Due Diligence for Buying a Business

Katie Fleming

Katie Fleming

Co-founder and COO of Owner Actions

An attorney and a business buyer review documents to complete due diligence before completing an acquisition

In the due diligence process, you’ll review the ins and outs of the business you intend to buy. You’ll gather the records and reports you need to assess its financial strength, verify the owner’s claims, and ensure that you know exactly what you're buying into.

A good accountant and attorney are a must for the due diligence process. Here's why:

  • Your accountant will help you work through the business’s financials, spot discrepancies, and find red flags.
  • Your attorney will help you make sense of the documents you’ll need to sign, decide how to structure your purchase, and 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.

Next, the seller will share the business’s financials, founding documents, procedures, and HR data you need to fully assess the business. You’ll be granted time to review this information. Your review could take a few weeks or several months depending on how complex it is and the questions you have about it.

 

Which business documents will I need for my due diligence assessment?

Here are some of the items you'll want to review:

  • Founding paperwork, including the business’s articles of organization or articles of incorporation
  • Valid permits and business licenses
  • Proof of 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 records, which should include tax returns, balance sheets, profit-and-loss statements, sales records, debt disclosures, payroll data, 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 valuations
  • 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 through every form and record you receive and share them with your accountant and attorney. Together, you’ll try to determine whether this business is one to invest in.

 

Your accountant's role

Your accountant will review the financial health of the business. This pro will look for consistencies among accounts, assets, and liabilities; point out 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 Review 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 request that the seller insures the business’s outstanding receivables. You may want to make this same smart move.

Line arrow: Rotate right Find 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 Look into whether the owner used business accounts to cover personal needs. If so, your accountant can adjust those expenses out of the numbers to create a better picture of the business’s cash flows and profitability.
Scatterplot Study sales patterns to see 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 the business’s sales volume.
Warning Look through reported and unrecorded liabilities, including employee benefit claims, settlements, liens, and uses of assets as collateral.
Monthly calendar Sum up the age of the business’s accounts receivable and study the payment patterns of the business’s top accounts.
Daily calendar Find the age of the business’s accounts payable to learn how quickly bills are paid and determine whether there are any liens on its outstanding payables.
Dollar Compare the employee wages to industry standards.

 

Your attorney's role

Your attorney will focus on legal and regulatory work. Here are some of the key tasks you can expect this pro to take on:

 

Clipboard Checked Ensure that the business is legally registered in the state(s) of operation.
Contract Study key documents, contracts, and agreements that legally bind the business and whether the business complies with them.
Folder Search Make sure that the business’s intellectual property has been filed correctly and will be included in the sale of the business.
List Read through the terms of real estate leases and learn whether they are transferable to a new owner.
Scales of justice Study past legal issues, including claims of wrongful terminations, settlements, disputes over intellectual property, or outside investigations, 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 whether there are any legal ramifications to them.
Diploma Certify that you'll be relieved of any debts that the current seller owes, including federal and state taxes.
Scribble Draft a covenant not to compete to prevent the seller from starting a competing business.

 

Your role

You’ll play an important role in the due diligence process, too. Besides working with your accountant and attorney, you’ll study the business's operations, customer data, employee structure, and competitive positioning. Here are some of the tasks you'll complete:

 

Closed book Review the business's procedures and protocols.
Help Ensure that the facilities meet safety and health requirements.
Boardroom Review the business’s insurance coverages and make sure that they're sufficient.

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.more on the business due diligence process

Open book Learn what the business does to attract customers.
Group of men Look into the current customer base, customer attrition rates, and common buying patterns.
Target Audience Find out if any customers have a significant connection to the owner and whether they'll stay with the business after it changes hands.
Review its price lists and compare them to those of its key competitors.
Business Growth Study how customers responded to past price increases.
City Find out what's going on in the business’s industry and with the local pool of buyers.
Address Book Obtain a list of the business’s employees, contract workers, union agreements, contracts, and the policies that pertain to them.
Viral Read Glassdoor, blogs, and other reviews to learn about employees’ experiences and perceptions of the business.
Podium Look into the business’s competitive positioning and scan for opportunities and threats that may cause it to shift.

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Internet Studying search results and social media reviews of the business.
Ribbon Make sure the business is in good standing with the Better Business Bureau, licensing agencies, industry associations, credit bureaus, and the local police station.
Chat Ask customers, suppliers, and others (when permitted) about their experiences with the business.

Because of the magnitude of work required, 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.

Here are a few accounting firms other business owner love using:

 

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Need help finding an attorney? Consider working with Contract Counsel. Check out their website here.

 

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

Problems can exist in every part 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 discourage you from moving forward with 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 and your team will learn a great deal about the business you intend to buy. The knowledge you gain 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 element 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 to account for lower valuations in inventory, disagreements about add-backs, or the discovery of unforeseen issues. Our article on renegotiation can help you work through the most important steps.

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Be sure to provide the seller with a thorough explanation of any changes you make to your offer price, and after agreeing to a final purchase value, ask your attorney to draft a formal purchase agreement.

 

What’s next?

Once you wrap up the business due diligence process and agree on the terms of your sale, you'll take on another key task: firming up financing. Log into your owner’s portal for a free step-by-step guide to work through the acquisition steps and prepare to run your new business.

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