Due Diligence When Buying a Business

What is Due Diligence When Buying a Business?

Due diligence is used for various situations, from buying a business to purchasing a home to hiring an employee. In the business world, this means looking at the company's cash flow, market, taxes, assets, and liabilities before it is purchased. It also means investigating the directors or officers of the parent company, if applicable, and analyzing where they are and where they have been. The due diligence process is the time to find any red flags before an investment is made.

Due diligence is useful for both the buyer and seller of a business. It gives the buyer the necessary information to decide whether to purchase a business, and it gives the seller factual information to share with the buyer and build trust.

Typically, due diligence is one of the last steps taken before the sale of the business is finalized. If the buyer feels the risks outweigh the business benefits, the sale will not be completed.

Who Pays for the Due Diligence?

Typically, each side of the business-for-sale transaction pays its own expenses. During the due diligence period of buying a business, the buyer and seller of the business are independent entities, yet they must work closely together. They may encounter expenses that include fees for accountants, lawyers, business brokers or M&A advisors.

In some cases, the buyer and seller of a business may negotiate to offset these expenses or delay payment to these advisors until the sale of the business goes through. For example, a buyer may request to pay their advisors with the cash flow from the business once the purchase is finalized. Alternatively, a seller may ask that their advisors be paid with the proceeds from the sale of the business.

What are the Types of Due Diligence?

Six types of due diligence should be investigated before buying a business: Financial, Legal, Human Resources, Operational, Environmental, and Strategic. We will discuss each type of due diligence in greater detail below.

Financial Due Diligence

Financial due diligence is sometimes referred to as hard due diligence. It is factual and numbers-based. Before buying a business, financial due diligence is critical because it lets the buyer see how well the business has performed. By analyzing financial statements, the company’s projected growth, inventory schedules, and a host of other data, potential buyers can better understand the risk involved with purchasing a particular business.

It is recommended that potential buyers request at least three years of financial statements, inventory management, liabilities, accounting systems, and income. Tax returns and accounts receivables also contain important information that should be analyzed during financial due diligence.

Legal Due Diligence

Legal due diligence is an important aspect of buying a business. It will help a potential buyer discover whether the company is involved or has been involved in any lawsuits, settlement claims, or tax liens.

Analyzing existing contracts, corporate documents, or board meeting minutes will help a potential buyer see whether the business is entangled in legal issues as well. The business should have up-to-date permits and licenses and comply with all federal, state, and local laws.

Human Resource Due Diligence

Before buying a business, it is important to conduct human resource due diligence. This will allow a potential buyer to analyze the workforce of a company. A precursory investigation of the workforce will help a buyer understand how the workforce is organized.

For example, the number of employees, the salary breakdown, and some basic details about the executives and directors of a company are often vital to dig deeper. Background checks on high-level executives and directors should be performed.

The employee handbook and employment tax statement should be reviewed to ensure federal, state, and local guidelines are being followed. Red flags such as harassment claims, toxic workplace issues, and wrongful terminations should be questioned before the business is purchased.

Operational Due Diligence

Operational due diligence is often overlooked in the due diligence process, yet it is important to analyze a company's operations before buying it. It helps the buyer understand the direction and pace of the company and looks at all the elements involved in the operations of a company.

Operational due diligence can be divided into six segments: organization, information technology, scalability, costs, potential, and known risks. The buyer should analyze each segment before purchasing the business. These segments are broken down into greater detail below.

