Purchasing a Business: How to Conduct Due Diligence
Purchasing a Business: How to Conduct Due Diligence
You see a business that looks profitable, you have the cash to make the purchase, but before you pull the trigger it pays to perform due diligence first. While there are many factors that determine the possible success or failure of a business, some of the risk can be mitigated if you have due diligence conducted before you make the purchase.
The Meaning of Due Diligence?
Due diligence is conducting an audit before the sale of the property. This determines the financial and legal status of the business, so that you know the condition before you make the purchase. Due diligence must be performed before there is any agreement made. This protects both the buyer and seller to ensure that everything is above board.
Today, thanks to the advancement of the internet, looking up public information is easier than ever. The days of hunting down little-seen publications or working with trade associations to find the information has been replaced by greater access to all types of public information almost instantly. In addition to finding out about the business itself, you can also learn about trends in the industry, the competition, reviews from customers and employers, and more.
The Letter of Intent (LOI) is a non-binding document that starts the due diligence process. This is a preliminary offer from the buyer that opens the door to further negotiations which start the due diligence process. Or, the seller rejects the LOI and the offer, so nothing is lost.
Three Components of Due Diligence
There is the legal, financial, and the operational aspects of due diligence that must be fully investigated before proceeding with the purchase. The information gathered will help you understand the status of the company, its financial state, and if the business will still function the same if you decide to make the purchase.
Legal Due Diligence
The investigation starts with the bylaws and amendments of the company itself, followed by any litigation that is pending, ongoing, or has recently been resolved. This is the type of work that a buyer’s attorney will typically perform and includes the following.
- Board Minutes
- Contracts: Suppliers, Employees, and Customers
- Employee Benefits
- Patents & Property Rights
- Regulations: Including relationships with regulatory agencies
Any issues in this field should be revealed by attorney investigations and reported, so that you will understand the legal obligations of running the company.
Financial Due Diligence
This usually goes back from three to five years of financial statements from the company. An accountant usually handles this aspect of due diligence which includes the following.
- Bank Account & Statements
- Credit Report
- Financial Projections: Including Strategic Plans
- General Ledger
- Internal Analyst Reports & Memos
- Inventory: Including debt, payables, receivables, and liabilities
- Physical Assets: Such as leases and purchases
- Revenue: Assessed from the largest customer purchases
Operational Due Diligence
This is how the business operates. You gather this information from the employees, customers, and suppliers. It lets you know how the business is run from the outside, so you can combine this information with the legal and financial status. This information includes the following.
- Input Prices: Review of the market, using substitutes for current practices, and so forth
- Inventory: Including the condition of the equipment
- Location: Of all facilities and equipment
- Logistics: How the company works with vendors and suppliers
Also, you’ll want to know about the contingency plans of the company. With the legal, financial, and operational information gathered, it will need to be synthesized into reports that can be read and understood.
Creating a Team for Due Diligence
As mentioned earlier, you will need the services of an attorney and accountant as part of your due diligence team. The team itself may comprise of individuals that work in the same firm or have never worked together before. The key is to have the right people looking over the information, so you can make the best-informed decision about the purchase.
Keep in mind that due diligence is going to take time. It will also involve several experts in their respective fields. While this may be expensive, the cost is minimal compared to discovering issues that would have caused you to change your offer or even your decision to buy the company had you known them in advance.
Hiring an accountant and attorney is the obvious first step, but you should also consult experts in business and the industry in which the company specializes. There are other experts you may want to consult as well. Attorneys and accountants who specialize in due diligence may have suggestions to help you complete your team.
Look for the Obvious
The old saying that a person cannot see the forest because of all the trees applies to due diligence as well. Start with obvious issues such as if the business has been sued, their relationship with suppliers, and if they have faced a major crisis, such as weather-related damage.
Reasons for Selling
There is what the seller tells you and what their real reasons may be. Quite often, they are the same, but sometimes there are important differences. For example, if the market for their products or services has reached its peak and projections show its only going downhill, they may want to get out now. While you probably do not want to purchase now because the profits are only going to shrink.
Keep in mind that many sellers will pre-plan their sale by working with the experts to correct issues that might keep buyers away. While you should always conduct your own due diligence, with the seller providing their information, it demonstrates the seriousness in how they are conducting the sale process.
In the end, due diligence works for you when purchasing a business because it identifies potential issues both within and outside the business that is being sold. The decision you make should be the best-informed possible, so be sure that you cover as much as possible before you make the purchasing decision.