How to Conduct Due Diligence Before Buying a Business

What is Due Diligence?

Buying a business is not like buying other assets. Much of a business’s value is intangible, and many of its component parts are difficult to price correctly, which is why a wise buyer will perform thorough due diligence before buying a business.

Due diligence is an audit of all material facts during a sale. This process will give a buyer critical insight into the target company’s legal, financial, and operational circumstances. It will equip them with the information they need in order to make an informed decision and avoid making a bad investment.

If you intend to purchase a business, you must prepare for the due diligence process in advance. In this article, we’ll review some of the major considerations you should keep in mind if you’re planning to undertake your own due diligence in the near future.

Your First Impression: Informal Due Diligence

Prior to the widespread use and accessibility of the Internet, it was difficult to find public information about businesses that was accurate and up-to-date. Buyers often had to lumber through side publications or trade associations to discretely verify the legal and financial characteristics of a target acquisition. This held up good deals, and buyers wasted time chasing dead ends.

Today, informal due diligence through online research allows a potential buyer to put together their first impression of a target acquisition by investigating such topics as industry trends, competition, marketing, supplier relationships, employee reviews, and owner biographies.

Formal due diligence normally starts after a letter of intent (LOI) is executed. This, mostly, non-binding document acts as a buyer’s preliminary offer, and it normally contains a range of possible purchase prices. It’s a simple way to kick off the business courtship.

The Three Components Of Due Diligence

Due diligence can be thought of as consisting of three components: legal, financial, and operational. Broadly stated, these help the buyer verify a business’s legal formation and its financial standing, and determine if it will function as expected after the deal.

As you progress through each, it is a good idea to circle back and review your expectations. The following is not an exhaustive review, rather, it is meant to highlight the general scope of proper due diligence.

Legal

Depending on the business, legal diligence can be relatively straightforward or fairly complex. In all cases, a business must be properly registered for all jurisdictions in which it conducts business. You need to review company bylaws and amendments. Buyers also need to know if the business has any recent, current, or pending litigation and understand any legal obligations the business has.

Examples of items that a buyer’s attorney typically will examine include:

• Contracts with suppliers, customers, and employees.
• Critical regulations and relationships with regulatory agencies.
• Product liabilities, warranties, and service guarantees.
• Employee benefits, i.e., stock option plans, retirement packages, and insurance.
• Board minutes.
• Patents and other intellectual property rights.

Financial

Financial due diligence centers around a target’s financial statements. A review of the past three to five years’ worth of statements is standard practice. You may need to hire an accountant or other financial adviser to execute this stage properly.

Examples of items reviewed as part of financial due diligence typically include:

• Schedules of inventory, payables, receivables, debt, and contingent liabilities.
• The company’s credit report.
• The company’s general ledger, along with a list of internal control processes.
• Any relevant financial projections and strategic plans.
• Internal memos, analyst reports, etc.
• List of physical assets, especially current leases and recent purchases.
• Revenue from the company’s largest customers; customer profiles if possible.
• Bank accounts and bank statements.

Operational

This is where you find out ‘how the sausage gets made.’ In the operational due diligence phase, a buyer will often interview key employees, suppliers, and customers.

Items that may be reviewed as part of operational due diligence include:

• Location of facilities and equipment.
• Logistics for all company operations, vendor, and supplier processes.
• Review of crucial input prices, possible substitutions, and the market environment.
• Status of inventory and condition of capital equipment.
• Potential contingencies in the event operations are disturbed.

Conducting due diligence before buying a business is a time consuming process and involves many experts, but it’s a necessary step if you want to make an informed decision.

---

We think you’ll also like:

1. 6 Tips for Successfully Pursuing an Acquisition
2. How to Find the Right Business Buyer for Your Company
3. The 4 Acquisition Financing Structures That Buyers (and Sellers!) Must Know

[Editors’ Note: To learn more about this and related topics, you may want to attend the following on-demand webinars (which you can view at your leisure, and each includes a comprehensive customer PowerPoint about the topic):

1. Selecting the Right Valuation Expert
2. Complex Financial Litigation / Common Issues and Strategies in Business Breakups
3. Post-Closing Issues: Integration & Potential Buyer/Seller Disputes

This is an updated version of an article originally published June 22, 2016 and updated August 21, 2020 and June 14, 2023.]

©2024. DailyDAC^TM, LLC d/b/a/ Financial Poise^TM. This article is subject to the disclaimers found here.