3 Critical Things to Check Before Buying a Small Business
When people start looking at buying a small business, they usually focus on the financial statements.
They examine revenue, profit margins, seller's discretionary earnings, and the asking price.
Those numbers are important, but they don't tell you everything you need to know.
In fact, some of the biggest risks in a small business acquisition have very little to do with the numbers on the financial statements.
They have to do with the person running the business.
The owner.
I've worked with many business buyers over the years, and one of the most important lessons I've learned is that small businesses are often built around their owners.
The owner may be responsible for key customer relationships, supplier negotiations, daily operations, and countless decisions that keep the company functioning.
So when you're buying a small business, you need to understand exactly what the current owner contributes and whether those responsibilities can be transferred successfully.
There are three things I want every buyer to investigate before making a major financial commitment.
Why the Business Owner Is One of the Biggest Acquisition Risks
Unlike a large corporation with established management teams and documented processes, a small business may depend heavily on one individual.
That person may have started the company, built its reputation, developed relationships with customers, and learned how to solve problems that nobody else in the organization understands.
When that person leaves, those capabilities don't automatically transfer to the new owner.
And that's where buyers can get into trouble.
A business might look profitable on paper, but what if the owner is working 90 hours per week?
What if the business survives partly because the owner's household has another substantial source of income?
Or what if the largest customers only do business with the company because of their personal relationship with the seller?
These are risks you need to investigate.
Let's look at the three factors I consider particularly important.
1. How Many Hours Does the Owner Work, and What Do They Actually Do?
The first thing I want to know is how many hours the seller works each week.
But I don't stop there.
I also want a detailed explanation of what the owner actually does during those hours.
Do they manage employees?
Handle customer complaints?
Prepare estimates?
Negotiate with suppliers?
Perform technical work?
Answer calls outside normal business hours?
You need to understand the full scope of their responsibilities.
Why the Owner's Workload Affects Business Valuation
When evaluating a small business, we often normalize its financial statements.
That means adjusting certain expenses to reflect what a typical buyer should expect when operating the company.
One common adjustment involves the owner's compensation.
A business owner may pay themselves more or less than someone else would earn performing the same job.
So we need to determine a reasonable market wage for the work being performed.
But there's a problem.
What if one person is doing the work of two or three employees?
Imagine a seller who manages the business, performs technical work, handles bookkeeping, and answers customer calls every evening.
You might assume that hiring one manager for $80,000 per year would replace the owner.
But after investigating the actual workload, you discover that you'll need a manager, an administrative assistant, and a part-time technician.
That changes the economics of the acquisition.
The additional labor costs reduce the cash flow available to support the purchase price.
The Difference Between an Owner-Operated and Systematized Business
I've seen businesses at both extremes.
Some owners have built excellent systems and hired capable employees.
They spend relatively little time in daily operations because the company can function without constant supervision.
Other owners are involved in nearly every decision.
They're the first person at work in the morning and the last person answering calls at night.
These businesses may report similar earnings, but they aren't necessarily worth the same amount to a particular buyer.
A company that depends on an owner working extremely long hours may require substantial additional investment in management and staffing after the sale.
How to Verify the Seller's Actual Working Hours
Don't rely exclusively on the seller's estimate.
Many owners won't simply tell you they work 80 or 90 hours per week.
They might say they arrive early, stay late occasionally, and answer calls whenever necessary.
During due diligence, look for evidence of the actual workload.
For example, a company's internet-based telephone system may show when calls are answered.
If the owner regularly answers calls at 6:30 in the morning and 9:00 at night, that tells you something important.
You can also review employee responsibilities, operational schedules, customer communication patterns, and the seller's involvement in major decisions.
The goal isn't to criticize how hard the seller works.
It's to determine what it will realistically cost to replace the seller's contribution.
Questions to Ask About the Owner's Workload
Before purchasing a business, I would want clear answers to questions such as:
How many hours does the owner work during a typical week?
What are their daily and weekly responsibilities?
Which tasks can existing employees perform independently?
Which responsibilities require specialized knowledge?
How much additional staffing would be needed after the owner leaves?
Could the buyer personally perform the same work?
If you can't answer these questions, you may not understand the true operating costs of the business.
2. What Does the Business Owner's Spouse Do for a Living?
This second question surprises people.
But I think it can provide valuable insight into the financial circumstances surrounding a small business.
What does the owner's spouse do?
The reason I ask is that the seller's household finances may affect how much income the business actually needs to generate.
Why Household Income Can Matter
Imagine two business owners operating similar companies.
The first owner has a spouse who doesn't earn outside income.
The family relies primarily on the business to pay household expenses.
