Buy a business? Think about due diligence
Congratulations. You have just decided to buy a business, merge with another company, or invest in someone else’s business. Exciting, right?
You’ve probably been busy learning about the business, talking to the seller about the operation, conducting market research, and planning how you can run it better than the previous owner.
It doesn’t matter if you’re buying a small cell phone store, a large high-tech company, or investing in a friend’s “next big thing.” There is one thing you should seriously consider: due diligence.
What is due diligence and why is it so important?
A (very technical and boring) definition of due diligence is: due diligence can be applied narrowly to the process of verifying data presented in a business plan or sales memorandum, or more broadly as the completion of the process of research and analysis that precedes a commitment to invest. The purpose is to determine the attractiveness, risks, and issues associated with a potential investment transaction. Due diligence should enable investment professionals to make an effective decision process and optimize the terms of the deal.
Actually, due diligence is a process in which the potential buyer (or investor) investigates, analyzes, inquires and tries to learn as much as possible about the acquired business in order to verify the accuracy of the information provided by the seller.
Since the information provided by the seller is the basis for the buyer’s decision to buy (or not) and the purchase price, it is crucial that any buyer verify that information before making the final commitment to invest.
How is due diligence done?
There are several aspects of the business that you should check:
legal exposure
Company-owned technology and patents
Business performance and financial position
Legal
Typically, you should contact the company’s attorney and request a letter listing all legal actions and claims the company is a party to. The objective here is to understand the legal risks that the company faces: Is there any legal action against the company that could end up in a lawsuit against it? What is the maximum exposure? How much will the lawyers charge to represent the company?
With the attorney letter and relevant information, you can go to the next level and hire your own layer to review the data and get a second opinion on those legal matters.
You should also request copies of all agreements, contracts, or other binding agreements the company has with third parties. Here is a partial list:
employment contract
shareholders agreement
Leases
purchase agreement
customer agreement
Licenses and royalties
loan agreements
Technology and patents
If you are buying the business partially because of its technology or patents, you should assess the following:
Is the technology or patent actually registered in the name of the company?
In which jurisdictions?
When does registration expire?
Has it been developed by the company or could a third party claim ownership of the technology/patent?
Ask for copies of all registration applications.
Once you have collected all the information about the technology / patents, you can:
Hire a specialist who can assess the value of the technology
Hire a patent attorney to ensure the validity of patents.
Business performance and financial position
Most business sale transactions are based on the company’s income/earnings in recent years or the company’s assets and liabilities on the date of purchase.
Therefore, it is extremely important to perform financial due diligence on the business before finalizing the deal.
What to do in financial due diligence?
1. Check the assets of the company:
Cash – Request all bank statements, petty cash, and all other places cash is kept. See if the total matches the seller’s numbers.
Accounts Receivable – Request a list of all customers who owe money to the business. See how long they haven’t paid. Ask if there is a dispute with any of the customers and how much of the total amount due will actually be paid (based on the seller’s belief?) Focus on large amounts and long overdue accounts. If it is older than 60 days, it should be reviewed. Call customers to verify that their balance matches the seller’s balance.
Inventory – Request a complete list of inventory items. Count the actual inventory and see if it matches the business inventory list. Request usage information, how much of each item is shipped each week/month. If the quantity shipped is very low, it could indicate that it is a slow-moving inventory item and its value is minimal.
Other Assets – Request a complete list of all other assets owned by the business. Identify assets, locations and market value.
2. Check the assets of the company:
Accounts Payable – Request a list of all vendors the company owes money to. Check the validity of the underlying transaction. Make sure that the products that were supposed to be delivered were delivered and in good condition. Has installation been provided? what are the payment conditions?
Bank loans and others – Consult loan agreements. Check the payment schedule, go back and track the previous payment, and verify that the outstanding balance listed is correct. Learn about the rate and terms of the loan and can you refinance for a lower rate loan? Know if the loan is guaranteed and by what assets?
Other Liabilities – Request a complete list of all other liabilities. For each, run the same questions we’ve suggested for Accounts Payable and Loans.
Note: A very important purpose of due diligence is to find out if there are any liabilities not listed or disclosed by the seller. You must verify that there are no additional debts with vendors, banks, other loan providers or any other undisclosed amount.
3. Check the income and expenses of the company:
Sales: Request a list of all sales transactions in the last 3 years. Go through them. Request documentation of the largest: Customer Purchase Orders, Invoices, Shipping Tickets and Receipts. Make sure that the transactions have actually been paid for by the customer, and if not, they will be paid according to the company’s credit terms. Compare the total sales for all three years to see if the business is growing, shrinking, or stagnant.
Expenses – Request a breakdown of each expense. You should first focus on purchasing inventory. See how much products cost, how much they sell for, and how much profit each item makes. Track purchases from inventory to sales transaction to see the full cycle. After inventory purchases, review all other expenses to verify the authenticity of each transaction. A partial list of expenses includes:
– Salaries and benefits
– Marketing and sales
– Rent and Utilities
– Legal and Accounting
– Office Expenses and Supplies
– Taxes
-Trip
– Interest and Finance Charges
– Foreign Service and Subcontractors
As with liabilities, you should look for unrecorded expenses to understand the true, real expense rate of the business so you don’t have any surprises down the line.
conclusion
Buying a business is a big investment you make. To ensure that “what you see is what you get”, you need to do your due diligence.
This article outlines ways and points to focus on when doing your due diligence.
And as always, there is no substitute for hiring a professional who understands due diligence and has the right experience. When buying a business, you really want to consult with an accountant and make sure you cover all your bases.