Due Diligence Checklist — What to Verify Before Buying a Business

Due diligence is where good deals get confirmed and bad deals get killed. It's the phase between signing a Letter of Intent and wiring the money — and it's the most consequential 30 to 60 days in the entire acquisition process.

I work with business buyers across Los Angeles, and the pattern I see over and over is this: buyers who do rigorous, structured due diligence close confidently and avoid costly surprises. Buyers who skip steps, trust the seller's narrative, or rush through the numbers end up overpaying, inheriting problems, or watching the deal collapse at the SBA underwriting stage.

This guide is the due diligence framework I walk buyers through on every acquisition. It's organized around the questions your SBA lender will ask, the financial verification steps that separate real cash flow from fiction, and the red flags that should make you renegotiate — or walk away.

The Four Proofs Audit — Verify Revenue From Four Independent Sources

Before you analyze the business, you need to confirm that the numbers are real. The most reliable way to do this is what I call the Four Proofs Audit — cross-referencing the business's revenue through four independent data sources that should all tell the same story.

The DSCR Stress Test — Can You Actually Afford This Business?

Once you've verified the revenue is real, the next question is whether the business generates enough cash flow to service the acquisition debt and still pay you a livable salary. This is the Debt Service Coverage Ratio (DSCR) analysis, and it's the single most important calculation in your acquisition.

Step 1: Calculate Baseline DSCR

DSCR = (SDE − Owner’s Salary Equivalent) ÷ Annual Debt Service

• SDE: The verified Seller's Discretionary Earnings after your Four Proofs Audit (not the seller's claimed SDE — your verified number)
• Owner's Salary: A market-rate salary for the role you'll play in the business (not zero — SBA lenders will impute a salary even if you don't plan to pay yourself)
• Annual Debt Service: Total annual loan payments at the expected SBA loan rate and term

Target: 1.25x minimum. Your SBA lender will require at least 1.25x DSCR. I recommend buyers target 1.4x or higher for comfortable margin.

Step 2: Stress Test Against Three Scenarios

Don't just calculate DSCR at today's numbers. Model what happens under adverse conditions:

1. Revenue decline scenario: What's the DSCR if revenue drops 10% in year one? (This happens more often than sellers admit — transition periods frequently cause temporary revenue dips.)
2. Rate increase scenario: If you're on a variable-rate SBA 7(a) loan and rates rise 1–2%, does DSCR still hold above 1.25x?
3. Combined stress scenario: Revenue drops 10% and rates rise 1%. If DSCR falls below 1.0x, the business can't service its debt. Walk away or negotiate a lower price.

The Working Capital Peg — Don't Inherit an Empty Tank

Working capital is the cash the business needs to operate day-to-day: money to make payroll, pay vendors, carry inventory, and cover operating expenses between billing and collection. It's one of the most overlooked elements of business acquisitions — and one of the most dangerous to get wrong.

Here's what to negotiate:

• Define a “working capital peg” in the LOI or purchase agreement. This is the minimum level of working capital (current assets minus current liabilities) the seller must deliver at closing.
• Calculate the historical average. Look at the balance sheet from the last 12 months and calculate the average working capital position. That's your baseline peg.
• Include a true-up mechanism. If working capital at closing is below the peg, the purchase price adjusts dollar-for-dollar. If it's above, you pay the difference. This prevents the seller from draining cash, running down inventory, or delaying vendor payments before closing.

What “Add-Backs” Really Mean — And How Sellers Abuse Them

Add-backs are expenses that are run through the business but are personal to the owner or non-recurring. They get “added back” to net income to calculate SDE, which directly affects the valuation and the purchase price. This is the area where sellers are most likely to stretch the truth.

Legitimate Add-Backs

• Owner's salary and benefits (the new owner can set their own compensation)
• Owner's health insurance, auto, and phone (if personal use, documented)
• One-time expenses that won't recur: a lawsuit settlement, a one-time equipment repair, moving costs
• Depreciation and amortization (non-cash charges)
• Interest on the seller's debt (you won't be inheriting their loans)

Questionable Add-Backs — Challenge These

• “Family members on payroll who don't work.” Common claim. Demand payroll records, W-2s, and job descriptions. If the family member is actually performing a function, their replacement is your cost — not an add-back.
• “Marketing spend we don't need.” If the business is spending $60K/year on marketing and the seller says “you don't need it,” ask what happens to revenue when you cut it. Marketing is usually a recurring cost, not a discretionary add-back.
• “Rent above market.” If the owner also owns the building and charges above-market rent, the overage can be an add-back. But verify the actual market rent with independent data, not the seller's opinion.
• “Travel expenses are all personal.” Some travel is personal. But if the owner attends industry conferences, visits suppliers, or meets clients, that travel is a business cost the new owner will likely incur too.

