Seven checks on one specific listing, in an order that puts verifying the earnings ahead of everything the earnings are used to justify - because every other number in the deal is built on top of a figure the seller had every reason to shape.
13 min read · Level 3
I think most small-business due diligence fails not from a lack of effort but from doing the checks in an order that makes the buyer emotionally committed before the hardest number gets tested. A buyer who has already fallen in love with the location, met the loyal staff, and pictured themselves running the place is a much worse auditor of the earnings than one who verifies the earnings first and only then decides whether any of that matters. This is why the order in this lesson is not a suggestion - putting quality-of-earnings first is a deliberate defence against a buyer's own optimism, which by the time an offer is on the table is usually running well ahead of the facts. A red flag found in week one, before any emotional or financial commitment exists, gets evaluated honestly. The same red flag found in week six, after a deposit is down and a moving date is half-planned, gets rationalised - and the rationalising is not a character flaw, it is simply what happens to anyone's judgement under sunk cost.
Seven checks on one specific listing, in the order that determines the outcome rather than the order a business-broker's package presents them in.
One. Verify the earnings before evaluating anything built on top of them. A quality-of-earnings review - tracing tax returns, bank statements and merchant-processor records against the reported SDE - is the single highest-value hour a buyer can spend, because every multiple, every financing calculation and every projection in the deal is arithmetic performed on this one number.
Two. Map customer concentration by actual dollars, not by the seller's description. Pull twelve months of invoices or bank deposits and rank customers by revenue, rather than accepting a verbal "we have a diverse client base."
Three. Check the working capital the business actually needs to operate, separate from the price paid for it. A business with 40,000 tied up in inventory and receivables that the seller is not including in the sale price leaves the buyer needing that 40,000 on day one just to keep the doors open at the same pace of trade - it is a real cost the multiple does not show.
Four. Stress-test the debt-service-coverage-ratio against a bad year, not the best year presented. Lesson two's coverage math needs to survive a 20-30% revenue decline, not just describe the year the seller chose to show.
Five. Run reference checks that the seller did not select. A reference-check with a customer, supplier or former employee the buyer found independently - not one handed over by the seller - is where the gap between the pitch and the reality usually shows up first.
Six. Read the disclosure schedule and every attached contract personally. The disclosure-schedule lists what the seller is formally representing as true; a lease, a supplier agreement or a non-compete-clause buried in an exhibit can change the economics of the deal entirely, and none of it is optional reading delegable to a broker's summary.
Seven. Identify every red flag found and decide, in writing, whether it is a price adjustment, a deal condition, or a walk-away. A red-flag found during diligence is not automatically fatal - the question is always whether it is priced, structured around, or disqualifying, and deciding which requires writing the reasoning down rather than reacting in the moment.
The order matters because everything downstream is arithmetic performed on the earnings figure, and a buyer who negotiates price, financing and terms before verifying the number underneath them is negotiating confidently about the wrong thing. A quality-of-earnings review that finds the true SDE is 15,000 lower than stated does not just lower the price by 15,000 times the multiple - it also lowers the debt-service-coverage ratio, which can turn a financeable deal into one a lender declines, which can end the whole transaction regardless of how good the negotiation on price was.
Customer concentration checked against actual invoices rather than a verbal description matters because sellers are not usually lying when they say the client base is diverse - they are often simply wrong, having never actually run the numbers themselves. A buyer who does the arithmetic independently frequently finds a concentration the seller genuinely did not realise existed.
Working capital is easy to miss because it does not appear as a line item in the SDE calculation at all - it is a separate cash requirement, on top of the purchase price and the down payment, and a buyer who has not budgeted for it can find themselves needing tens of thousands more in cash within the first month than the deal appeared to require.
Reference checks the seller did not select matter for the obvious reason that a reference the seller handed over has been selected precisely because they will say something favourable. A customer or a former employee found independently, through a public review, a supplier directory or a simple cold call, has no reason to perform for the buyer.
And reading every contract personally rather than through a broker's summary matters because a broker's incentive, however honestly they are acting, is to see the deal close - which is not the same incentive as a buyer's need to understand exactly what they are agreeing to. A non-compete that restricts the seller for only six months, or a lease with two years remaining and no renewal option, changes the entire risk picture of the purchase in ways a one-paragraph summary will not surface.
Educational, not personalised financial advice. Nothing in the Investor Academy is a recommendation to buy, sell or hold anything — what is right for you depends on your own circumstances and the rules where you live.
A dry-cleaning business listed at 420,000, with a stated SDE of 150,000 (2.8x), diligence conducted in the order above.
Check one, earnings. Tracing bank deposits against reported revenue over twelve months finds actual revenue roughly 6% lower than the tax return implies, once a cash-discrepancy the accountant could not fully explain is accounted for conservatively. Adjusted SDE: 141,000 rather than 150,000 - a 9,000 reduction.
