The Pivotal Role of Thorough Due Diligence in Business Brokerage

by | Blog, General Business

Effective pre-due diligence can give you more. More quality listings, more closings, and more time.

In the intricate world of business brokerage, effective pre-due diligence is not just a preliminary step; it’s a cornerstone for success. Effective pre-due diligence provides a bounty of benefits: high-quality listings, smoother transactions, and efficient use of time. It’s about delving deep into the potential client’s business to unravel the layers of its operations, financial health, and market standing. I recently had an empowering education through the masters CBI program where we covered this very subject led by Rich Mowry.

However, I’ve learned through challenging experiences that inadequate pre-due diligence can lead to significant time waste and unviable listings. For instance, I once represented a sports bar for sale. Despite finding several “qualified buyers”, the deals consistently fell through because the landlord rejected them. It wasn’t until later that the landlord revealed a crucial piece of information: due to previous negative experiences with the current operator’s lack of investment in their space, they had decided to lease only to major brands in that shopping center. This meant that no matter how suitable my buyers were, the landlord would never approve them for that particular restaurant. This revelation was a wake-up call. Not only did I expend considerable effort in vain, but it also resulted in disappointment for the business owner. This experience underscored the critical importance of conducting comprehensive research before accepting a listing, to avoid such pitfalls.

The Financial Deep-Dive:

The financial aspect of due diligence is often the most scrutinized. Brokers should aim to analyze financial statements from the past five to seven years. This timeline is crucial for understanding the business’s resilience, especially through economic downturns like the recent COVID-19 pandemic. It’s not just about the numbers; it’s understanding the story behind them. How did the business adapt? What changes were made post-crisis?

Seek to understand the inflection points of the business. Why did things suddenly increase in revenues, or decrease in revenues? What influences those trends? As an example, we saw a fishing retail business skyrocket during Covid. And we had a wedding business that experienced record sales in 2022, but that was likely due to the fact that people held off on getting married during the Covid era. Every buyer is going to want to know what’s happening after that blip in the marriage market. You will benefit from putting in the time and effort early on to understand what is driving those expense and revenue trends.

Beyond Numbers: Industry Context:

Understanding the broader industry context is vital. Each sector has its unique drivers and challenges. A thorough analysis involves comparing key financial ratios, like EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization) to gross revenues, against industry benchmarks. Deviations from these standards can be telling – they might indicate unique strengths or potential red flags. Don’t expect the business owner to know the industry ratios.

However, if you discuss the industry ratios compared to the subject company, you are likely to gain valuable insights that can help you better represent the listing. We had a pool service company whose COGs (cost of goods) increased significantly in one year. It helped to understand that chlorine experienced a steep rise due to a challenge with a major supplier; the subject listing could not raise prices due to contractual obligations at the time but improved their COGs the following year and changed the contracts to allow them to modify charges in the future.

Competitive Landscape and Market Positioning:

No business exists in isolation. Identifying how a business differentiates itself from its competitors is essential. This involves assessing its unique selling propositions, customer base, product or service range, and geographical presence. What makes this business stand out, and how sustainable is its competitive edge?

Customer and Supplier Relations:

The stability and longevity of a business often hinge on its relationships with customers and suppliers. Key questions include: Is there an over-reliance on a handful of customers or suppliers? How are family members involved in the business compensated, and what are the implications for a potential sale? The continuity of these relationships post-sale is a significant factor in the business’s future success.

Operational Insights:

The day-to-day operations provide a window into the business’s true health. Understanding the role of the owner and key employees is crucial. Are there dependencies or skill gaps that could pose risks to a new owner? Also, evaluating long-term leases and contracts is vital – are these transferable, and what are the terms?

The Human Element:

The cooperation of the current owners and employees can significantly impact the due diligence process. Gauging their willingness to provide necessary information and their openness to change and negotiation is crucial. This aspect often determines the smoothness of the transition process.

In conclusion, comprehensive due diligence by business brokers is an invaluable process that goes far beyond financial analysis. It encompasses a holistic view of the business, considering its industry positioning, competitive edge, customer and supplier dynamics, operational efficiency, and the human element. This thorough approach not only ensures a better selection of clients but also sets the stage for successful transactions, safeguarding the interests of both buyers and sellers. Invest your time and effort to conduct effective pre-due diligence and enjoy the benefits of more quality listings, more closings, and more time.