The second owner is married to a highly paid professional.
That spouse's income covers most of the family's living expenses.
Both businesses might appear profitable.
But the financial pressures on their owners could be very different.
In the first situation, the business may have needed to generate enough cash to support the household.
In the second, the owner might have been able to tolerate years of weak cash flow because the family had another substantial income source.
This doesn't mean the second business is automatically a bad acquisition.
It means I would want to investigate whether the company generates enough sustainable cash flow to support a new owner who may not have the same financial circumstances.
The Hidden Household Subsidy
I sometimes think of this as a household subsidy.
Suppose a business owner doesn't need to withdraw much money from the company because their spouse earns a substantial salary.
The business might survive with limited profits.
It might also operate without certain benefits or expenses that another owner would need.
For example, in the United States, the owner might receive health insurance through their spouse's employer.
A new buyer without that coverage may need to account for additional costs.
That can affect how much money is truly available from the business.
Why This Matters When Reviewing SDE
Seller's discretionary earnings, or SDE, is commonly used to evaluate smaller owner-operated businesses.
It attempts to measure the financial benefit available to one working owner under specified assumptions.
But SDE isn't automatically the amount a buyer can take home.
You still need to consider the owner's responsibilities, operating requirements, financing costs, and other obligations.
And you need to examine the adjustments made to arrive at the reported earnings.
If the seller has been able to operate with unusually low personal compensation or benefits because of outside household income, the buyer may face different economic requirements.
A Seller's Household Situation Is a Clue, Not Proof
I want to be clear about something.
A spouse's occupation doesn't prove whether a business is financially healthy.
A business supported by a single-income household can still have serious problems.
And a business owned by someone with a high-income spouse can be extremely profitable.
The household situation is simply another piece of information that may help explain the seller's operating decisions.
Rather than making assumptions about the seller's family, focus on the financial evidence.
Ask whether the business produces enough cash flow to support the compensation, benefits, and operating costs you'll require.
The important question isn't how much money the seller's family has. It's whether the business can support your financial needs on its own.
3. How Concentrated Are the Business's Customers and Suppliers?
The third factor involves concentration.
Many buyers understand that losing a major customer can damage a business.
But fewer examine supplier concentration with the same seriousness.
And even fewer investigate how personally involved the seller is in maintaining those important relationships.
I want buyers to examine both sides.
Customer Concentration: How Much Revenue Comes From the Top Five Customers?
Here's one of my favorite questions to ask a seller:
What percentage of total revenue comes from your five largest customers?
Notice how specific that question is.
If you simply ask whether the business has a few large customers, the answer may not tell you much.
But asking for the percentage gives you a starting point for evaluating risk.
Imagine two businesses.
| Customer concentration | Business A | Business B |
|---|---|---|
| Revenue from top five customers | 20% | 60% |
| Revenue from all other customers | 80% | 40% |
Business A has a more diversified customer base.
Business B depends on a relatively small number of customers for most of its revenue.
That doesn't automatically make Business B a bad acquisition.
But it creates additional questions.
What happens if one of those customers leaves?
Are the relationships supported by contracts?
How difficult would it be for customers to switch suppliers?
And who manages those relationships?
Why You Need to Examine Customer Concentration Over Time
Here's something many buyers overlook.
It's not enough to examine customer concentration for a single year.
You also need to know whether the largest customers remain consistent.
I once examined a business where the top five customers regularly represented more than half of annual revenue.
But the identities of those customers changed significantly from year to year.
A major customer in one year might disappear from the top five the following year.
Sometimes a customer would return several years later.
The business was heavily project-driven.
It had a strong reputation and an established pool of potential customers.
But every year, management had to secure enough major projects to replace those that had ended.
That's a very different risk profile from a business with recurring revenue from the same five customers.
What Customer Concentration Reveals About Future Cash Flow
When reviewing the largest customers, I want to know:
What percentage of revenue does each major customer represent?
How has that percentage changed over several years?
Are purchases recurring or project-based?
Are there contracts or other ongoing commitments?
How difficult would it be to replace a lost customer?
Does the seller personally manage these relationships?
The answers help determine how predictable the company's revenue may be after the acquisition.
Supplier Concentration: What Happens if a Key Supplier Disappears?
Customer concentration is only half the equation.
You also need to understand supplier concentration.
A business may depend on a particular manufacturer, distributor, or service provider.
But not all supplier relationships carry the same level of risk.
Example: A Bakery With One Flour Supplier
Suppose you're purchasing a bakery.
The company buys all its flour from one supplier.
At first glance, that looks like supplier concentration.
But flour is generally available from multiple sources.
