What financial documents to ask for when buying a business

At some point an owner who has been talking with you asks, "So what would you need to see?" This is when a purchase starts to feel real. Until now you've worked from the outside: what the company does, how long it has been around, and estimates. (The revenue and earnings figures on Second & Main are estimates built from public records, not the owner's numbers.) The documents you ask for next show what the company actually earns.

If you're still writing to owners, start with what to say in a first letter. If an owner is ready to share, ask for everything in one organized list, in writing, so they can hand it to their bookkeeper or accountant. A clear, reasonable list tells an owner you know what you're doing. A trickle of requests over months wears them out.

First, the confidentiality agreement

Before an owner shares financial records, expect to sign a confidentiality agreement, often called an NDA (non-disclosure agreement). It's a promise to keep what you learn private, to use it only to decide whether to buy, and usually not to contact employees, customers or suppliers without the owner's permission. It protects the owner, and signing it without fuss shows good faith. Read it, and ask an attorney about anything unusual, like a long ban on working in the industry.

The core list

Here's what to ask for, and what each item tells you.

1. Federal business tax returns for the last three years, complete with all schedules. For a sole proprietorship, that's the owner's Schedule C. These are the foundation; more on why below.
2. Profit and loss statements for the same three years, plus this year to date and the same months of last year. Comparing this year with the same period last year shows which way the business is heading right now.
3. Balance sheets at each year-end and as of today. These show what the company owns (cash, money customers owe it, equipment, inventory) and what it owes.
4. Business bank statements for at least the last 12 months. You'll compare the deposits with reported sales.
5. Accounts receivable and accounts payable aging reports. An aging report lists who owes the company money (or whom the company owes) and how long each bill has been unpaid. A pile of old invoices is either a collection problem or revenue that will never arrive.
6. A debt schedule: every loan, line of credit, equipment lease and credit card balance, with the monthly payment and payoff date.
7. A payroll summary: each role, what it's paid, and which employees are family. Include everything the owner takes: salary, distributions and benefits.
8. Revenue by customer for the last three years, at least the top ten. This shows whether a few customers carry the company.
9. Sales tax returns, if the company collects sales tax. They're another record of sales, filed with the state.
10. An equipment and vehicle list with ages and condition, and copies of leases for the building and any equipment.

You may not get everything at once, and a small company's records won't look like a big company's. That's normal. What matters is that the numbers in different documents agree with each other.

Why the tax returns matter most

The company prepares its own profit and loss statements, sometimes in the owner's spreadsheet. Tax returns are filed with the IRS and signed under penalty of perjury. For most small companies, they're the most reliable record that exists.

They also matter because your lender will rely on them. On an SBA loan, the lender works from the company's last three years and has to check the seller's figures against tax transcripts it gets directly from the IRS. The IRS releases transcripts only with the taxpayer's consent, so the seller will be asked to sign a form allowing it. Income that isn't on the returns doesn't count toward the loan, however real the seller says it is. If you're new to these loans, start with SBA loans for buying a business, in plain English.

Expect the returns to show a lower profit than the owner talks about. Many owners, quite legally, keep taxable profit low, and the expenses on the return include the owner's own pay, perhaps a vehicle, insurance and one-time costs. Once you have the documents, the next step is adjusting for those to reach owner earnings (profit plus what the owner pays themselves, before loan payments and taxes). Every adjustment has to be documented, and every one starts from the return.

Check the numbers against each other

When the documents arrive, sit down with a spreadsheet, or better, with an accountant who works on business purchases, and check that the documents agree:

• Revenue on the profit and loss statements should match the tax returns for each year, or the difference should have a clear reason, such as a different accounting method.
• Bank deposits should line up with reported sales. Checking them is a rough version of what's called a cash proof: rebuilding the year's money in and out from bank records and comparing it with the books and the return. It catches sales that are overstated and costs that don't appear in the books. SBA rules require a full cash proof in the earnings review lenders order on purchases of $3 million or more. For a smaller deal, add up the monthly deposits yourself, leaving out transfers between accounts and loan money.
• The trend should make sense. Three years plus year to date tells you whether sales and margins are growing, flat or slipping. Ask about any big change.
• Debts on the balance sheet should match the debt schedule, and both should fit the interest expense on the tax return.
• Payroll should match the people you've been told about.

Red flags

• "The real numbers aren't on the tax returns." Some sellers say they earn more in cash than they report. You can't verify it, a lender won't count it, and it's an admission that the returns are wrong. Value the company on what's reported.
• Missing returns. If the IRS has no record of a required return, an SBA lender can't fund the loan until the seller proves it was filed and the tax paid.
• Statements that never match. Small differences happen. Numbers that change every time you ask are a problem.
• Reluctance to sign the IRS consent form once you're both serious. Every SBA lender will need it.
• Long, unexplained delays. Sometimes it's a busy owner. Sometimes it's something else.

How to ask

Send the request in a short, friendly email or letter once the confidentiality agreement is signed. Explain that any lender will need the same documents, so gathering them once saves everyone time. Offer to have your accountant receive them directly if the owner prefers. And say thank you: you're asking someone to open up their life's work to a stranger.

What to do this week

• Turn the list above into a one-page request you can send as soon as an owner is ready.
• Find an accountant who reviews business purchases, so someone experienced reads the documents with you.
• Build a simple spreadsheet with a column for each year and rows for revenue, costs, owner pay and profit, ready for the numbers as they arrive.