Most buyers save their hardest questions to ask when buying a business for diligence, and by then the price is on paper and the deal has picked up momentum of its own.
The better time to ask is before you sign the letter of intent, because that’s when your leverage is highest, even though it’s also when you have the least information.
We do financial due diligence for acquisition entrepreneurs, and a lot of that work starts before any LOI exists. The questions below are the ones we ask first when a buyer sends us a target, and none of them need a data room, just a seller who’s willing to answer them.
Before the LOI, You’re Reading a Story the Seller Wrote
Before the LOI, the financial picture is whatever the seller and broker chose to show you. That usually means a CIM and maybe twelve months of profit and loss, and only occasionally a balance sheet.
Nobody is trying to trick you here, since that’s simply how this market works, but it does mean every number in front of you was prepared by someone who wants a higher price. The seller may well be right about those numbers, but they aren’t a neutral party.
Our floor is simple. Before you sign an LOI, you want a month-by-month P&L for the past 24 months, a balance sheet, and the CIM, because without those all you really have is the story the seller wrote.
The questions that follow are how you start testing that story, and they fall into a few buckets: documents, revenue, the balance sheet, people, and structure.
What Financial Documents Should You Ask for Before the LOI?
Start with the monthly P&L rather than the annual one, because annual totals hide seasonality, one-time spikes, and the month the owner stopped paying themselves.
Ask for two full years of monthly data if the seller has it, since that’s usually enough to tell a real trend apart from one good quarter.
Ask for the balance sheet as of the same date as well. If the seller can’t produce one, that tells you something on its own.
Then ask whether the P&L ties to the filed tax returns. You don’t need the returns yet, but you do need to know whether the two tell the same story.
If they don’t, ask why. Sometimes the answer is a timing difference, and sometimes it’s a sign that nobody has reconciled the books in years.
Once you have the documents, the next question is how the revenue in them got recorded.
Ask How Revenue Is Recorded, Not Just How Much There Is
Revenue is the number everyone trusts, but it’s also the one most often distorted by how the seller set up their books.
We recently scoped a quality of earnings review on a food and beverage franchise where the CIM looked reasonable on the surface, until we noticed the seller had booked sales tax as an operating expense instead of passing it through.
That one choice overstated revenue by a few hundred thousand dollars and threw off every margin in the CIM. Nobody was hiding anything; it was just how the books had always been kept.
So ask how revenue is recognized. Is it cash or accrual, does the top line include tax collected from customers, and are deposits counted when they’re received or when the work is done?
Backlog deserves the same scrutiny. On one deal under LOI, the seller counted about $1.2 million in accepted quotes as backlog, and none of those quotes had purchase orders behind them yet.
Once you weight each quote by stage, a number like that can land closer to $500,000 that you’d actually stake a price on. An accepted quote can still fall through, so ask what’s signed and what’s only hoped for.
Revenue questions tell you what the business earns, which brings us to what it owns and owes.
The Balance Sheet Questions Most Buyers Skip When Buying a Business
Everyone looks at the P&L, but the balance sheet is where the skeletons tend to live.
This matters most when the books were recently cleaned up. If a new accountant rebuilt the financials last year, the prior years are the ones we’d look at hardest.
Inventory is the clearest example. On a specialty retail acquisition, the physical count came back at less than 40% of what the books showed, and that one gap called the whole financial picture into question, so cash and customer deposits suddenly needed a second look too.
You won’t get a physical count before the LOI, but you can still ask when inventory was last counted and how the book value was set.
A few other balance sheet questions are worth asking early:
- Are there customer deposits or prepaid work you’d be obligated to deliver?
- Are there gift cards, store credits, or promotional balances still outstanding?
- Is there any debt, equipment lease, or loan that isn’t on the balance sheet?
- When was the balance sheet last reconciled to the bank statements?
Those answers tell you what’s on the books, and the next question is who actually does the work.
Who Works in the Business, and What Would It Cost to Replace Them?
Owner compensation is often the biggest single adjustment in a small business deal, and it’s also the easiest one to misjudge before the LOI.
Ask what the owner is paid, and then ask what the owner actually does all week. If they run sales, manage the crew, and keep the books, you’re replacing three roles, and the seller’s earnings figure may only account for one.
It gets murkier with more than one owner. We talked recently with a buyer looking at a service business with several owner-operators, some of whom worked in the field as technicians. Their pay was part of operations, so until owner pay and labor were separated, nobody could say what the business really earned.
Then ask how the team is classified, and whether the people doing the core work are employees or contractors.
The IRS looks at the degree of control and independence in the working relationship, so what the contract calls someone doesn’t settle the question.
A business that treats an employee as a contractor without a reasonable basis may be held liable for employment taxes for that worker. In a sale, that exposure should be priced into the deal, so you want to know about it before you name a price.
How much of that exposure you take on depends on the structure, which brings us to the next question.
Ask What You’re Actually Buying: Assets, Stock, or a Carve-Out
The structure of the deal decides which of the seller’s problems come with it, so it’s worth asking early, because the answer changes what you need to check.
In a stock purchase, you acquire the entity itself, history included. In an asset purchase, you generally take the assets and leave more of the seller’s liabilities behind.
That break isn’t always clean, though, because sales tax and payroll obligations can follow the business even in an asset deal. We lay out where that happens in which seller tax problems follow you when buying a business.
An asset deal also creates paperwork on both sides. The buyer and the seller each report the sale on Form 8594 when goodwill or going-concern value attaches, or could attach, and the allocation you agree to ends up on both returns.
Carve-outs add another layer, because if the business you want sits inside a larger entity, the tax return may not tell you much. A Schedule C gives you very little to work with, while a partnership or corporate return is usually easier to separate, so ask which entity files the return and whether it holds anything besides the business you’re buying.
Take the drafting questions to your attorney, since our role is the financial effect of each structure rather than the legal language.
Some answers to all of these questions should make you slow down, and there are three we see most often.
What Seller Answers Should Make Acquisition Entrepreneurs Slow Down?
The first is “my accountant handles that.” When a seller can’t explain a number, find out who can, because the person who prepares the tax return and the person who keeps the books often see very different things.
The second is a lease with little time left. On the franchise deal above, the lease had two years remaining, and that alone had already caused an earlier buyer to walk. The seller was offering a longer renewal, which is exactly the kind of term you’d want to stress-test before you close.
The third is a revenue story that depends on one thing going right, whether that’s one large customer, one ad channel, or one supplier on a handshake.
None of these kill a deal on their own, but they do tell you where your first questions after the LOI need to go, and knowing where to dig next starts with understanding what the LOI is for.
The LOI Is the Permission Slip, Not the Finish Line
Post-LOI is when the real diligence starts, and that’s when you go deeper into tax returns, bank statements, credit card statements, and a full reconciliation.
The LOI is the permission slip to actually look under the hood. Asking these questions first doesn’t replace that work, but it does make sure you’re doing it on a deal worth doing, at a price you can defend.
If you have a target and haven’t signed yet, our pre-LOI deal screen is a 30-minute consult and a first pass on the deal book, and we’ll flag the obvious problems before you commit to a price.
Once you’re under LOI, the buy-side due diligence checklist lays out the order we work in from there. If you’re still deciding how to fund the purchase, read search fund vs. self-funded acquisition next.
Have a deal in front of you?
Reach out to Ashford Sky with the target, and we’ll tell you what we see.
Until next time!
