Dig Into Due Diligence
by Diana Capirano
Certified Franchise Consultant
When exploring a resale, the level of due diligence will be driven by the complexity of the business model and how the owner is performing. Evaluation of resales must be comprehensive, even granular to mitigate risk. Although franchise systems are the same, owners are not, which leads to a great degree of variability in financial and operational performance.
A holistic approach is best in assessing the overall health of the business. Many buyers think they just need to evaluate financials. Not so! If you’re not prepared to ask the how and why behind the numbers, you may miss a whole lot more.
Following are the 3 most important categories and items that are fundamental in disclosure.
Standard disclosure is the past three years’ tax returns and corresponding profit-and-loss statements (P&Ls) and balance sheets. Also request current YTD (Year-to-Date) information. Tax returns tend to be of most value because they are holistic. Make sure the financials are verifiable or reviewed by a CPA as they are not audited. In some cases, a cash-flow analysis may be available. If not, view bank statements to verify money in and money out.
- If the business carries accounts receivable (AR), you’ll need an AR aging report to see money that’s due, collection trends, and the largest outstanding AR sources considered an asset in the purchase that may not attach to the sale.
- A current asset list should be documented in the tax returns if they are still being depreciated. These items may be cars, equipment, computers, furniture, etc. Get an updated list from the seller, and an inspection should occur later in the process.
- Other supporting information will be required for owner salaries or distributions; adjustments to earnings before interest, tax, depreciation and amortization (EBITDA), and any irregular items that don’t really attach to running the business. These should be discussed with the seller as they were discretionary, not necessary (examples: extravagant staff party or personal expenditures). These numbers will help you validate the Seller Discretionary Earnings (SDE), which is significant because some sellers set their asking price based on a multiple of the SDE.
Leases, organizational charts, contracts, price lists, payroll, staff records, third-party companies utilized, and a review of SOP are just a few on my checklist. The more complex the business model, the more items you can expect to dig into.
You’ll need to verify the business license(s), insurance policies, lawsuits/claims, liens, and other licensures (if required). Even if not planning a stock sale, any litigation is important as it can speak to the reputation of the brand name or future financial vulnerabilities. Businesses related to health and the trades tend to have more regulations. Make sure you check federal, state, and local requirements to operate this business. Verify that the existing business has been complying and is in good standing through past surveys or copies of licenses.
This is more about you than the seller. It’s how you can improve the top and bottom lines. Financials are a great indication of how the current owner is operating but not how you will run business. For example, if the seller has been in business for two to four years and revenue is declining rather than growing—why? This is a prime time for a great growth trajectory. For an owner after 10-plus years, declining sales may indicate burnout, not utilizing new or updated franchise processes, or in some cases, the competitive landscape changed and the owner did not adapt. Good data does not lie, and intangibles are harder to value but just as valuable!
Don’t be afraid if your due diligence doesn’t reveal great results. They may serve you well as leverage in negotiating. The nightmare would be not knowing the real deal and entering blindly into a sale.
Diana Capirano, CFC, has an expansive career which includes corporate and franchise sales and development, marketing and operations, merger and acquisitions, structuring and negotiations as well as business ownership. As a highly-respected consultant and mentor, Diana espouses a profound commitment to help prospective business owners and investors understand and navigate the process of deciding on a franchise business. Contact Diana at 941-999-0095, email firstname.lastname@example.org, or visit http://www.focusfranchise.com.