Financial Due Diligence for Owner Operated Service Roll-Ups
The GAAP Gap, and the Art of the Working Capital Peg
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I talk to a lot of CFOs and CEOs.
If you’re running a roll-up strategy, especially in fragmented, low-tech industries, you’ve probably come across this situation: the seller hands you a spreadsheet that looks like it was built in 2007, and swears their business “nets $800K a year.”
“My cousin Vinny does the books. He’s a CPA, or whatevah, ya call it”
That’s your cue to buckle up.
Buying owner operated service businesses is a high-variance game. For every well-run operation, there are ten more that look fine on the surface but are quietly bleeding working capital, masking liabilities, or inflating performance through one-time heroics.
And here’s the twist: it’s usually not malicious. These aren’t public company CFOs. They're mechanics, franchisees, or families trying to retire.
That’s what makes it tricky. In most cases, you’re not negotiating with a sharp seller trying to pull one over on you. You’re negotiating with someone who genuinely doesn’t know what their normalized inventory levels are (or why GAAP even matters).
This guide is for operators and acquirers who want to establish common ground for negotiating. It’s part forensic accounting, part behavioral science, and all about making sure you don’t get stuck holding the bag (or flipping the burgers) on Day 4.
Here’s what we’ll be covering:
The GAAP Gap: What does the business actually earn in profits each year?
Revenue Quality: Customer concentration and recurring vs transactional revenue
The Hidden CAPEX Bomb: Has equipment maintenance been deferred?
Normalizing Working Capital: How much gas are they leaving in the tank for day one?
The GAAP Gap
When you're buying add-ons in a roll-up, the seller’s financials are often a work of fiction; not because they’re trying to mislead you, but because they're using a completely different accounting language. Most small business owners operate on a cash basis and have never heard of GAAP (Generally Accepted Accounting Principles), let alone followed them.
What they call EBITDA is often something closer to “whatever’s left over after I pay myself and cover expenses.”
That number can look pretty healthy, until you adjust it for things like capitalized costs, unpaid liabilities, or aggressive revenue recognition. You can easily see swings of 20–40% when reconciling cash-based owner financials to an adjusted, GAAP-style EBITDA (and yes, I know EBITDA is not GAAP… don’t @ me. You get the point).
Spoiler: the seller is ALWAYS shocked.
That’s why every add-on deal needs a robust Quality of Earnings (QoE) analysis. Your job is to rebuild their financials into something that a grown-up finance team would recognize. That means:
Backing out one-time owner comp (boats and bonus checks included)
I once heard a story about a set of horses the owner’s wife owned that were purchased by the company. The horses didn’t sit on the balance sheet, but the trailer did
Correcting for timing mismatches between revenue and collections
This is huge in businesses that are either prepaid upfront (for example: a newsletter that gets paid before they run the ads) or in arrears (for example: an agency business where they do creative work and invoice after the project is completed)
Identifying any off-balance-sheet liabilities or “handshake deals” with vendors
“We pay the auto parts store down the street not really on a bi weekly or dollar limit basis, but when Frank finally gets off his ass and drives down to the garage to yell at us”
You have to take the narrative and try to get it into a spreadsheet. Run your own cash-to-EBITDA conversion analysis. If their business “makes” $1M of EBITDA but only throws off $500K in cash a year, you’ve got a problem. Either the business is quietly bleeding working capital (think: rising AR, overstocked inventory, or slowed payables), hiding necessary capex off the books, or the EBITDA itself has been fluffed up with non-operating income and unsustainable one-timers. As a forensic accountant would tell you: when cash and EBITDA don’t rhyme, something’s leaking (or being manipulated).
The sooner you close the GAAP gap, the sooner you can underwrite the business for what it really is, not what the seller wishes it were, and establish a true enterprise value you’re willing to purchase it for.
Note: In my experience agreeing on a multiple of EBITDA is easy. Agreeing on the EBITDA figure itself is much more difficult and fraught with difficulties (and debates).
Revenue Quality, Not Just EBITDA Quality
Okay, so you’ve rebuilt their EBITDA and it actually looks decent. $800K became $650K after adjustments, but that’s still workable at 4x.
Hold up.
Before you start drafting the LOI, you need to understand where that EBITDA is coming from. Because not all revenue is created equal, and a lot of owner-operated businesses have revenue concentration that would make 9 out of 10 CFOs break out in hives.
Here’s what to dig into…
Customer concentration risk
Pull the revenue by customer report. If 30% of revenue comes from the owner’s brother-in-law’s construction company, that’s not a diversified customer base, but a family favor that evaporates the day after close. I’ve seen deals where the top 3 customers represented 60% of revenue, and all three were personal relationships.
Guess what? Jim don’t work here no more.
Get a customer concentration analysis for the trailing 24 months. Anything above 10% from a single customer gets a hard conversation about contractual commitments and the nature of that relationship.
Contractual vs. transactional revenue
Is this business built on recurring contracts (landscaping service agreements, monthly maintenance retainers) or is it transactional “I hope the phone rings” revenue?
The difference is huge.