Organization: The organization of a company is the most important factor to consider in operational due diligence. This segment includes a study of the company’s structure, including employee roles, department hierarchy, employee salary, benefits and growth opportunities, leadership skills, and transparency of the management team.
Information Technology: In information technology due diligence, the IT infrastructure of the company is analyzed. The goal is to make certain that the technology is in place and running smoothly. Buyers may consider whether there is adequate data storage and whether that data is protected and easy to recover. They may also look at the network structure, firewalls, hardware, and program tools.
Scalability: Also falling under operational due diligence is scalability. When looking at scalability, a buyer can analyze whether the company has room to grow, and if so, how fast that growth may occur. Buyers may analyze whether the company has the staff, technology, and inventory to grow or whether those things will need to be added before growth can occur.
Cost: Cost is a major factor in operational due diligence. One of the best ways to analyze cost is through a cost-benefit analysis. If the cost of running the company is too high, the company will not be competitive in the market. If it cannot be competitive, it will likely fail. Cost may include anything necessary to run the business, such as labor, materials, tools, equipment, upkeep, rent/mortgage, and electricity.
Potential: Potential is a slightly different factor than scalability. While both have the goal of leading to growth in the company, scalability covers physical growth, while potential covers financial growth. Potential may consider whether the company can reduce cost and increase its competitiveness in the market, leading to greater potential financial success. When considering potential, a buyer may also look at the efficiency of the company. If the company can be more efficient, it can have greater potential to succeed financially.
Known Risks: When analyzing the known risks during operational due diligence, the goal is to identify them and see if they can be eliminated. Risks may include a poor materials supply chain, inadequate machinery or product quality, and poor customer satisfaction.

Environmental Due Diligence

Environmental due diligence allows the buyer to investigate whether the business complies with federal, state, and local environmental regulations. While buyers of some businesses will barely focus on environmental due diligence, others will rely heavily on their findings before buying a business. This is especially true for buyers of industrial businesses. Conducting environmental due diligence minimizes costly penalties and expensive mitigation down the road.

Strategic Due Diligence

Strategic due diligence is an important aspect of investigating the benefits and risks associated with buying a business. It explores the commercial attractiveness of buying a business and the likelihood it will succeed.

Strategic due diligence is different from legal and financial due diligence because it focuses on determining whether a business’s value is realistic rather than on the correct price of the deal. It also creates a solid platform that is data-driven and indicates if the business will be successful beyond its financial value.

In strategic due diligence, the buyer will evaluate the market in which the business exists. For example, the buyer may look at competitors and customers and then analyze the actual value of the business. Ultimately, strategic due diligence will help determine whether a company’s business plan will hold up to the reality of the current market, despite what the financial numbers indicate.

How Long is the Due Diligence Period?

The due diligence period is typically between 60 and 90 days, although this fixed time is negotiable between the seller and buyer. Once a buyer gives the seller a letter of intent to conduct due diligence, they generally have a fixed period of time to conduct due diligence. For complex businesses, the due diligence period may be much longer. If there is a good cause, and both buyer and seller agree, the due diligence period may be extended as well.

The amount of time agreed upon should give the buyer enough time to review the hundreds of pages of documentation, physically inspect the business's assets, and hire appraisers, consultants, lawyers, or accountants to assist in the analysis, if needed. The seller also needs time to collect audited financial statements if they are not readily available.

What Questions Do I Ask During Due Diligence?

There are countless questions that a potential buyer of a business may ask during the due diligence process. Getting detailed answers to these questions, in combination with analyzing information garnered from the checklist, will help protect the buyer from making a poor business decision.

A few questions a buyer may ask include:

• Why is the business owner selling the business?
• Have there been attempts to sell the business before?
• Is there cash flow within the business?
• Where does the revenue come from?
• Are the financial projections reliable?
• Are profits increasing or decreasing?
• Is the market increasing for the company’s goods or services?
• Are there competitors that could impact the business’s revenue?
• Is there an online presence?
• Is the valuation accurate?
• Are there liabilities?
• What risks are apparent?
• Is there a disaster recovery plan in place for the information technology systems?
• What patents, trademarks, or copyrights does the business own?
• How are trade secrets protected?
• Are the business’s taxes paid in full?
• Is there a lease on the property, and if so, when does it end?
• What is covered by insurance? If not, is it located in a flood zone, fire zone, or other risky location?
• What are the employee salaries and benefits?
• Does the property need to mitigate hazardous materials?
• Is parking sufficient?
• Is there car or foot traffic?
• How successful are the marketing campaigns of the business?

