Questions You Should Be Prepared to Answer Before Buying (or Selling) a Small Business

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It likely goes without saying that every transaction is different: Every company, industry, searcher, and investment opportunity presents unique considerations that in turn give rise to unique questions and areas for further due diligence.

With that said, over many years of evaluating countless acquisition targets alongside searchers, I’ve found that certain questions do indeed tend to apply more often than not. I’ve presented each of these FAQs in the blog post that follows, in hopes that they play a small role in how you structure your own due diligence process, and in turn how you think about the relative merits and risks of the opportunity in question.

If you’re a buyer, the list that follows can be thought of as a starting point for “Commercial Due Diligence 101” (excluding company-, industry-, and context-specific considerations). You may also choose to think of it as a basic checklist of items that you should include within the materials that you use to introduce any acquisition opportunity to your investors.  

If you’re a seller on the other hand, you should be prepared to address each of the questions and information requests below if you’re ever planning to sell your small to medium sized business (in reality, the actual list of questions and information requests will be many multiples larger than what I’ve presented below, but this should still serve as a useful starting point).

For each of the categories that follow, I list each of the relevant questions, and where applicable and non-obvious, I also attempt to add some commentary on why certain questions tend to be important more often than not.

Transaction Basics

Why These Are Important: Questions in this category serve as the basic underpinnings of any transaction. Think of these as prerequisites. Nothing should strike you as particularly wise or insightful here:

• Source of the opportunity (proprietary v. competitive)
• Sources & Uses analysis: For each source and use, include a) The Dollar Amount; b) The Multiple of EBITDA; and c) The Percentage of Total Sources/Uses
• If there is an earn-out: How will the earn-out payments actually be funded (i.e., through the company’s operating cash flow, additional leverage (often a line of credit), or additional equity)?
• Details of the proposed debt package, including any seller financing
• How did you decide how much leverage to put on this transaction?
  • Why I ask this: I like to understand why a given level of leverage has been proposed in any transaction. In my opinion, an example of a bad answer would be “This is what the banks were willing to give me”, as this lacks the thoughtfulness and nuance that I would expect to see. An example of a better answer could be “At this level of leverage, we never breach covenants, even in our model’s downside case”, or perhaps “At this level of leverage, we maintain a DSCR of 1.25x even under very low growth assumptions”
• Will the purchase price increase if EBITDA increases as we approach close, or is the dollar amount of the purchase price “static”?
• Copies of reports from external due diligence providers (QofE, legal, technical, etc.)

GP/LP Economics (If Applicable)

Why These Are Important: Questions within this category tend to be applicable only to acquisition entrepreneurs operating outside of the “Traditional” or “Funded” search model (i.e., self-funded searchers, independent sponsors, etc.). As somebody who invests in both of these emerging structures, I’ve noticed that searcher economics, governance, and even the security that investors hold often differs widely across individual opportunities, so I often spend the time upfront to ensure that I understand what is being proposed:

• What percentage carry will the searcher(s) get? What is the proposed GP/LP split?
• How does this carry vest, if at all?
• Will external investors hold participating preferred shares?
• What is the coupon rate attached to those shares? Will that coupon rate compound annually/cumulatively?
• Will external investors receive seniority in the capital structure via a 1.0x liquidation preference?
• What are the differences in the equity waterfall, if any, relative to the traditional search fund structure?
• Is the searcher/GP proposing a “catch-up”?
• Will the searcher/GP invest any of their own capital in the transaction?
• How many board seats will there be?
• Who nominates each member of the Board?
• Which decisions will require Board approval, and which decisions will not?

Sellers

Why These Are Important: Questions in this category are among the most important in evaluating the acquisition of any small or medium-sized business. Among other reasons, this is so because:

1. In spite of everybody’s best intentions, these types of transitions between incoming owner/CEO and outgoing owner/CEO tend to not work out as originally planned
2. There is massive asymmetry of information between buyer and seller in these types of transactions: The seller has likely forgotten more about their business than you’re likely to learn during the course of a due diligence process measured in months;
3. On the day after closing, what the seller largely wants from you (money), they have already received. What you largely want from the seller (help, introductions, context, etc.) hasn’t even yet begun;
4. A dishonest seller in an M&A negotiation is often suggestive of a seller who has also been dishonest with employees, suppliers, regulators, tax authorities, and the like;
5. In many small businesses, the seller tends to be very important to the day-to-day operations of the company (this gets increasingly true as company size decreases). In certain instances, the seller departing unexpectedly could represent a very material risk to the ongoing operations of the company

