Congratulations. You have just decided to buy a company, merge with another company, or invest in someone else’s company. Exciting, right?
You’ve probably been busy learning the business, talking to the salesperson about the operation, conducting market research, and planning how you can run it better than the previous owner.
It doesn’t matter if you’re 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 need to seriously consider: due diligence.
What is due diligence and why is it so important?
A (very technical and boring) definition of due diligence is: Due diligence can be applied in a restricted way to the process of verifying the data presented in a business plan or sales memorandum, or in general, how to complete the investigation and the process analytical that precedes a commitment to invest. The purpose is to determine the attractiveness, risks and issues related to a transaction with a potential investment. Due diligence should enable investment professionals to make an effective decision process and optimize the terms of the deal.
In reality, due diligence is a process in which the potential buyer (or investor) investigates, analyzes, inquires and tries to learn as much as possible about the purchased business 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 verify that information before making the final commitment to invest.
How is “due diligence” done?
There are several aspects of the business that you should check:
Company’s own technology and patents
Business performance and financial position
Typically, you should contact the company’s attorney and request a letter listing all legal actions and claims that the company is a party to. The goal here is to understand the legal risks the company faces: Is there any legal action against the company that could lead to a lawsuit against it? What is the maximum exposure? How much will the lawyers charge to represent the business?
With the lawyer’s letter and 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 request copies of all agreements, contracts, or other binding agreements the company has with third parties. Here is a partial list:
Licenses and royalties
Technology and patents
If you are buying the business in part because of its technology or patents, you should evaluate the following:
Is the technology or patent actually registered in the trade name?
In which jurisdictions?
When does the registration expire?
Has it been developed by the company or could a third party claim ownership of the technology / patent?
Request copies of all registration applications.
Once you have collected all the technology / patent information, you can:
Hire a specialist who can assess the value of the technology.
Hire a patent attorney to ensure validity of patents
Business performance and financial position
Most business sales transactions are based on recent years’ business income / earnings or business assets and liabilities as of the purchase date.
Therefore, it is extremely important to perform financial due diligence on the business before finalizing the deal.
What to do in a financial due diligence?
1. Check the assets of the company:
Cash – Ask for all bank statements, petty cash, and all other places where cash is kept. See if the total matches the seller’s numbers.
Accounts Receivable – Ask for a list of all customers who owe money to the business. See how long they haven’t paid. Ask if there is a dispute with any of the customers and how much of the total amount owed will actually be paid (according to the seller’s belief). Focus on large amounts and long overdue bills. If it is more than 60 days, it must be reviewed. Call customers to verify that their balance agrees with the seller’s balance.
Inventory – Request a complete list of inventory items. Count the actual inventory and see if it matches the commercial inventory list. Request usage information, how much of each item is shipped each week / month. If the quantity shipped is very low, it could indicate that it is a slow moving inventory item and that its value is minimal.
Other Assets – Ask for a complete list of all other assets the company owns. Identify assets, locations, and market value.
2. Check the assets of the company:
Accounts Payable – Ask for a list of all vendors to whom the business owes money. Check the validity of the underlying transaction. Make sure the products that were supposed to be delivered were delivered and in good condition. Has the facility been provided? what are the payment conditions?
Bank and other loans: apply for loan agreements. Check the payment schedule, go back and track the previous payment and verify that the indicated outstanding balance is correct. Ask about the rate and terms of the loan and can you refinance for a lower rate loan? Do you know if the loan is guaranteed and with what assets?
Other liabilities: ask for a complete list of all other liabilities. For each, make the same inquiries that we suggest for Accounts Payable and Loans.
Note: A very important goal of due diligence is to find out if there are liabilities that the seller does not list or disclose. You should verify that there are no additional debts with vendors, banks, other loan providers, or any other undisclosed amount.
3. Check the income and expenses of the company:
Sales – Request a list of all sales transactions in the last 3 years. Check them out. Request documentation of the most important: Customer Purchase Orders, Invoices, Delivery Notes and Receipts. Make sure the customer has actually paid for the transactions and if not, it will be paid according to the credit terms of the company. Compare the total sales for the three years to see if the business is growing, declining, or stagnant.
Expenses: request a breakdown of each expense. You must first focus on purchasing inventory. See how much the products cost, how much they sell for, and what the profit is on each item. Track inventory purchases through the sales transaction to see the complete cycle. After inventory purchases, go through all other expenses to verify the authenticity of each transaction. A partial list of expenses includes:
– Salaries and benefits
– Marketing and sales
– Rent and utilities
– Legal and Accounting
– Office supplies and expenses
– Interest and financing charges
– External service and subcontractors
As with liabilities, you should look for unrecorded expenses to understand the actual and actual expense rate of the business so you don’t have any surprises down the road.
Buying a business is a great investment that you make. To make sure “what you see is what you get,” you need to perform due diligence.
This article describes ways and points to focus on when conducting due diligence.
And, as always, there is no substitute for hiring a professional who understands due diligence and has the right experience. When buying a business, you really need to consult with an accountant and make sure you cover all the bases.