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 through 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 through 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.