Congratulations. You have just decided to buy a business, merge with another company, or invest in someone else’s company. Exciting, isn’t it?
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 memo, or more broadly as 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.
In reality, 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 goal here is to understand the legal risks 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 letter from the lawyer and the relevant information, you can go to the next level and hire your own layer to review the facts and get a second opinion on those legal matters.
You should also request copies of any 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 partly because of its technology or patents, you should evaluate the following:
Is the technology or patent actually registered in the name of the company?
In which jurisdictions?
When does the 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 revenue/profit 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 company assets:
Cash: Request all bank statements, petty cash, and all other places where cash is kept. See if the total matches the vendor’s numbers.
Accounts Receivable – Request a list of all customers who owe the business money. 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. Ask for 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 company assets:
Accounts Payable – Request a list of all vendors to whom the business owes money. Verify the validity of the underlying transaction. Make sure the products they were supposed to deliver were delivered and in good condition. Has the installation been provided? what are the payment conditions?
Bank loans and others – Consult loan agreements. Check the payment schedule, go back and follow up on the previous payment, and verify that the outstanding balance listed is correct. Find out about the rate and terms of the loan and can you refinance for a lower rate loan? Find out 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 that we have suggested for Accounts Payable and Loans.
Note: A very important goal 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 suppliers, banks, other loan providers or any other undisclosed amounts.
3. Consult 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 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 the three years to see if the business is growing, shrinking, or stagnant.
Expenses – Request a breakdown of each expense. You must first focus on purchasing inventory. See how much the products cost, how much they sell for and what is the profit on each item. 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
-Journey
– Interest and Financial Charges
– Foreign Service and Subcontractors
As with liabilities, you should look for unrecorded expenses to understand the true and actual expense rate of the business so you don’t have any surprises down the road.
Conclution
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 performing due diligence.
And as always, there’s no substitute for hiring a professional who understands due diligence and has the right experience. When buying a business, you really should consult with an accountant and make sure you cover all the bases.