How to Verify Every Add-Back

For each claimed add-back, demand:

1. Source documentation — the invoice, receipt, cancelled check, or credit card statement that proves the expense exists
2. Evidence of personal nature — if the seller claims a vehicle is 100% personal, show me the business mileage log (or lack thereof)
3. Ledger detail — the specific general ledger entries for the expense, with dates and vendors
4. Tax return treatment — was the expense deducted on the business tax return? If so, it was claimed as a business expense for tax purposes. Now the seller is saying it's personal? One of those positions is wrong.

The Complete Due Diligence Checklist

Beyond the financial verification above, here's the full list of items you should request and review during due diligence. No exceptions.

The Red Flags That Should Make You Renegotiate or Walk

After reviewing hundreds of deals, these are the patterns that consistently indicate trouble:

• Tax returns and P&Ls don't reconcile. If the numbers the seller shows you don't match what they reported to the IRS, one set of numbers is wrong. Either way, you can't trust the financial picture.
• The seller won't provide bank statements or merchant statements. There is no legitimate reason to withhold these documents during due diligence. If the seller refuses, walk away immediately.
• Revenue has declined in the most recent year without a clear, verifiable explanation. Sellers will always have a story. “We lost a big customer but already replaced them.” “COVID hangover.” “We reduced marketing intentionally.” Verify every claim independently.
• Customer concentration above 25% in a single account. If the business's largest customer represents more than a quarter of revenue, you're exposed. What happens if they leave after the sale? Read more about what buyers look for in a business.
• The lease has less than 3 years remaining. SBA lenders typically require 10+ years of lease term (including options). A short lease means either no SBA financing or a landlord negotiation that can derail the deal.
• Key employees are flight risks. If the business depends on 1–2 people who have no retention agreements and no reason to stay after the sale, you're buying a job, not a business.
• Undisclosed liabilities. Unpaid payroll taxes, pending OSHA violations, unreported workers' comp claims, environmental contamination — any of these can surface after closing and become your problem. Get representations and warranties in the purchase agreement, and back them up with an escrow holdback.
• The seller is in a rush to close. Urgency from the seller is a red flag, not a negotiating tool. Sellers who push for fast closes often have something they don't want you to discover. Take the time you need.

California-Specific Due Diligence Items

Buying a business in Los Angeles adds compliance layers that buyers from other states may not anticipate:

• Bulk Sale Act (California Commercial Code §6101–6111): California requires public notice of bulk asset transfers. Failure to comply can expose you to the seller's creditors. Work with an attorney who understands California bulk sale requirements.
• Employment law compliance: California has the most complex employment regulations in the country. Verify meal and rest break compliance, overtime classification, harassment prevention training records, paid sick leave compliance, and proper worker classification. A single misclassification claim can cost six figures.
• EDD and tax clearance: Request tax clearance certificates from the California Employment Development Department (EDD) and the Franchise Tax Board (FTB). Outstanding tax liabilities can follow the business through the sale.
• ABC test for independent contractors: Under AB5, California uses the strict ABC test for worker classification. If the business relies on 1099 contractors, verify they actually qualify. Misclassification creates liability for back wages, taxes, and penalties.
• Proposition 65 compliance: If the business involves any chemicals, materials, or products that could trigger Prop 65, verify current compliance. Prop 65 lawsuits are a cottage industry in California.

Your Next Move

Due diligence isn't about finding reasons to kill a deal. It's about confirming that the deal you're making is the deal you think you're making. When the numbers check out, the risks are known and manageable, and the business genuinely cash-flows at the purchase price, you can close with confidence.

If you're in the process of buying a business in LA — or thinking about starting the search — I can help you structure the due diligence process, connect you with experienced SBA lenders and M&A attorneys, and evaluate deals objectively before you commit your capital.

Call or email directly anytime: (310) 774-2163 · bryanthoover@tworld.com