Financial Due Diligence: What You Need Before a Business Sale or Acquisition

The deal didn't close at the price it would have closed at if the issues had been found and addressed before the process started.

This is the pattern I see repeatedly in financial due diligence. The issues that kill deals or reduce price aren't usually fraud — they're usually accounting policy choices that were made without understanding the implications, documentation that was never properly maintained, or business reality that wasn't reflected in the financials.

The sellers who get the best outcomes in M&A are the ones who ran their own due diligence process before the buyer did — who found the issues first and addressed them or priced them into the transaction before the buyer discovered them. The sellers who get the worst outcomes are the ones who were surprised by their own data.

The work to be done:

Clean up 3 years of financials. Every accounting policy needs to be documented and consistent across all three years. Revenue recognition policy, depreciation schedules, capitalization policies — if they changed between years, they need to be documented with a business rationale. A buyer doing a QoE will find every inconsistency.

Reconcile revenue. If your revenue includes anything that isn't fully documented — progress billings that haven't been approved, milestone payments that are contingent, revenue from contracts that don't have signed documentation — it needs to be cleaned up or explained. Undocumented revenue is treated as potentially fictitious in a QoE.

Clean the AR aging. Every AR item over 90 days needs a documented reason why it's collectible. If you can't document it, you should probably write it off before the process — because the QoE will.

Document all contingent liabilities. Pending lawsuits, tax audits, warranty claims, any environmental or regulatory issue — if it's a known contingent liability, it needs to be in the disclosure schedule. The buyer will find it anyway.

Review all related-party transactions. Any transaction between the company and the owner or an affiliated entity needs to be documented at arm's length. These are red flags in a QoE if they appear non-standard.

This work — which I've seen take anywhere from 90 days to 18 months depending on the starting point — is the foundation of a clean deal.

Normalized EBITDA: Starting with reported EBITDA and making a series of adjustments. The adjustments are usually: adding back non-recurring items (one-time legal fees, a plant shutdown cost, a natural disaster loss), removing non-cash items (depreciation, amortization), and normalizing owner compensation (if the owner is paying themselves below market, the QoE adds back the difference as an adjustment).

Revenue quality: The QoE examines whether revenue is recurring, whether it's concentrated in a small number of customers, and whether the revenue recognition policy is conservative and defensible. Revenue that depends on a single large customer, or that is recognized ahead of having documented right to payment, is flagged.

Working capital analysis: The QoE examines the components of working capital — AR quality, inventory obsolescence reserve, AP legitimacy — and adjusts the working capital to what it would look like under a conservative standard.

Debt and debt-like items: The QoE identifies items that are treated as debt in the transaction's debt schedule — convertible notes, earn-outs, seller notes, any items with characteristics of debt — and makes sure the capital structure being assumed at closing is correct.

The output of the QoE is a set of findings, each with a dollar impact. The buyer uses the QoE to negotiate the purchase price — typically every material finding becomes a price adjustment or a specific indemnity.

The CFO work for a buyer before acquisition:

Validate the financial model. The seller presents a model showing projected revenue and EBITDA growth. The CFO tears it apart — tests the assumptions, compares to industry benchmarks, checks whether the historical performance supports the growth thesis. The model that can't survive scrutiny shouldn't drive the valuation.

Build the acquisition model. What does the acquisition cost in total (purchase price + debt + transaction costs + integration costs)? What does the combined entity look like? What's the accretion/dilution from the deal? The CFO builds this model before the LOI is signed — because once you're in exclusivity, the analysis is constrained.

Stress test the working capital assumptions. If the target is supposed to deliver $5M in working capital at closing, what are the components? The CFO models the working capital based on the target's current balance sheet and the projected closing date — and flags whether the target is likely to hit the peg.

Coordinate the due diligence process. A CFO who's done this before knows the data room checklist, knows what the QoE firm will focus on, and can pre-flag issues before the QoE finds them. This is the value of having a CFO in the room who has been the seller's CFO and the buyer's CFO — they know where the bodies are buried because they've seen both sides of the process.