the last look before invoices go out, and they make little manual adjustments based on their knowledge of the given client or project. You need to know if that’s the case or if the company’s staff can truly handle invoicing independently.
Make a full list of processes and who does each step.
3. Understand how the business makes money.
This may sound like a repeat of #2 above, but it’s not. #2 is how the business generates revenue.
#3 is how the business generates money. Cold, hard cash. A classic buyer error is not realizing that having a large inventory is part of the reason a business may be successful. Clients are basically “renting” the company’s balance sheet by letting them hold the working capital. You can get caught offsides real quick if you don’t bring enough working capital into the business to maintain that differentiation.
To understand how the business makes money, you need to understand when cash flows. When do suppliers get paid? When do employees get paid? How does that compare to when customers pay you? How do you ensure customers pay you? And who in the business is accountable for that? (Hint: If you’re not sure, it’s you.)
If you’re looking for more in-depth learning here, spend some time googling “Cash Conversion Cycle” and learning about net working capital.
4. Understand how much EBITDA and cash flow you’re buying.
But wait, isn’t this now the same as #3?? Not really. The first three items above are all focused on how the business has done things in the past. This item is about how the earnings profile will look like for you, the buyer.
This does not go without saying. I got this wrong on my deal — I did my best, and have a TON of accounting training, and I still made material errors.
Here’s an example — the business I acquired was a home-based business. We could still be a home-based business, but I wanted to move it to a commercial facility to help establish a longer-term growth plan. I did the research to figure out what the per-square-foot rental rates in my market were for the type of building I’d want.
I nailed it on that front — I found a rental that met our needs at the pricing I had modeled.
What I hadn’t anticipated is that you can’t really find a building footprint as small as we needed — they just come naturally larger, so I had to rent a lot more square footage than we initially needed. Now, we will hopefully grow into the space over time, but those types of errors add up…and almost never break to the positive.
Now, the good news is this was more of a growth-oriented miss on my part. A more classic miss is you think you can replace the owner yourself. But you didn’t model in that you need spent $1500/month on a bookkeeper to replace the owner’s spouse. That’s an $18K/year miss, and if you’re paying a 4x EBITDA multiple, that’s a $72K valuation decline on day one.
I wrote a detailed post on how to bridge from SDE to EBITDA to Cash Flow — it’s easily been my most-read post. If I convince you to read nothing else I’ve written, please read this before you buy a business.
5. Understand the company’s compliance requirements.
Small business ownership is all about figuring things out as you go. It’s not a game of being perfect.
But if there’s anywhere you need to be as close to perfect as possible, it’s around legal compliance — that’s the one area of the business that presents near-constant existential risk. This can come in many forms: the state suspending your contractor license, your insurance carrier dropping your coverage, OSHA stopping your job sites, etc.
You need to have clear answers to the following at a minimum:
Do we need a state business license? (Probably.)
Do we have a business license in every city we operate in? (Probably.)
Do we have a sales tax calculation & compliance process? (I hope you do…)
Do we need an industry-specific license, like a contractor license? (Probably.)
Does the seller’s existing insurance coverage actually meet the insurance requirements required of us by the state and/or every city we operate in? (Work with someone like Oberle Risk on this)
Have we properly allocated risk codes in our general liability and/or worker’s comp coverage? (Ask the seller how they allocate payroll hours to risk codes.)
Do we have the required permits/sign-offs to complete our work? Examples:
Tree removal permits
Company location use matches the zoning use of that land
Manufacturing facility equipment has been inspected at required intervals
Safety equipment in general has been inspected at required intervals
Again — it’s really, really hard to be perfect in any aspect of small business ownership. But this is an area where the potential repercussions can be quite dramatic for your business, so ask the questions. Do your best to learn your legal requirements, because ignorance of the law will not be a defense to the $100K fine you end up paying.
Conclusion
Most of the time, I’m jazzed to support searchers in acquiring small businesses. I believe it’s one of the most meaningful ways they can positively impact their lives, their families, their employees, and their communities.
But sometimes I have a moment of panic that searchers don’t know what they’re getting into. Honestly, it often occurs when I listen to a Will Smith Acquiring Minds episode that involves a hard story.
I write this blog to help people buy businesses, and also to help people NOT buy business they should not buy. The middle zone is the large number of businesses that you should buy, but only once you understand the items above. Remember, it’s always buyer beware when it comes to transactions like this, and ignorance is not a defense.
For thoughts or feedback, just hit reply to this email or post/DM me on Twitter.
Best,
Kaustubh // Guesswork Investing