Contracted revenue = predictable cash flow.
Transactional = hope is not a strategy.
I talked to a PE operator once who bought a commercial cleaning company where 70% of revenue came from one-off project work, not recurring contracts. The seller’s pitch was “we’ve had these customers for 15 years!” Sure, but without a contract, you’re re-selling them every single month in a commoditized service business.
Pricing audit
When was the last time they raised prices? If the answer is “never” or “not since 2019,” you’ve got a problem. It means either:
They’re competing on being the cheapest (terrible margins, no moat)
They’re afraid to have pricing conversations with customers (terrible margins, no spine)
Their customers are price-sensitive and will leave over a 5% increase (terrible margins, no loyalty)
Look at gross margin trends over 3-5 years. If margins are compressing, that’s a business being commoditized in real-time. If they’ve been flat while input costs have risen, they’ve been eating inflation and haven’t passed it through.
The best businesses raise prices annually (or more) and customers barely notice. That’s pricing power. Everything else is a grind.
The (Hidden) CapEx Bomb
Alright, you’ve normalized EBITDA, stress-tested revenue quality, and you’re feeling good. The business actually works.
Then you close the deal.
Thirty days later, the HVAC dies. Sixty days in, you realize the delivery van needs a new transmission. At 90 days, a health inspector shows up and suddenly you need $75K in kitchen equipment upgrades to stay compliant.
Welcome to deferred maintenance.
Owner-operators are masters at running equipment into the ground in the 12-18 months before a sale. Every dollar spent on a new roof or replacing worn-out machinery is a dollar that doesn’t go into their retirement account. So they patch, duct-tape, and pray it holds together through due diligence.
And it usually does. Then it becomes your problem.
Here’s how to protect yourself:
Run a physical inspection
Don’t just accept their financials—walk the facility. When was the roof last replaced? What’s the useful life on major equipment? Are there rust spots on the industrial freezer that suggest it’s on borrowed time?
Get maintenance records for every major asset. If they can’t produce service logs, assume it hasn’t been serviced. A well-run operation has a maintenance schedule. A “wing it” operation has explanations for why the records are missing.
Build a “catch-up capex” schedule
Historical capex numbers in owner-operated businesses are usually fiction. They’ll show $20K/year in capex, but that’s just the stuff that broke catastrophically and had to be replaced.
You need to model 12-18 months of post-close catch-up spend: deferred maintenance, regulatory compliance, and the stuff that’s held together by hope and WD-40.
Budget for it in your model. If you’re underwriting to $650K of EBITDA and you discover $150K of catch-up capex in Year 1, your returns just got a lot uglier.
I’ve seen PE guys try to negotiate a “capex reserve” as part of the working capital peg, but sellers hate this (because it’s real money out of their pocket). The better move is to bake it into your purchase price assumption and build the escrow mechanism to claw it back if you uncover undisclosed deferred maintenance.
The equipment age audit
Ask for a fixed asset register. If they don’t have one, make them create one during diligence. You want:
Description of each major asset
Date of purchase
Estimated useful life
Current condition
If they’ve got a 15-year-old commercial oven that’s “running great,” cool, but it’s probably got 6-12 months left before it becomes a $30K problem.
Better to find out now than after you wire the money.
Normalizing Working Capital
Let’s say you’ve gotten through the initial financials. You’ve adjusted EBITDA, identified the one-time owner expenses (goodbye, bass boat), and now you’re ready to model cash needs post-close.
Not so fast.
Working capital is the silent killer in most add-on deals. And here’s the catch: in non-GAAP businesses, it’s rarely tracked properly (if at all).
As we established, sellers typically run on cash accounting, so they focus on how much is in the bank, not how it got there. But as the buyer, you need to understand what it takes to keep that business running on a normal day, not just the day after they juiced collections and stopped paying bills to dress it up for sale.
Here’s where it gets tricky:
The seller might have sped up collections in the weeks leading up to diligence.
They might have stretched payables, essentially borrowing float from vendors.
Inventory could be underreported because they don’t have a true cycle count process.
That means the balance sheet you’re reviewing might reflect a one-time spike in cash, at the expense of working capital that needs to be replenished once you take over.
Because remember: Most deals are done on a cash free, debt free basis. Which means it’s in the seller’s favor to leave you with an empty tank of gas.
That means you need to:
Build a trailing 12-month working capital schedule (net of cash/debt)
Look at AR, AP, and inventory trends (not just ending balances)
Identify seasonality: does the business carry more inventory in the summer? Do customers pay slower in Q4?
The peg is your best friend. A working capital peg is the agreed-upon target level of net working capital that the business should deliver at close. Think of it as the baseline float needed to operate the business without disruption. If actual working capital at close falls below that peg, the purchase price gets adjusted downward, usually dollar-for-dollar. Set the peg based on a trailing 3- or 12-month average, not a one-time low point. It’s your insurance policy so you’re not writing a surprise check 30 days after the wire clears.
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the Peg is a such a common stumbling block in lower middle market acquisitions. Most businesses broker franchises don’t train their brokers on it which results in the buyer having to educate the seller.