• Profile of the sellers (age, experience, interests, management constraints, day-to-day operational involvement, etc.)?
• Why are they selling? Have their answers to this question (which should be asked multiple times in multiple different ways) remained consistent? Do we believe their stated answer(s)?
• What is your view of the integrity of the seller? Do we have any reason to be skeptical?
• Specific details of the agreed upon transition plan, including non-compete agreements (length of post-close employment, full-time v. part-time, employee v. contractor, length and scope of non-compete, etc.)
• If the seller is rolling equity: Are they expecting a Board seat on the post-close entity?
• What percentage of customers does the seller have a personal relationship with?
• For what percentage of customers did the seller play a material role in the initial sales process?

Other Key Employees

• For any members of the current management team currently occupying a particularly important role: How, if at all, are we planning to retain them post-close?
• Please provide an org. chart, including the tenure of each employee
• What has voluntary employee turnover been throughout each of the past 3 years?
  • Why I ask this: Though a certain level of voluntary turnover (i.e., employees quitting) is entirely normal and to be expected, asymmetrically high levels of it may be suggestive of a larger problem that warrants further investigation (cultural issues, competitive issues, limited prospects for future growth, etc.). Nobody has the “inside track” on a company quite like the people who spend most of their time working within it.
• Have you gotten a chance to speak with key company employees yet? If not, will you be able to speak with them prior to close?

On this last point: It’s both very common and entirely understandable for sellers to be hesitant about introducing prospective buyers to employees, including and especially members of their senior management team. That said, these are critical conversations for any buyer to have. In spite of your best efforts, if your seller doesn’t provide you with employee access during the due diligence process, buyers can add these types of conversations to the list of “Conditions Precedent”: This is a section within the purchase agreement where buyer and seller mutually agree on the list of late-stage items that must take place in order for a transaction to successfully close. These often include conversations with key employees/customers/suppliers, getting any required customer approvals, amendments to any change-of-control clauses in existing company contracts, release/cancellation of any company obligations that won’t be part of the post-close entity, and so on.

Financial

• On a single page, summarize the top 5-10 assumptions that drive the model, including a) The assumption in the base/upside/downside cases; & b) The relationship to historical averages for each key assumption
  • Why I ask this: Models are nothing more than a collection of assumptions, and as a result, investors need to better understand what the major assumptions are, as well as how those assumptions compare to what the company has been able to achieve historically: For example, if a base case forecasts a 20% revenue CAGR over the next 5 years, but the company has only achieved a 5% revenue CAGR over the past 5 years, I would want to better understand the reasons why we think new ownership can accomplish something that previous ownership had never been able to
• In the model’s downside case, what are the annual covenant cushions? Do we ever breach (or risk breaching) our bank covenants?
  • Why I ask this: As a new CEO who lacks industry, company, and leadership experience, there are plenty of things to keep you up at night. As much as possible, I like to ensure that the possibility of breaching covenants is not added to that list. Not only does a more conservative capital structure provide the new CEO with a much needed “sleep at night factor”, but additional leverage can always be added in the months and years to come should circumstances dictate that it’s appropriate to do so. I’ll mention that not all equity investors will necessarily agree with this approach- it tends to be more conservative than than most.
• What do the model’s major assumptions have to look like in order for us to breach covenants?
• What is the company’s average cash conversion cycle?  Said another way: What is the average time between service provided/sale made and the company collecting on its revenue?
• What has EBITDA to free cash flow conversion been over each of the past 3 years?
• What is the company’s history of passing through price increases (if any)? Is there a pricing opportunity within the company’s base of existing customers?
  • Why I ask this: Price is a unique value-creation lever, in that it’s one of the few changes that a CEO can make whose benefits will accrue almost entirely to the company’s bottom line, and often in short order. Pricing tends to be as much of an art as a science, and it’s not abnormal for founders to leave pricing untouched for years (and in more extreme cases, even decades), despite their own cost inflation. However, proceed forward carefully, as not all businesses posses the same degree of pricing power (to evaluate the extent of your own company’s pricing power, please see “Pricing Power: How Small Changes Can Have Big Impacts“.
• If they have increased prices in the past, what has been the impact on customer churn, if any?
• What percentage of LTM (“last twelve months”) revenue is from existing customers vs. new customers?
• If there have been material capital expenditures in the past: What has been the mix between maintenance vs. growth capex?
  • Why I ask this: Search funds generally tend to steer clear of capex intensive businesses, and while I generally believe that they should continue to do so, not all capex is created equally: More specifically, search funds should be especially careful to avoid business models that require a lot of maintenance capex: That is, capital expenditures that are required to essentially keep the lights on. Growth capex, on the other hand, tends to be more palatable in the eyes of investors (relatively speaking), as it only becomes a consideration if the company is playing offence and pursuing continued growth. This is particularly true if growth capex (for example, opening a new facility) presents strong unit economics with reasonably quick payback periods.
  • Though this all sounds perfectly logical in theory, it’s worth mentioning that many SMBs don’t even account for capex properly to begin with (they often just expense these items straight to their income statements during the time periods in which they are incurred), to say nothing of breaking them down between growth- and maintenance-oriented investments. As a result, the prospective acquiror is likely to have to perform quite a bit of additional, manual analysis to better understand the relative mix between the two.

