Most acquisitions that go wrong don’t go wrong at closing. They go wrong in the six weeks before the letter of intent, when a buyer decides emotionally that this is the business — and every piece of information after that gets read as confirmation.
I have sat on both sides of these transactions for more than twenty-five years, as a CFO inside businesses being bought and sold, and as the valuator producing the number the negotiation turns on. What follows is the discipline I apply on the buy side. It is not exhaustive, and it is not a substitute for professional diligence on a specific deal. It is the sequence I would want any buyer to understand before they spend their first dollar on professional fees.
The asymmetry you are working against
The seller has lived inside the business for years. You have a data room, a set of financial statements, and a broker’s summary. The seller knows which customer is about to leave, which employee holds the operation together, and which line on the income statement would not survive scrutiny. You know none of it.
That asymmetry is not dishonesty. It is structural. A seller is not obliged to volunteer the weaknesses, and most genuinely believe their business is worth what they are asking. Your job as a buyer is not to catch anyone out. It is to convert their knowledge into your knowledge before the price is fixed.
Everything below is a method for doing that efficiently.
Sequence beats thoroughness
The most expensive diligence mistake I see is not a missed number. It is spending forty thousand dollars on legal work, environmental assessments, and equipment appraisals before checking whether the customer contracts survive a change of ownership.
Diligence should run in three phases, and the money should follow the sequence, not lead it.
Phase one is the deal-killers. These cost you time, not fees. They are the handful of questions where a bad answer ends the transaction regardless of how attractive everything else looks. If you cannot clear phase one, you have saved yourself the entire diligence budget.
Phase two is confirmatory. This is where third-party spend begins — quality of earnings work, environmental assessment, equipment valuation, legal review. You commission it only once phase one is clear.
Phase three is integration preparation. What you need to know to run the business from day one. Important, but not price-determinative.
Buyers who invert this sequence pay for expensive answers to questions that never needed asking.
The five things to verify before the LOI
Phase one varies by industry, but the shape is consistent.
Do the revenue relationships transfer? Customer contracts frequently contain change-of-control provisions. Platform accounts, franchise agreements, distribution rights, and supplier terms often do not automatically survive a sale. If a meaningful share of revenue depends on a relationship that must be re-earned by a new owner, you are not buying what you think you are buying. Get this in writing from the counterparty where the concentration is material.
Who actually holds the business in their head? In most owner-operated companies, one or two people carry the pricing knowledge, the customer relationships, the technical judgment. Map them by name. Then ask what happens to each of them at closing. A business where the departing owner personally quotes every job is a business that stops quoting the day he leaves.
Do the licences, certifications, and qualifications transfer? Tobacco licences, liquor permits, industry certifications, security clearances, professional registrations — many are issued to a person or a legal entity and do not follow the assets. This is a five-minute question with an answer that can invalidate the whole thesis.
What does the lease say? Remaining term, renewal options, escalation, assignment rights, landlord consent. A profitable business with eighteen months left on its lease and no renewal option is a different asset than the same business with ten years of security.
Why is the seller really selling? The stated reason is retirement, health, or family. Sometimes that is true. Sometimes a major customer has signalled they are leaving, a lease is not being renewed, a competitor is arriving, or a regulatory change is coming. You will not always get a straight answer, but the question — and the way it is answered — is information.
Read the earnings, not the income statement
Owner-operated financial statements are prepared to minimize tax, not to present value. That is normal and not sinister, but it means the reported profit is rarely the profit you will inherit.
Build the second income statement — the one a buyer would construct. Add back the owner’s compensation above market replacement cost and subtract the cost of whoever will do that work after closing. If the business occupies property the owner also owns, deduct market rent, because you will either pay it or forgo it. Strip genuinely non-recurring items and be sceptical about how many items qualify as non-recurring. Then look hard at what is missing entirely.
The absences are usually more revealing than the entries. In owner-operated businesses I routinely find no insurance line, no professional fees, no licence costs, no maintenance reserve, no allowance for shrinkage or waste, and no owner compensation of any kind. Every one of those is a real cost a buyer will incur. Their absence inflates reported earnings and, at any multiple, inflates the price.
Two further tests are worth the hour they take.
Test the cost of sales against the business model. If a business reports a gross margin materially above what its product mix could plausibly produce, either purchases are being understated or inventory is being consumed. Both reduce value; you need to know which. Supplier statements requested directly from the wholesalers, reconciled against recorded purchases, settle it.
Test the wage cost against the hours the business is open. Multiply the staffed hours by minimum wage, add statutory employer costs, and compare to the recorded payroll. If the books show less wage expense than the legal minimum cost of staffing the business, there is unrecorded labour somewhere — family working unpaid, cash wages, or hours that are not actually being covered. Each has different consequences, and all of them reduce the earnings you are buying.
Where a business is really two businesses
When a company operates from property its owner also owns, you are looking at two assets in one set of statements: an operating business and a piece of real estate.
Value them separately. The operating company should be assessed on earnings after a market rent deduction, because that is the economic reality any buyer inherits. The property should be assessed independently, on its highest and best use — which is not necessarily its current use.
This separation frequently reveals options the seller has not considered. The buyer may want the business but not the real estate, or the reverse. The property may be worth more redeveloped than it is as an industrial site. Structuring the property into a separate holding company with a lease back to the operating business can materially reduce the capital required at closing. None of these possibilities are visible while the two assets are priced as one.
Structure carries the risk you cannot eliminate
Diligence reduces uncertainty. It never eliminates it. What remains should be handled in the deal structure rather than absorbed by the buyer.
Where a specific risk is identified and quantifiable — a tax exposure, an environmental question, a customer whose retention is uncertain — the natural response is an escrow, a holdback, or a specific indemnity. Where the risk turns on something only the seller can genuinely predict, an earnout tied to that outcome puts the risk with the party who has the information.
A seller’s willingness to accept structure is itself diligence. A vendor who refuses to tie any consideration to the continuity of the business they are describing as stable is telling you something about their own confidence. So is a vendor who refuses to hold any paper.
Knowing when to walk
The hardest discipline in buy-side work is not analytical. It is emotional. By the time diligence produces bad news, a buyer has usually invested months, spent money, and told people about the deal. Walking away feels like failure.
It is not. The purpose of this entire exercise is to make a good decision, and a good decision includes not proceeding. The cost of thorough diligence on a deal you abandon is always smaller than the cost of a deal you should have abandoned.
The question I return to with buyers is simple: if you knew everything the seller knows, would you still pay this price? Diligence is the process of getting close enough to that knowledge to answer honestly.
Sanjay Kulkarni, CPA, CFA, CBV, C Dir
I advise buyers and sellers of Ontario mid-market businesses on valuation, diligence, and deal structure — independently, and without commission on whether a deal closes. Twenty-five years as a CFO, more than one hundred completed valuations.
If you are looking at an acquisition and want a second set of eyes before the LOI, that is a thirty-minute conversation.
Book a consultation: https://calendar.app.google/5nb1Jq32VJMNxxF38
sanjay@sankulinc.com | 647-297-7025 |
www.businessvaluegrowth.com
This article is general guidance, not advice on any specific transaction. Diligence on an actual acquisition should be conducted with appropriate professional support.
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