Check two, concentration. Invoices show no single customer above 4% of revenue - a genuinely diversified base, confirming the seller's description this time.
Check three, working capital. The sale price excludes 18,000 of inventory (uniforms, supplies, hangers) currently on hand, which the buyer will need to fund separately at closing to keep operating at the current pace.
Check four, stress-tested coverage. At the adjusted 141,000 SDE and a re-negotiated price of 141,000 x 2.8 = 394,800, financed at 90% (355,320) over 10 years at 10%, annual debt service is 355,320 / 6.1446 = 57,835.72. Coverage at the adjusted SDE: 141,000 / 57,835.72 = 2.44x - still comfortable, but stress-tested at a 25% revenue decline (SDE falling to roughly 105,750), coverage falls to 105,750 / 57,835.72 = 1.83x, which still clears a typical 1.25x floor with real room to spare.
Check five, references. A supplier found independently, not through the seller's list, mentions in passing that the business's largest commercial account - a hotel laundry contract worth roughly 15% of revenue by the buyer's own later check - is currently being competitively re-bid. That account had not been flagged anywhere in the seller's materials.
Check six and seven. The hotel contract, once located and read directly, turns out to run for another fourteen months with an automatic renewal clause unless either side gives ninety days' notice - a real risk, but a bounded and disclosed one rather than an immediate threat. The buyer's decision: proceed, but with the price re-based on the adjusted 141,000 SDE, the 18,000 of working capital budgeted separately, and a specific closing condition requiring written confirmation from the hotel that no notice of non-renewal has been given.
None of the seven checks individually killed the deal. Together they moved the effective price down by roughly 34,000, added an 18,000 cash requirement the original numbers did not show, and surfaced a real but manageable contract risk the seller's own materials never mentioned - which is exactly what a diligence process done in this order is supposed to produce.
Negotiating price before verifying the earnings, which means renegotiating everything - price, financing, and sometimes the whole deal's viability - if the quality-of-earnings review finds a materially different number later.
Accepting a seller's description of customer diversification without independently ranking actual invoices or deposits by customer. Sellers are frequently wrong about their own concentration, not dishonest about it.
Forgetting that working capital not included in the sale price is a real, separate cash requirement, and discovering it only after closing, when there is no negotiating room left.
Using only the references the seller or broker provides. A reference list assembled by the seller has been selected for a reason, and it is not to surface problems.
Delegating contract review to a broker's one-paragraph summary rather than reading the lease, supplier agreements and any non-compete clause personally, or with a lawyer, before relying on the summary's characterisation of what they say.
Trace bank deposits and merchant-processor statements against the reported revenue and every SDE add-back, over at least twelve months. Do this before, not after, agreeing to a price, so any adjustment happens while there is still real room to renegotiate.
Pull invoices or deposit records and build the ranking yourself. A seller's honest belief in their own diversification is not evidence of it.
Ask specifically what inventory, supplies or receivables are excluded from the sale price and will need to be funded at closing, and add that figure to the total cash required rather than treating it as covered by the purchase price.
Model a 20% and a 30% decline in SDE and recompute coverage at each. If either scenario falls near or below the lender's stated minimum, treat the financing as fragile even though the base case looks comfortable.
A supplier, a competitor, a former employee, or a customer located independently through public information. What they mention in passing, unprompted, is frequently more informative than a direct answer from a seller-selected reference.
Pay particular attention to remaining lease term and renewal options, any customer contract nearing renewal or re-bid, and the exact scope and duration of any non-compete clause protecting the buyer after closing.
For each item, decide explicitly whether it changes the price, requires a specific closing condition, or is serious enough to walk away from - and write the reasoning down, since a decision made under the pressure of a closing date is far more likely to rationalise a flag away than one made calmly on paper beforehand.
Before making any offer on a specific listing, before agreeing to a final price, and again before signing final closing documents if diligence surfaced anything unresolved.
Do not run a full seven-point diligence process on a listing you have not yet decided is worth pursuing at all - do a quick screen on price, industry fit and stated SDE first, and reserve the full process for listings that clear that initial screen, or the process itself becomes the bottleneck rather than the deal.
It is a common pattern for a seller to genuinely and sincerely describe their customer base as diversified, having never once actually ranked customers by dollar revenue - the belief comes from a general impression of a busy shop with many faces coming through the door, not from an invoice-level analysis. Buyers who take the description at face value and buyers who pull the actual numbers frequently arrive at very different conclusions about the same business, and the gap is rarely a matter of the seller lying. It is a matter of nobody, including the seller, having done the arithmetic before the buyer showed up asking.
A seller's honest belief about their own customer diversification is not a substitute for ranking actual invoices. Do the arithmetic yourself, even when you have no reason to doubt what you are being told.
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