Due Diligence Checklist

When buying a business, it is important to have an inclusive due diligence checklist. Auditing and analyzing every aspect of the business while following the checklist will decrease the amount of risk the buyer might face after the purchase.

A checklist for potential buyers may look similar to the list below and should be reviewed prior to buying a business:

Financial data associated with the business, including financial statements from the last three years, including:

• Financial paperwork: Income statements, accounts receivable and payable, balance sheets, and cash flow statements
• Tax returns
• Any debts, including details on their liabilities and terms
• Gross profit analysis, including the rate of return for each product
• Analysis of all expenses, both variable and fixed
• Inventory and value of all products associated with the business, including equipment, real estate, cars, or boats
• Past projection, actual results, and future projection summaries

Financial data should be assessed because it shows buyers the business's past and current financial health, and it will also point to the company's financial future.

Vast unpaid debts, increasing debt-to-equity ratio, fluctuating cash flow, and decreasing revenue can all be seen in the financial data. It may reveal warning signs that the business may be in financial jeopardy.

Operation of the business and any data on competitors, the market, and the customer base, including:

• Articles of incorporation, bylaws, meeting minutes, and amendments of the business
• Investor and shareholder information
• Brand analysis, including trademarks, website, and logo information
• Marketing plan, including cost and margins for all goods or services, the territory associated with the company, and competitor analysis

Generally, corporate records should be straightforward. It is important to look for red flags, such as an unusual provision or actions taken that were violations of the corporate documents.

These violations may include violations of shareholder agreements, elections of officers, or business transactions. Also, look for issues with a trademark or copyright infringement, especially surrounding the logo. Such issues could turn into legal problems down the road.

All contracts, including:

• Loan agreements, equipment leases, lines of credit, and real estate leases
• Any non-compete or non-disclosure agreements
• Purchase orders, including warranties, quotes, and invoices
• Sales and stock purchase agreements
• Director or executive contracts
• Employee contracts and independent contractor contracts

Contracts are essential in every business, but they are legally binding. Hence, a buyer needs to review all contracts to make sure they are aware of their legal obligations before purchasing the business. The vendor contracts and customer contracts should be straightforward and clear.

Potential buyers should look for anything that will impact the ability to make sales or acquire supplies. They should also look for issues with pricing, such as indications in the contract that pricing is expected to increase after a certain duration. Any unusual provisions, such as exclusivity, non-compete agreements, and minimum purchase requirements should be noted.

All customer data, including:

• Customer databases and lists
• Customer analysis, including first-time customers compared to repeat customers, peak purchasing times, popular goods or services, and best price points
• Customer correspondence
• Marketing and advertising programs
• Policies on purchasing and refunds

One of the most important aspects of any business is its customer data. Ideally, data should indicate that the business has a solid customer base. However, after assessing the customer data, there may be signs that the business is at risk of losing a certain demographic. These warning signs should be noted and questioned.

All employee data, including:

• Material employee employment history and responsibilities
• Payroll information and employee benefits
• Human resources handbook procedures and policies

One key component to owning a successful business is its employees. As a result, assessing employee data is vital. Potential buyers should look for warning signs such as a high rate of employee turnover, staffing issues, and handbook policies that are outdated in the current workplace environment.

All legal issues, including:

• Past, present, or pending litigation
• Any unsatisfied judgments or settlements
• Up-to-date permits and licenses
• Federal, state, and local laws have been followed
• Any intellectual property issues, including patents, copyrights, or trademarks owned by the business

Legal issues can be expensive and time-consuming. Buyers should check for signs of prior, pending, or even potential legal troubles, such as bankruptcies or lawsuits. If such issues are discovered, buyers should look at the resolution, whether damages were assessed, and whether the same issue can arise in the future.

Conclusion

By the time the due diligence process is complete, the buyer should have a clear, factual view of the risks and benefits associated with the business, an idea of how the business will grow in the future, and whether the asking price is reasonable for that particular market.

With the help of an experienced business broker, accountant, lawyer, or investment banker, most buyers will have a solid understanding of whether the purchase of a specific business is the right move for them.

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