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What Is the Due Diligence Process?

Buying a business is not like buying other assets. Much of a business’ value is intangible, and many of its component parts are difficult to price correctly. A wise purchaser relies on the due diligence process for protection.

 (Note: Intelligent sellers pre-plan a business sale by looking at their business through a buyer’s eyes. This may enable you to identify and remedy issues ahead of time. For more information, you may want to read Planning and Staging a Company for Transition. This process will also help you value your company.

While you should also conduct your own due diligence of potential buyers (for example, you can find out if they have been sued for breaching purchase agreements with other sellers, among other things), this article is about the due diligence as performed by prospective buyers. Like all BTEP content, however, it provides valuable perspective to both sides.)

Due diligence

Due Diligence This is an audit of all material facts during a sale. Buyers need to know they can trust the target company’s legal and financial circumstances. Due diligence ensures that you ‘look before you leap.’ This is not something prospective buyers or sellers can take lightly.

If you are an acquirer, you must be prepared for the due diligence process in advance. Find experts to help you (whenever necessary), ask good questions, and kick the tires a bit. You’ll become a stronger buyer and have a better chance of negotiating the right deal.

Use the Internet for Early Due Diligence

Two decades ago, before the internet, it was difficult to find public information about businesses that was both 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, online due diligence is part of your first impression. It is also a fantastic resource for gathering information. You can investigate industry trends, competition, marketing, supplier relationships, employee reviews and owner biographies, among other things

Start Formal Due Diligence After the Letter of Intent

Formal due diligence normally starts after a Letter of Intent, or 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.

(Financial Poise contributor and Principal at ROGC Stephen Reisler says the LOI is “akin to a father asking his daughter’s date, ‘What are your intentions with my daughter, young man?’”)

Kinds of Due Diligence

Due diligence can be thought of as consisting of three components: legal, financial and operational. Broadly stated, these help the buyer to verify a business’ legal formation, see if it honestly presents its financial standing, and find out 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. This is not an exhaustive review, and every deal will be a little different. Rather, this is meant to highlight the importance and 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/pending litigation and understand the business’ legal obligations.

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

  • Contracts with suppliers, customers, employees, etc.;
  • Critical regulations and relationships with regulatory agencies;
  • Product liabilities, warranties, service guarantees, etc;
  • Employee benefits — stock option plans, retirement packages, insurance;
  • Board minutes;
  • Patents and other intellectual property rights considerations; (For more on how to buy, sell and value intellectual property, click here.)

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 properly execute this stage.

Examples of items reviewed as part of financial 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 largest customers (customer profiles if possible);
  • Bank accounts and bank statements.

Operational:

Find out how the sausage gets made. In the operational 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, etc;
  • Review of crucial input prices, possible substitutions, market environment, etc;
  • Status of inventory and condition of capital equipment;
  • Potential contingencies in event operations are disturbed.

Form a Due Diligence Team

Buying a business is not like buying other assets. Much of a business’ value is intangible, and many of its component parts are difficult to price correctly. A wise purchaser protects himself or herself through the due diligence process. Assemble an acquisition team to help you create a strong diligence program.  For more information on this, read Assembling the Right Transaction Team.

Due diligence is commonly a time consuming process and normally involves many experts, but it is a necessary step if you want to make an informed decision.

 

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