In this series, Inside the Deal: Insights From Business Acquisition Pros, we are breaking down the roles of the key players in a small business acquisition. In Part 1, we explored the role of the business broker and how they serve as the bridge between buyer and seller. In Part 2, we turned to the attorney and saw how critical it is to have legal guidance tailored to small business M&A and SBA 7(a) financing.

In this third installment, the focus shifts to another indispensable member of the deal team: the financial due diligence professional. Even when a business looks healthy on the surface, diligence is what reveals the true picture beneath the numbers. The right diligence advisor helps buyers avoid costly surprises, ensures the financials tell the real story, and gives them leverage in negotiations. Without it, buyers risk overpaying or stepping into liabilities they never saw coming.

For this interview, I sat down with Gershon Morgulis of Imperial Advisory, a team of CFOs with deep experience conducting Quality of Earnings (“QoE”) studies and financial due diligence on small and mid-sized business acquisitions. I asked Gershon the questions buyers often raise, and his answers shed light on what every buyer should know before signing on the dotted line.

The Interview

Jerry: When you first open the books, what are the biggest red flags you’re scanning for?
Gershon: The first things we look at are trends and consistency. Is the business heading in a good direction? Things to look at include profitability and, especially in an acquisition context, the addbacks. It is also important to dive into the balance sheet early on, because that is where issues are often hidden, such as bad receivables or liabilities that will not show up in a clean P&L. Checking cash flow is also key, since a business that is “profitable” but has no cash may be heading for a crash.

Jerry: Can you explain the difference between “quality of earnings” and “tax returns”? Why does it matter?
Gershon: Tax returns, especially for smaller businesses, are often more like cash statements. They show money coming in and out, but they do not necessarily reflect true profitability. Timing differences and deductions can distort the picture, sometimes making a company look profitable when it is not. The reverse can also happen, where tax returns show a loss when in reality you are investing in things critical to the success of the future business. Bottom line, tax returns do not always tell the full story.

Quality of earnings, by contrast, is about understanding sustainable profitability. It looks at concentration risks, one-off items, and operational dependencies. For example, if all profit depends on one client or one key employee, that lowers the quality of earnings even if the tax return looks good. Buyers need a QoE study to assess long-term value, not just tax-reported results.

Jerry: You mentioned “addbacks” earlier. Can you explain what addbacks are and share some of the craziest examples you have seen?
Gershon: Addbacks are adjustments designed to give buyers a truer sense of ongoing profitability by excluding unusual or personal expenses. The idea is to strip out one-time or non-recurring expenses so buyers can see a clearer picture of ongoing profitability. Some addbacks are perfectly reasonable, like removing the seller’s personal car lease or an above-market salary. But others can get pretty wild. Imagine calling family vacations “team-building” or erasing an entire IT department from the books. Those kinds of adjustments don’t stand up to scrutiny, and instead of strengthening the financial picture, they can make buyers doubt the reliability of the numbers altogether. Another common misstep is treating personal distributions as though they were compensation, but since distributions never hit the P&L, they don’t qualify as valid addbacks.

Jerry: What are the most common addbacks sellers try to include, and how do you test whether they’re legitimate?
Gershon: Sellers often add back their own salary, arguing a new buyer would not need to carry that cost. That can be valid, but only if it is above a market-level replacement cost. The same goes for personal expenses, entertainment, and overcompensated family members. We also see personnel costs that are not in line with best-practice HR policies.

One “creative” addback we once saw was excluding the entire sales team’s salaries just because they were recently fired. That is not likely to be a sustainable change. Testing legitimacy comes down to asking: would this cost actually disappear under a new owner? If not, it is not a true addback.

Jerry: At what point is it best to engage a financial due diligence professional?
Gershon: The earlier, the better. Ideally, buyers should bring in a diligence professional right after signing a letter of intent and before committing significant deposits or legal fees. This way, you uncover financial issues before you are too far down the road. In some cases, even a quick pre-LOI review of high-level financials can be helpful to flag obvious concerns before making an offer. Waiting until late in the process risks wasting time, money, and energy on a deal that may not hold up once the numbers are tested.

Jerry: Can you explain what proof of cash is and why it is so important?
Gershon: Proof of cash is a reconciliation exercise tying together bank statements, the general ledger, and reported financials. It verifies that reported revenue really turned into cash and that expenses were truly paid. It is important because it is much harder to manipulate actual cash flow than accrual accounting numbers. If there are discrepancies, we investigate to understand the root cause, whether it is process, training, or fraud.

Jerry: How can buyers avoid overpaying by using diligence findings in price negotiations?
Gershon: As diligence uncovers risks such as reliance on the owner, client concentration, or operational weaknesses, the valuation multiple comes down. For example, a diversified business might command five times earnings, but with heavy dependency on a single person or client, the multiple could drop to three. Buyers use diligence findings to justify lowering the price, ensuring they do not overpay for hidden risks.

