Business Brokers Blog: Guide to Buying or Selling a Business

Performing Due Diligence When Buying a Business

Due diligence is a very important step of the buying a business process.  As a buyer, you want to verify the information that the seller has provided that relates to the business operations, its financials, and legal status.  The process of due diligence verification of information occurs after the letter of intent is signed by both parties in the transaction.  The letter of intent usually sets the period of time for the due diligence to be completed.

The due diligence process usually takes place in two steps.  First, the buyer provides a written list of information needed to review.  Second, an onsite verification is often completed to verify some of the information that was provided in step one.

The legal due diligence is typically the easiest of the three sections.  When buying a business, most legal questions relate to asking for and supplying documents.  When something is found that needs explanation or is incomplete, the attorneys will determine the necessary fixes to correct the issue.  Typical requests for information include corporation documents, past or present litigation issues or threatened issues, contracts, and insurance coverage documentation, amongst other requests.

Financial due diligence is usually more complex due to the complexity of small business financial statements.  The buyer and their professional advisors need to ask questions to get an accurate understanding of the accounting methods used in creating the financial statements.  Though public companies have audited financial statements, most small business do not have the size of business to warrant the expense of audited statements.  Income statements, balance sheets, and cash flow statements are almost always requested during due diligence.  When buying a business, tax returns are also requested to verify reporting.  A detailed breakdown of the owner’s discretionary earnings is important to document the seller’s true profit.  Other breakdowns that may be requested include accounts receivable and payable reports, customer and vendor reports, inventory reports, an asset depreciation list, trial balance and general ledgers.  Breakdowns by various periods may also be requested to understand seasonality affects which is useful for determining cash flow needs which may affect the line of credit requirements.  Other detailed reports may also be requested in regards to sales and backlog, employee compensation, and leases, to name a few.

Due diligence on operations can also be very involved.  Depending on the complexity of the business operations, its size, and number of employees, this process can take some time to complete.  A buyer needs to understand the employee related issues such as compensation and roles, as well as review personnel manuals and employee handbooks.  Other documents need to be reviewed such as licensing agreements, distribution agreements, supply contracts, and forms used in operations.  The buyer also has to do their own due diligence on the industry and compare the findings to the business opportunity at hand.

When buying a business, there will always be things that are uncovered during due diligence that the seller may or may not have known that could affect the transaction.  In many cases, these issues can be worked out when a buyer and seller, along with their advisors, are cooperative.  The fastest way to end a deal is to not be flexible as some issues pop up.  Small issues usually involve some give and take from both parties and the transaction will stay on track.  Major findings during due diligence could result in a dead deal or a deal that gets renegotiated.