Whether you’re looking to buy a brand new startup that you expect to thrive in the future, or an established business with a strong customer base, conducting due diligence is one of the most critical components of the buying process. After all, the purchase of a business is probably the biggest investment you’ll ever make.
Don’t Wait for Formal Due Diligence
“The most crucial stage in the process of buying a business is when the formal due diligence phase begins,” writes Richard Parker, founder of Diomo Corporation. “This is the time when the parties have come to an agreement and the buyer will have a certain period in which to investigate the business and, if necessary, rescind their offer if they determine the business does not meet their criteria.”
As Parker points out, the process of “formal” due diligence begins once an agreement is made between the buyer and seller. However, you can’t actually wait until this time to begin researching the business. The formal period may only last for two to four weeks and should be reserved for certain tasks that can only be conducted once full access is granted.
If you want to make a calculated buying decision, you need to start investigating well before this period. Parker says that an estimated 50 percent of all deals that enter the formal due diligence period never survive long enough to make it to the closing table. “One key ingredient that leads to this is the buyer’s lack of preparation to complete an exhaustive review in the period allocated,” he warns.
So, when you hear people talk about conducting due diligence, it’s imperative that you take this to mean both formal and informal due diligence. Otherwise, you could end up making a decision that’s based on shallow facts or rushed judgments.
6 Things to Look For
A seller isn’t going to automatically hand over every piece of documentation they have to the buyer. It’s your prerogative to ask for the information you want to see. While not a comprehensive list by any means, you should ask for the following items:
1. Audited Financial Statements
The best place to start is with the company’s audited financial statements. You should request income statements, balance sheets, cash flow statements, and tax returns from previous years. Review these statements with your accountant and make sure the business is properly collecting its accounts receivables, avoiding bad debt, and paying good debt in a timely manner. Also take this opportunity to examine the business’ actual profit margin and identify any outstanding liens.
2. Employee Information
One important issue that often goes overlooked in the due diligence period is employee information. However, this is extremely important. As Kyle Rohner, an experienced business broker, points out, you need to obtain a list of all active and inactive employees, obtain copies of agreements, review confidentiality agreements and non-compete clauses, scan resumes, look at payroll reports, and more. Don’t just assume the current owner is properly managing employees.
3. Professional and Consulting Agreements
You and your attorney should ask for all copies of professional and consulting agreements the business has, as well as insurance polices, intellectual property documentation, licenses and permits, and files related to lawsuits and legal proceedings. The purpose of reviewing these documents is to make sure agreements are enforceable and that the business is properly protected against future claims.
4. Business Structure Information
While you should already know a lot about the structure of the business from your informal due diligence, take time to meticulously analyze official documentation during the formal timeframe. This includes the company’s corporate charter, bylaws, and minutes of meetings that are held with shareholders. Your attorney can help you ensure the business is properly structured and compliant. This will also help you determine whether current shareholders will need to be bought out.
5. Review of Operations
As the buyer, you need to make sure you’re entering a situation that’s properly set up with the right operations. Ask for a list of suppliers, vendors, and customers. Also, make sure they can give you a copy of an operations manual.
6. Leasing Information
If the seller currently leases the property where he conducts business, then you can’t just assume that lease will move over with the sale of the business. You need to find out whether or not you can assume the lease, how much time remains on it, and what conditions and terms the landlord has in place. It’s also important that you ask about the seller’s security deposit. Depending on the property, this can be a sizable amount. You should solve this issue prior to sitting down at the closing table.
Take Your Time
Most people who’ve purchased a home in the past understand the process of due diligence. However, you can’t assume that buying a business is just as easy. While conducting due diligence on a residential property is fairly straightforward, it takes lots of time and energy to do the same with a business. Keep this in mind, remain patient, and don’t skip anything.