If the existing supplier stops delivering, the bakery may be able to find another supplier, subject to price, quality, and availability.
The concentration exists, but there may be practical alternatives.
Example: A Motorcycle Dealership
Now imagine purchasing a dealership selling a specific brand of motorcycles.
The manufacturer is central to the business model.
If the company loses its authorized dealership agreement, the consequences could be severe.
And the manufacturer may have approval rights concerning a change in ownership.
That's a very different situation from the bakery.
The risk isn't simply how much the business purchases from one supplier. It's how difficult that supplier would be to replace.
Questions to Ask About Supplier Concentration
I would investigate:
Which suppliers are essential to the business?
What percentage of purchases comes from each major supplier?
Are alternative suppliers available?
Are there exclusive distribution or licensing agreements?
Will those agreements continue after ownership changes?
Does the seller have personal relationships that influence pricing or access?
These questions help you understand whether the business can continue operating under new ownership.
The Hidden Risk: Does the Seller Personally Control Key Relationships?
There's another layer to customer and supplier concentration that I consider especially important.
Who actually owns the relationships?
A company might employ salespeople and account managers.
But the largest customers may still insist on dealing directly with the owner.
I've seen situations where major customers want a personal relationship with the person who controls the business.
They don't simply want to speak with a salesperson.
They want access to the owner.
And if the owner is leaving, that relationship could change.
Why This Matters During an Ownership Transition
Suppose a customer represents 30% of the company's revenue.
The seller has maintained that relationship for 15 years.
The customer trusts the seller personally.
After the acquisition, the seller retires.
Will that customer continue buying from the business?
Maybe.
But you shouldn't assume the relationship will transfer automatically.
You need to investigate how the relationship works and what steps can reduce the risk of losing it.
How to Reduce Owner Dependency Before Closing
Depending on the circumstances, you might negotiate a transition period during which the seller introduces you to major customers and suppliers.
You could also arrange meetings with important accounts during due diligence, with appropriate confidentiality safeguards.
Another approach is to develop internal employees who can maintain those relationships after the seller leaves.
The goal is to ensure that the business's most valuable relationships don't disappear with the previous owner.
How These Three Factors Affect Business Valuation
These three areas are closely connected.
The seller's workload affects how much it may cost to operate the business after closing.
The seller's household financial circumstances may help explain why certain compensation or benefit costs aren't reflected in the business's current cash flow.
And customer and supplier concentration affects the stability of future earnings.
Together, they help answer a fundamental question:
Will this business produce the same economic benefits when the current owner is no longer involved?
A buyer who ignores these factors may overestimate the company's sustainable earnings.
And that can lead to overpaying.
Why Financial Statements Alone Aren't Enough
Financial statements tell you what has been recorded.
They don't necessarily explain every activity, relationship, or personal contribution that made those results possible.
That's why I encourage buyers to examine both the financial and operational sides of a business.
You need to understand not only how much money the company earns, but also what it takes to generate those earnings.
A Practical Due Diligence Checklist for Small Business Buyers
Before making a final acquisition decision, I recommend investigating these three areas systematically.
| Area | What to investigate | Potential warning sign |
|---|---|---|
| Owner workload | Hours, responsibilities, after-hours work | Seller performs multiple full-time roles |
| Replacement staffing | Skills and personnel required after closing | Reported cash flow excludes necessary labor |
| Household financial support | Whether operating economics depend on unusual compensation or benefits | Business can't support a replacement owner's needs |
| Customer concentration | Top five customers' share of revenue | Large percentage dependent on a few accounts |
| Customer consistency | Changes in major accounts over several years | Large customers change every year |
| Supplier concentration | Essential vendors and alternatives | Critical supplier cannot easily be replaced |
| Relationship dependency | Seller's involvement with major customers and suppliers | Important relationships may not transfer |
This isn't a complete business acquisition due diligence checklist.
But it's a useful way to uncover risks that might not be obvious from the initial financial statements.
Final Thoughts: Understand the Owner Before You Buy the Business
When you purchase a small business, you're not just buying equipment, inventory, customers, and cash flow.
You're buying an operation that may have been built around one person's knowledge, work ethic, relationships, and financial circumstances.
That's why I want buyers to investigate the seller as carefully as they investigate the financial statements.
Find out how many hours the owner works and what they actually do.
Understand whether the business's economics depend on financial support or benefits outside the company.
Examine customer and supplier concentration, including how those relationships are maintained.
And most importantly, develop a realistic plan for replacing the seller's contribution.
A business that works for the current owner won't necessarily work the same way for you.
The more thoroughly you investigate these issues before closing, the better prepared you'll be to evaluate the opportunity and manage the transition into ownership.
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