Customers

• How many customers did the company serve in the LTM period?
  • Why I ask this: Though a simple customer count is admittedly a bit of a crude, “blunt force” type of metric, it also tells me quite a bit about the extent of product/market fit that the company in question has been able to achieve (it also tells me about possible customer concentration, which is, by definition, higher in companies with very small customer bases). In a software company, for example, small customer counts might be indicative of a company that has customized each deployment to the specific needs of any given customer, which is a big red flag due to the lack of scalability, technical debt, and ongoing maintenance costs that this practice often creates. On the surface, I’d be much less concerned about this risk if evaluating an otherwise identical company with, say, 300 customers.
• What have new logo acquisitions been over each of the past 3 years?
  • Why I ask this: Due to the information asymmetry between buyer and seller mentioned above, the buyer needs to be sure that the seller doesn’t see a headwind on the horizon that they’re not disclosing, particularly if that headwind is already impacting the company’s ability to acquire new customers. Though a declining trend in new logo acquisitions doesn’t necessarily suggest that this is taking place, it should at least prompt further questions from the buyer as to the reasons why
• Of the 20 most recent new logo acquisitions: What percentage have been from inbound, and what percentage have been from outbound?
• What is the length of the average/typical sales cycle?
• Have you engaged in customer calls yet? If not, will you have a chance to do so before closing?
  • See my commentary above on “Conditions Precedent”. Buyers need to find a way to have these conversations with customers, even if sellers are understandably hesitant to facilitate them. This is particularly true for any large customers that represent, say, 10% of revenue or more.
• What percentage of current year customers were also customers in t-1 year, t-2 years, and t-3 years?
  • Why I ask this: Even if your target company doesn’t generate contractually recurring revenue, this analysis helps investors understand the extent to which the revenue stream can be described as “repeat” or “re-occurring”
• What percentage of total revenue is represented by the company’s top 1, 5, 10, and 20 customers?
• What percentage of a given customer’s revenue is spent on the company’s products/services?
  • Why I ask this: Ideally, buyers are looking for a product that generates out-sized operational value relative to the price that customers pay for it. As a customer, if a given opex item represents 10%+ of your revenue, you will likely revisit that expense annually, compare & contrast as many suppliers as possible, and negotiate the lowest possible price with your supplier. If, however, a given opex item represents 1% of your revenue, and it’s working well enough for you, then none of those efforts are likely to be pursued

Software-Specific

Why These Are Important: While many of the considerations above are as applicable to a software company as they are to a widget company, there are indeed certain questions, risks, and considerations that are highly unique to the enterprise software business model that prospective buyers should be sure to ask. Some of these include:

