A business buyer and an attorney sit at a desk reviewing documents as part of the due diligence process

The Due Diligence Process for Business Acquisitions

In the due diligence process, you’ll review the ins and outs of the business you intend to buy. You’ll gather the data you need to assess its financial strength, verify the owner’s claims, and ensure that you fully understand the business as it stands today.

You'll need a good accountant and business attorney for the due diligence process. Here's why:

  • The accountant you select will help you work through the financials, spot discrepancies, and find red flags.
  • The attorney you choose will help you understand the documents you’ll be asked to sign to ensure confidentiality, make sense of how your purchase should be structured, and help you negotiate the terms of your deal.

 

You’ll start the due diligence process by signing a non-disclosure agreement (NDA) that the seller’s attorney creates. This document assures the seller that you won’t share any of the confidential information you learn about the business with undisclosed outside parties.

After receiving your signed NDA, you can access the business’s financials, founding documents, operations manuals, and HR information you need to form a complete assessment of the business. You’ll be given time to review this information, which could take as little as a few weeks or several months depending on the complexity of the business and the questions you have about its operations.

 

Which documents will I need for my due diligence assessment?

At a minimum, you should ask the seller for the following items:

  • Founding paperwork, including the business’s articles of organization or articles of incorporation
  • Valid permits and business licenses
  • Proof of relevant trademarks, copyrights, and patents
  • Insurance declarations
  • Real estate documents or lease information that spells out terms and transferability
  • Contracts, including lease and purchase agreements, distribution agreements, vendor contracts, subcontractor agreements, sales contracts, union contracts, employment agreements, and other contracts the business is bound to fulfill
  • Three to five years’ worth of financial information, which should include tax returns, balance sheets, profit-and-loss statements, sales records, debt disclosures, payroll information, and marketing costs, as well as a 30-, 60-, 90-, and greater-than-90-day breakdown of accounts receivable and accounts payable information
  • Organizational charts
  • HR policies and benefit plans
  • Inventory records and valuations
  • Furniture, fixtures, and equipment records and valuation
  • Information regarding closed and outstanding legal concerns
  • A certificate of good standing, which the seller can attain from the Secretary of State in the business’s home state

 

How do I make sense of this information?

You’ll want to read all of the items you receive in their entirety and share them with your accountant and attorney. Together, you’ll study the business’s financial, legal, operational, and HR strengths and weaknesses.

 

Your accountant's role

Your accountant will play a key role in assessing the financial health of the business. This pro will look for consistencies among accounts, assets, and liabilities; identify trends; and form projections about the business. Here are some of the specific tasks your accountant will take on:

 

Checkbox Checked Ensure that the tax returns and financial statements have passed a formal audit.
Upward trend Assess and project the profitability of the business.
Loan Look into the business’s debts and liabilities and advise you of the risks of taking them on.

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A quick tip: Many buyers ask the seller to insure the business’s outstanding receivables. You might consider doing the same.

Line arrow: Rotate right Study the speed of inventory turnover.
Magnifying glass Help you find an appraiser who can advise you on the age, condition, and value of the inventory, furniture, fixtures, equipment, and building(s) offered in the sale.

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A quick tip: You should compare your appraiser’s and seller’s valuations. If you find a discrepancy between the two values, you may want to adjust your purchase price accordingly.

Piggy Bank Find out whether the owner used business accounts to cover personal needs and adjust out those expenses. This will create a more accurate account of the business’s cash flows and profits.
Scatterplot Study sales patterns to determine if the business experiences seasonal sales cycles, whether cash or credit sales seem to be the norm, and whether a small number of client accounts make up the bulk of its sales volume.
Warning Look into the reported and unrecorded liabilities, including employee benefit claims, settlements, liens, and uses of assets as collateral.
Monthly calendar Tally up the age of the business’s accounts receivable and study the payment patterns of its top accounts.
Daily calendar Sum up the age of the business’s accounts payable to confirm how quickly bills are paid and determine if there are any liens on those payables.
Dollar Compare the salaries of the business’s employees and to industry standards.

