Buying A Business? Think Due Diligence

Congratulations. You have just decided to purchase a business, merge with another company or invest in a someone else’s company. Exciting, isn’t it?

You have probably been busy learning the business, talking to the seller about the operation, conducting market research and planning how can you run it better than the previous owner.

It does not matter if you are buying a small cell phone store, a large high-tech company or investing in a pre-ipo due diligence services friend’s “next big thing”. There is one thing you should seriously consider: a due diligence.

What is a due diligence and why is it so important?

One (very technical and boring) definition of a due diligence is: Due diligence can apply either narrowly to the process of verifying the data presented in a business plan or sales memorandum, or broadly as completing the investigation and analytical process that precedes a commitment to invest. The purpose is to determine the attractiveness, risks, and issues regarding a transaction with a potential investment. Due diligence should enable investment professionals to realize an effective decision process and optimize the deal terms.

In reality due diligence is a process in which potential buyer (or investor) investigate, analyze, inquire and try to learn as much as possible on the purchased business in order 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 will verify that information before making the final commitment to invest.

How do you “due diligence”?

There several aspects of the business you should check:

Legal exposure

Technology and patents the business own

Business performance and financial position

Legal

Usually you need to contact the business’s lawyer and ask for a letter listing all the legal actions and claims the business is a party to. The goal here is to understand the legal risks that the business is facing: Is there any legal action against the business that could end in a judgment against it? What is the maximum exposure? How much will the lawyers charge to represent the business?

With the lawyer’s letter and the 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 ask for copies off all agreements, contracts or other binding understandings the business has with third parties. Here is a partial list:

Employment contract

Shareholders agreement

Leases

Purchasing agreement

Clients agreement

Licensing and royalties

Loan agreements

Technology and patents

If you are buying the business partially because of its technology or patents, you should assess the following:

Is the technology or patent actually registered on the business name?

In which jurisdictions?

When does the registration expire?

Has it been developed by the business, or does a third party could claim ownership of the technology / patent?

Ask for copies of all registration applications.

Once you have collected all the information about the technology / patents you can:

Retain a specialist who can assess the value of the technology

Retain a patent lawyer to assure the validity of the patents

Business performance and financial position

Most business sale transactions are based on either the business income / profits in the past few years, or the business assets and liabilities on the purchase date.

Therefore, it is extremely important to conduct a financial due diligence on the business before finalizing the deal.

What to do in a financial due diligence?

1. Check the company’s assets:

Cash – Ask for all bank statements, petty cash and all other locations in which cash is held. See if the total matches seller’s numbers.

Accounts Receivable – ask for a list of all customers who owe money to the business. See how long they have not paid. Inquire if there is a dispute with any of the customer and how much of the entire amount that owed will be actually paid (based on seller’s belief?) Focus on large amounts and long overdue accounts. If it is over 60 days it should be checked out. Call the customers to verify that their balance agree with the seller’s balance.

Inventory – Ask for a complete list of inventory items. Count the actual inventory and see it it matches the business inventory list. Ask for usage information, how much of each item is being shipped every week / month. If the shipped quantity is very low, it could indicate that this is a slow moving inventory item and that its value is minimal.

Other Assets – ask for a complete list of all other assets that the business owns. Identify the assets, locations and market value.

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