• Do you have recorded product demos that you can send me?
• What has gross logo retention been for each of the past 5 years?
  • Why I ask this: If I were forced to evaluate the health of a software company utilizing only a single metric, I think gross logo retention (“GLR”) might be my metric of choice. This is so for several reasons, including:
    • It’s one of very few metrics that can tell me about several different aspects of a company simultaneously (product quality, customer service quality, stickiness, pricing power, etc.)
    • Unlike Net Dollar Retention (“NDR”), it can’t be “inflated” by upsells into the company’s base of existing customers. While these types of “back-to-base” sales are an unambiguously positive thing, at some point, the company may come close to fully mining the new business opportunities that exist within their current base of customers
    • Net dollar retention tends to fluctuate more drastically than gross logo retention does: During prosperous economic times when customers are hiring, they’re likely adding new seats and purchasing new licenses (which will drive NDR up, but leave GLR unchanged). During more turbulent economic times however, when hiring slows or stops, customers are either not adding new seats or they’re cancelling existing ones (which will drive NDR down, but leave GLR unchanged). Assuming the product in question has high stickiness/switching costs, these seat subtractions are more likely to occur than an outright cancellation of the entire product in question, hence the higher volatility of NDR
    • Net dollar retention can fluctuate based on the addition or subtraction of a single large customer with a high ACV. The addition (or subtraction) of this large quantum of revenue may hide the addition (or subtraction) of a larger number of smaller customers, which may be suggestive of a broader story that is worth paying attention to
    • For more on the distinction between GLR and NDR, please see “Considerations Unique to Acquiring a Software Company (Financial)“)
• What has net dollar retention been for each of the past 5 years?
• Discuss the product’s switching costs: How expensive/disruptive/time consuming is it for customers to use a competitive solution, or in-house these capabilities?
• Discuss how frequently customers use the company’s products (i.e., daily, weekly, monthly, etc.)
  • Why I ask this: Though this isn’t always true, more frequent usage of a product is often suggestive of higher switching costs
• What is the average tenure across all of the company’s customers?
• Do you have a churn attribution analysis (i.e., for every customer that has churned historically, why they have done so)?
  • Why I ask this: Not all churn is necessarily created equally. Just because company A and company B both have 10% annual logo churn, it does not necessarily mean that their products are equally sticky. For example, if all of Company A’s churn is attributable to customers leaving for a competitive product, then that’s likely to be quite concerning. However, is half of Company B’s churn is attributable to a non-core vertical that they recently entered and have yet to achieve true product/market fit, then that may be less concerning
  • Again, this all makes sense in theory, but it’s worth mentioning that the majority of SMBs don’t actually perform churn attribution, so actually getting this data might be quite difficult
• Do you have customer LTV data? Do you have CAC data? If so, what has LTV/CAC been over the past 3 years?
• Within service revenue, what is the relative mix between i) implementations; & ii) custom development for customers?
  • Why I ask this: As a buyer, whenever you hear “custom development for each customer”, run away as fast as you can! As Rich Mironov points out in his incredible four-part blog series entitled “The Four Laws of Software Economics“, the goal of any software company should be to “build once and sell many times”, not “build many times and sell each once”.
• Walk me through the “typical” implementation (time, cost, etc.)
• How much technical debt do you think resides within the company’s code base?
  • (For much more detail on how to evaluate that question, see my other blog “Considerations Unique to Acquiring a Software Company (Product)”

Competitors

Why These Are Important: Businesses don’t operate in a vacuum. Though a large industry may sound attractive in and of itself, many large industries are intensely competitive, price sensitive, and feature few, if any, barriers to entry. Instead of being evaluated in isolation, any given company should instead be evaluated relative to its competitors operating within the same vertical

• Against whom does the company compete?
• Why does the company win deals from its main competitors?
• Why does the company lose deals to its main competitors?
• How competitive is the typical new customer acquisition?
• What % of new customer acquisitions over the past 3 years have been: a) “Greenfield” (i.e., replacing internally developed tools, or selling into a company where no similar tools have ever been used) vs. b) “Brownfield” (replacing an incumbent/competitive provider)
  • Why I ask this: Search funds rightly target industries that tend to demonstrate high switching costs, which in turn support highly recurring and predictable revenue streams. While companies undoubtedly benefit from these switching costs with respect to existing customers, they sometimes suffer from high switching costs when attempting to acquire new customers: After all, if a given prospect is already using a competitor’s solution, then by definition it will be hard for that prospect to switch to yours. As a result, industries with a lot of “white space” (featuring companies who don’t have many similar products currently in place) are preferable to those with a lot of incumbent providers already operating within them
• How does the company’s prices compare to those of its direct competitors?

General/Other

Why These Are Important: This is a bit of a “catch all” category, that includes questions that don’t neatly fit within each of the categories profiled above.

• What do you view as the 3 biggest risks with respect to this investment?
• What does this business look like in a prolonged recession?
• What do the company’s sales and marketing operations look like currently? Are there any outbound sales & marketing efforts? If not, should there be?
• Who are the company’s major suppliers? What do they supply to the company, and what percentage of COGS is attributable to their largest ones? 

In Sum

While it’s impossible to produce a list of questions that can cover every conceivable business model, industry, and transaction, I have found myself asking each of the questions above more often than not, regardless of the company or specific opportunity in question. If nothing else, consider this a list of questions that you’re likely to be asked by your investors at some point throughout your diligence and fundraising processes.

This is a list that I update very frequently, so to the extent that you have questions that you think I should be adding to it, please do let me know, as I would very much welcome your feedback!

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