If it’s unfamiliar to you, the phrase 'conducting due diligence' might sound like legal jargon — something best left to your lawyer. In reality, though, it simply means gathering information and analyzing it when you’re preparing to buy a business.
The period of due diligence provides a prospective buyer with the opportunity to investigate any facet of the business to make sure they know exactly what they’re getting into. The buyer has the right to review all business, financial, and legal records and anything else relevant to business operations before making a final decision and signing on the dotted line.
While the length of the due diligence period is negotiable, it should last at least three or four weeks to give the buyer time to collect and properly analyze all pertinent information.
Smart buyers won’t try to handle the labor-intensive and complex due diligence process on their own. Instead, it’s wise to work with both an accountant and a lawyer to help organize the process and ensure important insights aren’t being overlooked or misinterpreted. After all, the due diligence process isn’t just a formality that confirms facts you already know about the business. It’s your one and only opportunity to dig deep into the company’s current and historical status and uncover issues that could have an impact on your ability to succeed as its new owner.
What are some key issues to look out for while conducting due diligence?
With the company’s legal and financial records in hand, a prospective buyer (and his or her team of professionals) needs to take a long, hard look at the company’s historical and current activity and compare it to industry benchmarks as well as the owner’s own narrative.
Unfortunately, many owners who are eager to sell can be overly positive or optimistic about aspects of business operations that could actually reveal warning signs to a buyer. Whether they’re purposely trying to mislead, or simply don’t realize the seriousness of the situation, it’s up to the buyer to recognize these issues before signing a purchase agreement.
“Creative” bookkeeping
A trained accountant will likely be able to spot straight-up fraud in a company’s financial records within minutes. But most business owners haven’t been consciously taking unethical or illegal actions in the course of running their companies. What they have been doing, however, is everything in their power to maximize profits, reduce taxes, and control expenses.
In so doing, many business owners have resorted to “creative” bookkeeping that may not break any laws, but should raise red flags for a prospective buyer because of its misleading impact on the company balance sheet and P&L statements.
For example, we can imagine a retail store being evaluated for purchase: the seller explains a declining cost of goods as the result of smart negotiation with suppliers and strategic mark-up on popular items. However, investigation by the prospective buyer and their accountant during the due diligence period reveals the main reason for the decline in cost of goods sold is that the seller was drawing down on his inventory to make sales without replenishing his stock. This made it appear, incorrectly, that the cost of goods was declining.
Too many eggs in one basket
A thorough review of the customer, vendor, and supplier lists should reveal a well-balanced list of individuals and organizations across a broad spectrum of industries, localities, and even personas. If that’s not the case, it could indicate that the company — even though it’s recording adequate revenue and impressive profit — is actually in a financially precarious position.
For another hypothetical example, if due diligence reveals that a service firm derives half its income from a manufacturing company owned by the owner’s brother, there’s definitely cause for concern. Even with a longstanding history of profitable business between the two organizations, the prospective buyer should be rightfully concerned that once they take over the business, half of its income could disappear without warning.
Profits padded by receivables
Another red flag issue involves balance sheets that are heavily weighted in the Accounts Receivable column. While a healthy level of accounts receivable is a good sign that the business is staying busy, too much in the receivable column could indicate a serious problem with collecting on invoices.
For example, if a construction firm’s balance sheet indicates healthy profit but a large part of the calculated assets are in the form of receivables, a prospective buyer should definitely investigate the age of those receivables and what sort of arrangements are in place for collection. If that investigation reveals a number of dissatisfied clients who are refusing to pay their invoices because they’re considering (or actually involved in) litigation against the construction firm for shoddy work, it could very well save the prospective buyer a tremendous amount of money and stress to pull out of the deal at that point.
Negative customer feedback
A final issue that’s far more readily available to prospective buyers than it was just a few years ago is negative customer feedback. With easy access to social media and various sites set up specifically to collect customer reviews, every business has an online history in this regard. And, for better or worse, dissatisfied customers tend to be the loudest.
While every business is bound to have a backlog of customers who they’ve been unable to perfectly satisfy, and items like online reviews should be taken with a grain of salt under the best of conditions, if there’s an obvious negative trend in the customer feedback, that’s going to affect the company’s reputation. Under those circumstances, unless the prospective buyer intends to completely rebrand the business or combine it with an existing organization with a significantly better reputation, they could be starting off at a deficit.
While this has been just a sample of issues due diligence can bring to light, the basic principle is clear: any legal, financial, or personnel activity being conducted by the business that raises the eyebrows of the buyer, buyer’s accountant, or buyer’s lawyer is worthy of serious investigation. It’s important to remember that sellers may be intentionally or accidentally misleading in their efforts to sell their businesses at the best possible price, and it’s up to the buyer to do whatever is necessary to get to the truth of the matter before signing the purchase agreement.
What should your due diligence cover?
- Personnel - What are the terms and conditions of employment? What skills and experience do the staff have? Also, review commercial management including customer service, research and development, and marketing.
- Financial records - Study the company's books and records as well as its accounting and bookkeeping methods. Focus on the company’s past and projected cash flow. Review how relationships have been cultivated with banks and lenders along with the debt of the business.
- Products and services - Consider what the business offers, especially the pricing in comparison to industry standards and competition.
- Assets - Always review the company’s property and equipment, including IT systems and technology. Look at leases and deeds and investigate the depreciation of property and equipment values.
- Business operations - Take into account the location, inventories, suppliers, management, customer relations and insurance policies.
- Legal concerns - In addition, look out for outstanding litigation, major contracts and orders, and environmental issues.
The extent and complexity of due diligence will vary based in part on the size of the transaction, time constraints, cost, and availability of resources. Of course, it’s impossible to know every last detail about a business, but it's crucial to learn enough to make good, informed business decisions.
Conducting adequate due diligence will protect the buyer from a range of problems and avoid unexpected issues from surfacing after the transaction is complete: finding that the purchase price was too high, discovering there is pending legal action, revealing misunderstandings about the condition of the business and uncovering an unfavorable financial situation. It is an invaluable process that’s well worth the investment of time and effort it requires.
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