Due Diligence for Buying a Business
What exactly is due diligence for buying a business? Simply put, performing your due diligence means taking a highly scrutinizing look at the business you are considering purchasing regarding
Beyond just proving that the seller's financial information is accurate, this process allows you to dig into the company and find out how it works, where its strengths lie, what weaknesses it has and how you can or can't make a difference as the new owner. A Pro Forma financial analysis should also be developed during due diligence to run best and worst case scenarios to get an idea of revenue and cash flow possibilities. Before you go forward and read the information below on due diligence for buying a business, it's important that you have already prepared yourself to buy, find and value a business. To make sure you are ready for the information on this page, please look at the Preparation, Finding a Business, Business Valuations and Letter of Intent pages first. (Get a head start by picking up a free report on preparing to buy a business.)
How Long Does it Take? First, you should know that preparing yourself for due diligence starts at the point that you decide "this business seems like a very possible fit to me". Start writing down any questions you have about how the business operates whenever they come into your head. There really are no stupid questions when it comes to operations issues so don't be afraid to ask. Research the company through the selling broker, the internet, etc. At this time you can ask about the business around the neighborhood but be as discreet as you can. DO NOT make the mistake of contacting vendors of the seller about the business at this time unless you can do it without it getting back to the seller. This often causes a disturbance of the business, normally against any kind of non-disclosure policy, and it will quickly sour the seller on your integrity when he finds out you did it. So, although mentally you should start your due diligence immediately upon true interest in buying the business, the actual due diligence period usually runs anywhere from 2 to 6 weeks, depending on the industry type. It may take longer if it's a very intricate type of business. You will also find that almost all sellers and brokers will push for a standard 2 to 3 weeks time. You have no obligation to agree to that but this is often enough time to perform a thorough due diligence of most small businesses, especially if you are prepared. The other time issue to keep in mind is that you should stipulate that the due diligence period does not officially begin until you have specific documentation in your hand. This is not a given and it should be in writing in your Letter of Intent (LOI).
Every Business Type is Different I'm sure you can get some kind of due diligence checklist from your accountant and maybe even a business attorney as well as other fairly reliable sources out there. Unfortunately, you will find out very quickly that how you conduct your due diligence for buying a particular type of business really depends on the industry the business is in. For example, performing due diligence for buying a restaurant is not even close to due diligence for buying a laundromat. You will be laughed out the door if you ask for the wrong kind of documentation. Especially documentation that has no bearing on the particular business you are looking at. Or worse, you will rely on information given to you that will almost certainly be inaccurate and cause you to completely botch the due diligence. This could lead to missing out on a great opportunity. Again, as an example let's take a cash based business. Asking for 3 years of tax documents is not going to prove much to you when the purpose of being in a cash based business is to not report everything on your taxes. That's why you want to get into this business and it's why the seller got into it. You will need to know what type of documentation and information allows you to truly "see" what is going on in the business and its history. Often this is done through bills and working backwards to come up with the correct numbers. Also, retail related businesses will often require literally watching customer flow in and out for an entire week or more. Sometimes, the best way to perform part of the due diligence in retail is actually working with the seller for a week.
Basics to Look for in Financials Again, "official" financial statements such as tax returns with many small businesses usually give you a very small piece of accuracy. For the most part, the accuracy is in the expenses but even that may be off so as to not make the entire tax return seem odd to the government. Your best bet is the "true" books that most business owners keep. Some use a notebook and some use a financial program like Quick Books. These are the most accurate documents available so be ready to sit down with the seller to go over them and understand the method to their madness. When dealing with a business that doesn't really have the opportunity for cash payments such as manufacturing or some kind of consulting or brokering company, the financial statement should be accurate. In this case, get a Profit & Loss (also called a P&L or Income Statement) from their accountant as well as a Balance Sheet. In any business, especially highly cash based, get all of the bills and payroll information available for the past 1 to 3 years. At a minimum, this should tell you what the true company expenses are. If the seller does not have accurate revenue statements, then he will have to prove his claims to you physically by letting you basically count the money with him on a weekly basis. Another thing you want to look for in this information is revenue growth vs. shrinkage in the last 3 years and whether profit margins are in line with industry averages. Keep an eye out for trends in Accounts Receivable (from the Balance Sheet) to see if they have too many slow paying customers or have been having trouble for multiple years in collecting payments. Find out what the typical liabilities and Accounts Payable are like. Are there a lot of big ticket items? Will you need to take over any payments for any loans or leases? What kind of cash needs to be laid out each week or month to keep the business going? With all of this information and your thorough digging into the business, you should be able to see where you can add to the revenue or cut costs or both. This will be important in determining the possible future of the business with you at the helm. Now that you have this information and can "see" a possible future of the business, you, or you and your accountant, or you and your business advisor can sit down and make a Pro Form statement to run different financial scenarios. A Pro Forma statement is basically a projected Profit & Loss statement using different revenue and expense possibilities to paint a possible future picture of the business. It is normally a good idea to make assumptions such as the fact that revenues will probably drop at first and that you will not take a large salary for yourself at first. Again, your accountant and advisor should work closely with you on this so nothing is missed.