Jerry: When diligence findings do not come back favorably, what is the best way for buyers to approach the seller?
Gershon: This is where communication and tone really matter. Buyers should avoid treating diligence as a “gotcha” exercise. Instead, frame the findings as facts that affect valuation and risk. For example, you might say, “We discovered that 40 percent of revenue comes from one client, which changes the risk profile, and here is how that impacts price.” When you present the data clearly and respectfully, most sellers understand, even if they do not love the outcome. The worst approach is being vague or confrontational, which only breeds mistrust. At the end of the day, relationships are key to negotiation. Many sellers are not just selling a business. Rather, they are selling their legacy. If you have built a solid rapport, presenting a fair rationale for a price adjustment can actually make the conversation much smoother.

Jerry: Beyond just financial statements, what operational or market data do you consider essential in diligence?
Gershon: Operational capacity is key, whether the infrastructure, staff, or systems can support future growth. We also look at service quality and marketing capabilities: are the products or services well-positioned to compete and grow?

Market data is equally important: is the industry growing or shrinking, what is the business’s market share, and are they positioned to gain or lose ground? This context determines whether today’s financial performance is sustainable. That said, with smaller businesses, we often find the grit and ability of the team to execute is just as important as macro trends.

Jerry: How do you handle situations where the books don’t reconcile, but the business looks strong operationally?
Gershon: If the books do not reconcile, it undermines trust. You can try to rebuild from bank statements or other evidence, but the uncertainty drives down valuation multiples. Financing also becomes difficult, since banks will not trust unreliable numbers. Even if operations look strong, unresolved discrepancies mean the buyer pays less or walks away.

Jerry: What advice would you give to a first-time buyer who isn’t sure how much diligence they really need?
Gershon: It depends on the buyer’s risk tolerance. If revenue and costs are straightforward, you may not need exhaustive financial diligence, but you still need to confirm team, legal, and HR risks. With an asset purchase, some liabilities can be left behind, but you still need enough diligence to ensure the seller delivers what they represented.

Not all liabilities are left behind in an asset deal. Legal and HR liabilities, for example, can survive through successor liability. Bottom line, you need to go in with eyes wide open. Do enough diligence to feel confident you are not walking into a mess.

Jerry: How should a buyer who is super excited about buying a business balance that excitement with the results of due diligence, especially if the seller is reluctant to reduce the price and walking away might be the only option? I have found that many buyers are blinded by issues that can have serious post-closing implications, and they also struggle to come to terms with sunk deal costs. The way I see it, it is better to walk away from a transaction and absorb some sunk costs than to buy a business and be on the hook for a loan on a business that may ultimately fail. Any thoughts?
Gershon: This is one of the toughest parts of the process. Excitement and momentum can make it tempting to overlook red flags, but those same issues will not disappear after closing. Buyers need to separate emotion from analysis by asking themselves, “If I saw these issues in someone else’s deal, what advice would I give them?” If the numbers and risks do not justify the price, the right move is to push for a fair adjustment, and if the seller refuses, be ready to walk away. That discipline is difficult in the moment, but it is far easier than living with the consequences of a bad deal.

Jerry: What are some examples of items that could sink a deal?
Gershon: Here are a few issues that could kill a deal or dramatically decrease the price:

• A seller inflating profits by cutting critical infrastructure, like eliminating the sales team.
• Businesses fabricating revenue streams or relying on fragile government grants.
• Receivables and debts hidden in the books that create meaningless paper profits.
• HR issues, such as key employees threatening to leave when the sale closes, undocumented workers, or hidden liabilities from former employees.
• Excessive cash revenue that the seller never reported.

Each of these issues can cause valuation to drop. Some are outright deal breakers. If they surface too late, they can create trust issues and spook the buyer. Sellers should be prepared for these to come up.

Closing Thoughts

Talking with Gershon highlights just how important diligence is for protecting buyers. Numbers can look fine on the surface, but without digging deeper, it is impossible to know if they hold up under scrutiny. Financial diligence does not just protect buyers from overpaying, it ensures the business they are buying is truly worth what they think it is.

Stay tuned for the next installment in the Inside the Deal series, where I will be speaking with a CPA about tax structuring and post-closing accounting.

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About the Experts

Gershon Morgulis is a financial due diligence professional and the founder of Imperial Advisory Group, where he and his team provide outsourced CFO services and support to small and mid-sized businesses. Gershon has served as an Adjunct Professor of Finance at Touro College and as a visiting lecturer at Hofstra’s Graduate School of Business. He is also a contributor to Oxford University Press’s recent book on Fixed Income Markets. He brings deep expertise in uncovering hidden risks, validating earnings, and guiding buyers through negotiations and closing. Contact Gershon at [email protected].

About the Author
Since 2018, Jerry Freedman, founder of Freedom Business Financing, has helped entrepreneurs across the country acquire businesses and secure owner-occupied commercial real estate through SBA 7(a) and 504 loans. Drawing on his background as an accountant, auditor, and CFO, and a track record of closing deals across multiple industries, Jerry is recognized for guiding buyers with clarity and integrity from LOI to closing. Contact Jerry by visiting freedombf.com.