 

Your attorney's role

Your attorney will take on another set of critical tasks. Here are a few:

 

Clipboard Checked Ensure that the business is legally registered in its state of operation.
Contract Study key documents, contracts, and agreements that legally bind the business and whether the business is in compliance with them.
Folder Search Ensure that the business’s intellectual property has been filed and will be included in the sale of the business.
List Decipher real estate lease terms and see if they are transferable to a new owner.
Scales of justice Evaluate past legal issues and how they were resolved.
Checkbox Checked Ensure that the business fully complies with local zoning and environmental laws.
Magnifying glass Review the business’s list of liabilities and see if there are any legal ramifications to them.
Diploma Certify that you'll be relieved of any debts the current seller owes, including federal and state taxes.
Scribble Draft a covenant not to compete to keep the seller from starting a competing business.

 

Your role

You’ll play an important role in the due diligence process, too. Of course, you'll work with your accountant and attorney and ask the seller for the information your team needs to make its assessments. But you'll also analyze other parts of the business that are key to its success. Here, you'll look into its operations practices, customer information, employee structure, and competitive positioning. Let's look at a short list of the tasks you'll take on:

 

Closed book Study the organization’s procedures and protocols.
Help Ensure that the facilities meet safety and health requirements.
Boardroom Review the business’s insurance coverages and make sure the current coverages are sufficient.

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Open book Study the practices the business uses to attract customers.
Group of men Look into the current customer base, their attrition rates, and their common buying patterns.
Target Audience Find out if any customers have a significant connection to the owner and whether likely to leave when ownership changes hands.
Review the business’s pricelists and compare them to those of its key competitors.
Business Growth Learn how customers responded to past price increases.
City Make sure that the industry shows signs of longevity.
Address Book Obtain a list of the business’s employees, contract workers, and union agreements and the contracts and policies that pertain to them.
Viral Read Glassdoor, blogs, and other outside reviews to learn about employees’ experiences and perceptions of the business.
Podium Study the business’s competitive position and what could alter the competitive landscape.

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Internet Study search results and social media reviews of the business.
Ribbon Assess the business’s reputation to ensure that there aren’t any negative claims or outstanding issues against the business. The Better Business Bureau, licensing agencies, industry associations, credit bureaus, and the local police station are often good sources of information.
Chat Interview customers, suppliers, and others (when permitted) to learn about their experiences with the business.

Lots of work is required, and it’s easy to see why working with an accountant and an attorney is important. If you haven’t already located an accountant or an attorney, get started now.

You can check out some of our favorite accounting firms here:

 

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What are some of the red flags we might find during due diligence?

Problems can exist in every facet of a business. Some of these problems may be relatively insignificant and easy to overcome. Others, including hefty business debts, the need for expensive upgrades, quality issues, or issues with the brand or owner’s affiliation to it, may turn you off from the purchase altogether.

It’s also possible that you’ll find problems in the market that’ll make you shy away from the purchase. Problems like a diminishing market, rising costs of inputs, and strengthening competitors could fall into this category.

 

What happens after our assessment?

Through the due diligence process, you'll learn a great deal about the business you intend to buy. This will help you decide whether you should proceed with the purchase.

Be sure that you don’t rush the process. Take the time you need to review each part of the business thoroughly. Verify every claim and find answers to your outstanding questions.

Based on what you find, you may want to revisit the purchase price you offered the seller in your letter of intent (LOI). It’s not uncommon for buyers to lower an offer price. Many do it to account for lower valuations in inventory, disagreements about add-backs, or the discovery of unforeseen issues. This article can help you work through the most important steps:

 

Talk to the seller about any changes you make to your offer price. Then, after agreeing to a final purchase value, ask your attorney to draft a formal purchase (sales) agreement. Check out this article, which explains this important document.

 

What’s next?

Log into your owner’s portal for articles and advice that’ll help you wrap up these key acquisition steps and prepare to run your new business.

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