Basics to Look for in Assets Assets of a business vary by business type but the due diligence involved will be very similar regardless of the business type. For instance, something food related will have ovens, refrigerators, furniture, registers, etc but a route business will have only things such as trucks and computers. In general, these assets do not add value to most small businesses as far as the sale price goes because without them, there is no business. That's why it is best to use due diligence valuation methods with cash flow based multipliers and not asset based methods. What is important about these assets is that everything will be included in the sale and that everything is in working order. Your valuation of the business can greatly change if you will need to replace something inside of a 5 year time period. That replacement or overhaul cost needs to be subtracted from your original valuation. A list of the assets is a must. If possible, you should also get a depreciation schedule and any warranty information for each item.
Basics to Look for in Inventory As for inventory, this is often paid for outside of the asking price. Regardless, you must get a good idea of what is "good" inventory and what isn't. This is not the time to do a full valuation of the inventory, that gets done right before the purchase contracts get signed. But you do need to figure out what inventory the business has that is typically sold or used in a short period of time. Depending on the business, this could mean a year, 6 months or 6 days. Either way, if you won't be able to sell it in a reasonable time, you should write it down as something you will not pay for as part of the sale at all.
Basics to Look for in General Operations Every industry has its own type of standard ways to operate. Bars have to order liquor, restaurants have to order food, gas stations have to order gas. They almost all have employees. And they all have finances to track. The difference though, is how they keep track of these things. Some do it better than others and some use more sophisticated systems (but that doesn't necessarily translate to doing things better. Another part of general operations is banking. This subject should definitely be part of your due diligence checklist. It's a very good idea to know this upfront to prepare yourself with extra cash on hand to cover these things before you can establish a line of credit. Lastly, make sure you get copies of any legal documents like licenses, proof of incorporation and a list of all of the owners.
Basics to Look for in Sales & Marketing How a business gets its customers/clients is very important to you as a business buyer and therefore should not be overlooked in your due diligence checklist. This goes for any type of business. Keeping the flow of customers that has already been established and how you can keep it that way as well as increase it should be a major concern. Again, depending on the type of business you are looking to buy, the due diligence for sales & marketing can vary tremendously but the above questions are pretty basic to most industries. Some industries/businesses get very lucky and don't advertise at all as well as don't need a sales force but still be wary at first for a business that claims $0 in marketing/advertising. Dig deep and find out how they make their money.
Basics to Look for on Employees Some businesses don't have employees, others have a few part timers and other have a whole bunch of full time people. As long as there is even one part time employee, you need to find out at least a few key things such as how long employees have been there, who are the key ones and who is staying to name a few. Again, these are basic questions that can work for almost any company. Your due diligence questions about people within the company will vary and get much more in-depth for different industries. Don't be surprised if you are limited to only talking to key employees. You must get permission to talk to employees before barging in and accosting them. To not disrupt the business, it is very likely that most employees do not know about the pending sale of a small business.
Basics to Look for on Vendors/Suppliers Every business has some sort of vendors and suppliers. Even consulting companies. These could be suppliers of products being sold, spare parts, machinery, equipment, office supplies, repairs/maintenance, insurance, etc. Be sure to come up with a thorough list and get the seller to give you as much information as possible. This information would include any contracts, licenses, special deal/discounts, etc. Don't count on being allowed to contact vendors during due diligence but ask to do so. If you get the green light, ask the vendors/suppliers about the relationship with the business you are about to purchase. Many times talking to vendors at this stage may disrupt the sellers business so it is discouraged. Just make sure your attorney gives you an out during the contract writing phase to be able to talk to these suppliers and drop the deal if you get very negative feedback that you don't feel is worth going forward.
Basics to Look for in Competition I don't want to be the bearer of bad news but the seller is not going to help you much in your due diligence as far as competition is concerned. Most will hope that you forget to look at this aspect of the business. Everyone has competition, but each type of business has to fight it out in a much different arena. Retail and local services businesses are fighting anyone in reach of the local yellow pages as well as a short driving distance from the store front. Distribution and manufacturing businesses have a much wider scope to deal with, especially if they do business out of state. You need to find out the main competition and determine if they are truly a threat or just another small fish in the lake with you. Also find out hoe they actually compare to the company you are buying based on price, service, quality etc. This will give you an idea of what to watch out for and what you may be able to change to better the business and protect yourself from these competitors.
When to Get Your Attorney Involved Attorneys are expensive. They are also unnecessary for a majority of the due diligence process. Normally you would leave them out of the loop until the due diligence is over and you are ready to go to contract. Sometimes though, when you suspect the business may have had some recent legal trouble or it is a complicated deal involving a lot of license transfers, you may want to get your lawyer in to do some legal research for you.
What's Next? Once you have completed your due diligence, it is time to decide to go through to the closing phase. This is otherwise known as "going to contract". Sometimes this involves adjusting your asking price down if you have very valid reasons to do so such as assets that will need to be replaced or the seller has not significantly "proved" his numbers. This counter offer may end up shutting the whole deal down or the seller may make some kind of concession. If the seller and you have a green light, it's off to the closing phase. The information on this page is only a piece of the puzzle. To get the whole story on due diligence, especially for specific industries, get the tool serious business buyers are using in the due diligence kit below:
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