Congratulations. You have just decided to purchase a business,
merge with another company or invest in a someone else's
company. Exciting, isn't it?
You have probably been busy learning the business, talking to
the seller about the operation, conducting market research and
planning how can you run it better than the previous owner.
It does not matter if you are 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: a due
diligence.
What is a due diligence and why is it so important?
One (very technical and boring) definition of a due diligence
is: Due diligence can apply either narrowly to the process of
verifying the data presented in a business plan or sales
memorandum, or broadly as completing the investigation and
analytical process that precedes a commitment to invest. The
purpose is to determine the attractiveness, risks, and issues
regarding a transaction with a potential investment. Due
diligence should enable investment professionals to realize an
effective decision process and optimize the deal terms.
In reality due diligence is a process in which potential buyer
(or investor) investigate, analyze, inquire and try to learn as
much as possible on the purchased 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 will verify that information before
making the final commitment to invest.
How do you "due diligence"?
There several aspects of the business you should check:
Legal exposure
Technology and patents the business own
Business performance and financial position
Legal
Usually you need to contact the business's lawyer and ask for a
letter listing all the legal actions and claims the business is
a party to. The goal here is to understand the legal risks that
the business is facing: Is there any legal action against the
business that could end in a judgment against it? What is the
maximum exposure? How much will the lawyers charge to represent
the business?
With the lawyer's letter and the 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 ask for copies off all agreements, contracts or
other binding understandings the business has with third
parties. Here is a partial list:
Employment contract
Shareholders agreement
Leases
Purchasing agreement
Clients agreement
Licensing 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 on the business
name?
In which jurisdictions?
When does the registration expire?
Has it been developed by the business, or does a third party
could 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:
Retain a specialist who can assess the value of the technology
Retain a patent lawyer to assure the validity of the patents
Business performance and financial position
Most business sale transactions are based on either the business
income / profits in the past few years, or the business assets
and liabilities on the purchase date.
Therefore, it is extremely important to conduct a financial due
diligence on the business before finalizing the deal.
What to do in a financial due diligence?
1. Check the company's assets:
Cash - Ask for all bank statements, petty cash and all other
locations in which cash is held. See if the total matches
seller's numbers.
Accounts Receivable - ask for a list of all customers who owe
money to the business. See how long they have not paid. Inquire
if there is a dispute with any of the customer and how much of
the entire amount that owed will be actually paid (based on
seller's belief?) Focus on large amounts and long overdue
accounts. If it is over 60 days it should be checked out. Call
the customers to verify that their balance agree with the
seller's balance.
Inventory - Ask for a complete list of inventory items. Count
the actual inventory and see it it matches the business
inventory list. Ask for usage information, how much of each item
is being shipped every week / month. If the shipped quantity is
very low, it could indicate that this is a slow moving inventory
item and that its value is minimal.
Other Assets - ask for a complete list of all other assets that
the business owns. Identify the assets, locations and market
value.
2. Check the company's assets:
Accounts Payable - Ask for a list of all vendors the business
owes money to. Verify the validity of the underlying
transaction. Make sure the products they were suppose to deliver
was in fact delivered and in good condition. Has installation
been provided? What are the payment terms?
Bank and other loans - Ask for loan agreements. Check the
payment schedule, go back and track past payment and verify that
the listed outstanding balance is correct. Inquire about the
loan's rate and terms and can it be refinanced for a lower rate
loan? Learn if the loan is collateralized and by what assets?
Other liabilities - Ask for a complete list of all other
liabilities. For each one, run the same inquiries as we have
suggested for Accounts Payable and Loans.
Note - a very important goal of the due diligence is to find out
if there are liabilities not listed or disclosed by the seller.
You need to verify that there are no additional debt to
suppliers, banks, other loan providers or any other undisclosed
amounts.
3. Check the company's income and expenses:
Sales - ask for list of all sales transactions in the past 3
years. Go thru them. Ask for documentation of the largest ones:
Customer Purchase Orders, Invoices, Shipping Slips and Receipts.
Make sure that the transactions have been actually paid by the
customer and if not that it will be paid according to the
company's credit terms. Compare the total sales of the three
years to see if the business is growing, shrinking or in a
stagnation.
Expenses - Ask for a breakdown of each expenses. You should
first focus on inventory purchase. See how much the products
cost, for how much it being sold for and what is the profit on
each item. Track the purchases of the inventory to the sale
transaction to see the full cycle. After inventory purchases go
thru all other expenses to verify the authenticity of each
transaction. A partial list of expenses includes:
- Wages and Benefits - Marketing and Sales - Rent and Utilities
- Legal and Accounting - Office Expenses and Supplies - Taxes -
Travel - Interest and Finance Charges - Outside Service and
Subcontractors
As with liabilities you should look for unrecorded expenses to
understand the true and actual expenses rate of the business so
you will have no future surprises.
Conclusion
Buying a business is a huge investment you make. To make sure
that "what you see is what you get" you should conduct a due
diligence.
This article describes ways and points you should focus on when
conducting the due diligence.
And as always, there is no substitute to retaining a
professional who understands due diligence and have the right
experience. When buying a business you should really consult
with an accountant and make sure you cover all bases.
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