What a buyer checks in due diligence on a service business

A buyer spends due diligence answering one question: how much of this company’s earnings will still be here after the owner leaves. Everything on the list comes back to that. The books get reconciled against the tax returns, the revenue gets sorted by customer to see how concentrated it is, the licenses get checked to see whether they transfer, the contracts get read for clauses that let the other side walk on a change of ownership, and the crew gets assessed for who stays. Knowing the order this runs in lets you fix the problems before a buyer prices them.

The books, against the tax returns

The first exercise is a reconciliation, not a reading. A buyer lines up three years of financial statements against three years of filed tax returns and against the bank deposits, and looks at whether the three agree. Revenue on the profit and loss that never appears in the deposits, or a return reporting less than the statements, stops a deal or reprices it.

Where a lender is involved, the verification is direct. The IRS Income Verification Express Service lets a lender request your tax return transcript with Form 4506-C, and the IRS releases it only after you approve the request with your signature. The transcript comes from the IRS rather than from you, so what you were filing is established independently.

The rest of the financial review covers the receivables and how old they are, the payables and what is overdue, the debts and which ones survive the closing, the equipment and vehicle loans against the titles, and the gross margin by service line. A buyer also recalculates seller’s discretionary earnings using your figures rather than accepting yours, which is where the add-backs get tested. Our SDE calculator runs the same arithmetic, and how a small service business is valued covers which add-backs hold up.

Customer concentration

A buyer sorts revenue by customer for each of the last three years and looks at the top five. When one account carries a large share, losing it after closing can wipe out a year of the buyer’s return, and the price reflects that risk. The trend matters as much as the snapshot: a top customer whose share is growing is a concentration problem getting worse.

Two related questions follow. How long have the top accounts been with you, and are they on paper or on a handshake? A ten-year relationship with no contract is stronger than it sounds and weaker than a contract. And whose relationship is it, yours or the company’s? An account that stays because of you is an account that leaves when you do.

Licenses, and the ones that cannot move

This is the item that surprises owners most. A license attached to a person or an entity does not automatically come with the business. In Tennessee, contracting requires a license: under Tenn. Code Ann. § 62-6-103 it is unlawful to engage in or offer to engage in contracting without being licensed with a monetary limitation sufficient for the project.

The Board for Licensing Contractors is explicit that while a business may be sold, the license cannot be sold or transferred to another person, firm or entity, and that a change in majority ownership requires a new license. A change in the mode of operation without a change in ownership, such as a sole proprietor converting to an LLC, goes through a revision process, and the contractor cannot contract in the new mode until it is approved.

The buyer will want the plan before closing: who the qualifying agent will be, whether the buyer already holds a license with an adequate monetary limit, and how long the application takes. Occupational licenses in other trades and other states have their own rules, and the pattern is the same. Sort this out in the letter of intent rather than the week of closing.

Contracts, leases and consent

A buyer reads every agreement looking for one thing: who can walk away when the company changes hands. The list to pull is the customer and maintenance agreements, the lease, the supplier and vendor terms, the equipment and vehicle leases, any franchise or dealer agreement, and employment, non-compete and non-solicitation agreements with your people.

Anti-assignment clauses are the ones that bite. A customer contract requiring consent to assignment turns a customer into a veto, and a lease requiring landlord consent can hold up a closing on its own. In an asset sale the contracts do not travel automatically, which is exactly why a buyer wants the consents identified early. Read your own agreements before the buyer does.

The crew

For a service business the crew is most of what is being bought. A buyer asks for the roster with roles, tenure, pay rates and classification, whether anyone is a contractor who functions as an employee, who holds the licenses and certifications, who the customers ask for by name, and who is planning to leave.

The related question is what happens when they hear about the sale. Most owners tell the team late, and a buyer will want to agree how and when that happens. Retention of the key people is often written into the deal, through a stay bonus, an employment agreement, or a portion of the price tied to the crew still being there some months after closing.

Taxes, liabilities and what follows the business

Unpaid tax follows the company. Section 67-6-513 requires a purchaser to withhold enough of the purchase money to cover unpaid sales tax, interest and penalties until the seller produces a receipt from the commissioner or a certificate that nothing is due, and makes a purchaser who fails to withhold personally liable, capped at the purchase money paid. The statute gives a purchaser protection where it receives a sworn affidavit from the seller stating the amount due and withholds accordingly. The practical step for a seller is to get current and get the certificate before diligence starts.

A buyer also checks for open litigation and claims, workers compensation history and experience rating, warranty obligations on work already performed, environmental exposure where the trade creates any, and liens against the equipment. Where goodwill attaches to the deal, both sides file Form 8594, and agreeing the allocation in the purchase agreement keeps the two filings consistent.

If a lender is funding it, add a second reviewer

An SBA 7(a) loan can fund a complete or partial change of ownership, and the borrower has to be creditworthy with a reasonable ability to repay, with documentation that varies by loan size and the lender’s method. The lender reviews your business too, which adds weeks and a second set of questions about the same records. Plan for it rather than being surprised by it.

What to fix before anyone asks

• Reconcile the books to the tax returns and the bank deposits, for three years.
• Produce revenue by customer by year and look at your own top five.
• Confirm who holds every license and what a change of ownership does to it.
• Read the lease and the top customer agreements for consent and assignment clauses.
• Clear the tax accounts and obtain the certificate showing nothing is due.
• Write down the processes that currently live in your head.

Doing that work converts diligence from a search for problems into a confirmation of what you already disclosed, which is the difference between a price that holds and a price that gets re-traded. Our page on selling a service business covers what a buyer looks at and how to run a sale without your crew hearing early.

This is general information, not legal or tax advice. Talk to an attorney or CPA about your situation.