Financial Due Diligence for Search Funds and ETA Buyers
By Tom McCollum, ACA · Former KPMG Corporate Finance · Compass & Ledger
The short answer
Most small-business earnings figures presented to buyers include adjustments, or add-backs, that need testing. Buyer-side due diligence tests those adjustments, the quality of revenue, working capital and customer concentration, then builds an acquisition model that sizes the debt you can safely carry. It's the difference between buying the business you think you're buying and the one you're actually getting.
Buying a business is the biggest financial decision most searchers make. The seller's numbers need testing before you sign, your lender needs a model it can rely on, and the business needs a working finance function from day one. Our advisers come from Big Four corporate finance and buy-side investing, with 100+ completed transactions between them. We work for the buyer.
Where the numbers usually move
Add-backs
Sellers and brokers present adjusted earnings, adding back costs they argue won't continue. Some are legitimate; others aren't. Common problem areas:
- Owner salary. If the owner is paid below market, you'll need to pay a replacement manager, or yourself, a market rate. That cost doesn't disappear.
- "One-off" costs that happen every year.
- Personal expenses run through the business. Legitimate to add back, but they need evidence.
- Missing costs. Roles the owner covered personally that a new owner will need to hire for.
Revenue quality
- Recurring versus project revenue.
- Customer concentration and whether key relationships sit with the owner personally.
- Revenue recognised on a cash basis, which can hide timing.
Working capital
The purchase price usually assumes a normal level of working capital is left in the business. If that "peg" is set wrong, you can pay for the same cash twice. It's one of the most negotiated, and most misunderstood, parts of a deal.
What we do
- Review historic financials and the seller's adjustments to earnings.
- Analyse revenue quality, customer concentration and margins over time.
- Assess working capital and propose a peg.
- Build the acquisition model: operating forecast, debt sizing, cover ratios and returns.
- Prepare lender and investor materials.
- Set up the data room and diligence question lists.
After completion
- 13-week cash flow forecasting.
- Monthly close and management reporting.
- Board, investor and lender reporting, including covenant compliance.
Debt sizing: don't borrow to the limit
Most acquisitions are funded partly with debt, often SBA loans in the US. Lenders will tell you the most you can borrow; the model should tell you the most you should. Test debt service cover under a downside case, with a market salary for the operator, and keep headroom for the first year, when things usually move.
When to bring us in
As soon as you have a signed LOI, or earlier if you want to pressure-test a target before committing to one.
Frequently asked questions
Is this the same as a quality of earnings report?
It covers similar ground: testing earnings and adjustments. Some lenders require a formal quality of earnings report; we can work alongside that provider or scope work to fit.
What does it cost?
Operating models start from $4,000. Transaction support is quoted on the call, based on the size and complexity of the deal.
Thirty minutes. No pitch. Your situation, and what we would do about it.
If we are a fit, we will say so. If we are not, you will hear that too, and where to look instead. Either way you leave with a clearer picture of what good finance looks like for your business.