Business Advice

Due diligence when buying a business

Cameron Fleming | 28 April 2021 | 3 years ago

Due diligence when buying a business

Buying a business is not a small task, whether you are an old hand at it or a first-time buyer. The number of businesses available, and the diversity of options, can take a significant amount of time to process as well as requiring a profound knowledge resource.

If your meetings with the seller are all successful, including your offer, it is now the time for the final phase – due diligence. Due diligence should always be a condition of your buying offer.

How do you conduct due diligence when buying a business?

Due diligence involves the verification of the information you have gleaned, researched and/or have been supplied with about the business, including: The checking of financial documents, legal issues, operations, employee relations, asset treatments and physical condition, product and customer data.

This highly complex process should always be conducted by professionals like your accountant/financial advisor and attorney.

The financial records and physical conditions must meet your expectations before the deal can be signed off.

A seller should not be surprised by the arrival of this phase and should be well prepared for it in advance.

Review and verify all financial information

Request audited financial statements for the past three years. Most SMME financials have been compiled with tax minimising goals, so that detailed explanations will be required.

Your accountant should meet with the seller’s accountant to review, verify and possibly recast the numbers. The following records are usually required:

  • Financials: Income statements, cash flow statements, balance sheets, general ledger, accounts payable and receivable
  • Credit report
  • Tax returns for at least the past three years
  • All debts, their terms and any contingent liabilities
  • Analysis of gross profit margins
  • Analysis of fixed and variable expenses
  • Gross profits and rate of return by each product
  • Inventory of all products, equipment and real estate, including the total value

Review and verify the business structure and operations

Review the business structure and what its primary source of income is. Get highly detailed information about competitors, market share, market conditions and customer base quality. This will enable you to determine the company’s earnings potential. Review and verify the business model, customer base, products, services, and costs. The following records are usually required:

  • Company’s articles of incorporation and amendments
  • Company’s bylaws and amendments
  • Summary of current investors and shareholders
  • All company names and trademark brand names
  • All states where the company is authorised to do business
  • All products and services, including production costs and margins
  • Business compliance requirements
  • Marketing plan, customer analysis, competitors, industry trends
  • Company’s brand identity, including logo, website and domain

Review and verify all contracts

Ascertain what obligations or agreements are in place that you may be expected to comply with or respond to that are part of doing business. The following records are usually required:

  • All nondisclosure or non-compete agreements and any guarantees
  • Company purchase orders, quotes, invoices or warranties
  • Security agreements, mortgages, collateral pledges
  • Letters of intent, contracts, closing transcripts from mergers or acquisitions
  • Distribution agreements, sales agreements, subscription agreements
  • All loan agreements, material leases, lines of credit or promissory notes
  • Contracts between officers, directors or principals of the company
  • Stock purchase agreements or other options

Review and verify all customer information

Verify which are the largest customers (sales) and obtain their purchase history. Review how these customers were acquired and retained? The following records are usually required:

  • All customer databases, subscriber lists and sales records
  • Copies of standard communications and correspondence
  • All advertising programs, marketing programs and events
  • Purchasing policies and refund policies
  • Any customer research data, white papers or research
  • All attorneys and law firms representing the company, area of practice
  • Pending litigation or threats of litigation
  • Any unsatisfied judgements
  • All insurance coverage and policies
  • All professional licenses and permits

Review and verify all employee information

Ascertain who the key employees are and what their responsibilities entail. Are those important employees planning to leave the company after the sale? Why? Consider incentivising them to stay. The following records are usually required:

  • Employee roster and organisational chart
  • Employee contracts and independent contractor agreements
  • Payroll information and employee tax forms
  • Human resources policies and procedures
  • Employee benefits, retirement plan and insurance

Review and verify legal issues

Your lawyer will check for any outstanding legal issues and the seller must confirm in writing the existence and status of any such items. Verify what valid insurance the company has in place, as well as relevant licenses and permits.

Review and verify physical assets and properties

Get a full inventory of all the company’s property and its current market value, including automobiles, equipment, real estate and inventory.

  • Real estate, including office locations, warehouses, current leases and titles
  • A schedule of all fixed assets, including product inventory, furniture, fixtures and equipment
  • Any automobiles or boats

Review and verify IP (intellectual property)

Intellectual property includes trademarks, copyrights, patents or all intellectual information owned by the company.

  • All company designs, even if incomplete
  • All company’s patents, trademarks and copyrights
  • Product inventions, formulas, recipes, or technical know-how
  • All rights owned data and digital information
  • All work-for-hire or consulting agreements
Due diligence will help confirm whether the asking price is fair and will enable a sound decision as to whether or not to purchase the company. During the process ascertain why the current owner is selling and leverage this if possible. Next step: close the deal and make money!

What are good questions to ask when buying a business?

It helps if you ask the right questions at the beginning of your buying process, thereby avoiding a significant waste of time if you pick up a showstopper during the due diligence.

Why are you selling your business?

This can give you vital negotiating power. The seller may want to retire, they might be financially incapable of expanding the business, or they may have become ill or physically impaired.

The business might be failing or be in need of an overhaul. You can use the answer to strategise your negotiations.

What is the justification behind the asking price?

Asking prices usually carry a heavily subjective bias. The price is generally more than the company is worth.

Is the business financially viable?

The seller’s behaviour when answering this question will be telling. An unclear answer could be a warning sign.

Do you have full financial records for the business?

The seller MUST provide you with previous tax returns, purchase orders, invoices and other documents to verify claims of past earnings.

It is critically important that the correct amount of tax has been paid to avoid tax fraud cases.

Are there any legal issues?

Ask the seller this in the presence of your lawyer and then have your lawyer and accountant check again in the background.

Who are your customers?

The seller should give you a clear overview of who the clients are supported by their marketing documentation pack. You can then assess whether the customer base is a good match for you.

Is there an existing client base as part of the deal?

A business that comes with an existing client base means the difference between a simple ‘change of management’ notice or running at a loss while you build a customer base.

Will the customers follow the selling owner?

Do employees know of the sale situation?

If there are employees do they know of the sale and feel their employment is at risk?

If employees are taken through a sensitive change management process, you might be left without key staff at a critical time.

Is there a commercial lease involved?

Ascertain lease lifespans and whether they are renewable. Obtain a copy of the lease contract for your property lawyer to determine if the lease terms are in good order.

You could end your question session by asking what the seller will do if they can’t sell their business. This could boost your negotiating power or change your negotiation tactic. It also might reveal some business insights that haven’t come out via the above questions as it is an unexpected question.

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