Buying a Business 101: What Does Due Diligence Mean?
Author: Elliott Holland
Your offer to buy a business should always be contingent on what the due diligence process uncovers
Key Takeaways
Due diligence is one of the final phases of purchasing a business
The deal's finalization should depend on what due diligence discovers
This process involves verifying financials, legal issues, asset treatment, physical condition, and operations
Due diligence is complex and requires the assistance of an industry professional
Purchasing a business is a stressful experience because there's always a risk. Even a seemingly successful company could have some skeletons in the closet that prevent its long-term success and leave you holding the bag.
Learning what you're getting into before making this investment is essential because taking information from the seller as the truth without verification could put you in a challenging position.
That's where due diligence comes in. This process is a way to verify the information you've acquired during the initial phases of the purchase. As a result, learning what due diligence means and how it works is an important part of buying a business.
This article will help you understand what due diligence means and why you don't want to overlook it when buying a small or medium-sized business.
What does due diligence mean?
Due diligence involves reviewing and verifying information you've received or researched when vetting a business to purchase. You’ll want to carefully analyze this data to ensure everything is accurate (and meets your business needs) before completing the deal.
Information you'll want to vet includes:
The company's financial standing
The condition of the organization's assets
Any potential legal issues
The business's employee relations
The company's customer list
Due diligence can eliminate many potential surprises you might uncover later, reducing your risk when buying a business.
When to begin due diligence
You'll typically wait until just before closing your purchase before beginning the due diligence process. By the time you start, you should have a deal in place that's contingent on what your due diligence discovers.
However, the seller shouldn't be surprised by this condition. Your letter of intent should make it clear the due diligence phase is essential to your purchase agreement.
Eight steps to complete due diligence
You’ll need to complete several steps during your due diligence process to ensure you have a clear picture of the company you want to buy. It's often impossible to learn everything you need to know during the buying window without assistance, but having a professional verify as much information as possible can help limit your exposure. Here are the steps you’ll want to complete:
1. Verify financial information
The most crucial aspect of your due diligence is verifying the company's finances, including audited balance sheets, income statements, cash flow statements, accounts payable, and accounts receivable. You'll also want to look over credit reports, tax returns, debt, gross profit margins, fixed and variable expenses, inventory, and profits. Remember to gather detailed information on the owner's benefit, as well.
2. Review the business's structure and operations
Next, examine how the company is structured and its method for making money. This step could include verifying the organization's bylaws and learning about investors, shareholders, trademarks, production costs, compliance requirements, and alternate company names. Also review where the company can do business, its marketing plan, and its brand identity.
3 Check for legal problems
If the company you're purchasing has any legal issues, you'll want to learn about them. Ongoing litigation could quickly turn your venture into a nightmare, so researching this aspect is essential. You’ll also want to find out who represents the company and whether they have the proper insurance, licenses, and permits.
4. Verify all contracts
The company you're buying could have partnerships or joint ventures with other parties, so you'll want information on those before finalizing your agreement. You'll also want to uncover any noncompete or nondisclosure agreements, standing purchase orders or quotes, mortgages, letters of intent, sales agreements, loans, equipment leases, and stock purchase options. If the company has a legal contract with another party, you should know about it.
5. Confirm customer information
The business you want to buy will likely have a customer database you can review before signing a deal. This information should inform you of subscriber lists, communication expectations, marketing programs, purchasing policies, and customer research data. You'll also want to look into any unsatisfied judgments and legal issues involving customers while verifying the insurance in place will cover them.
6. Review physical assets
Getting a complete inventory of the business's physical assets is another vital part of due diligence. These assets include real estate, furniture, fixtures, equipment, and vehicles. You'll need to verify condition and market value before finalizing a deal.
7. Verify intellectual property
Intellectual property – like trademarks, copyrights, and patents – is just as important as physical property. Be sure to learn about the company's product inventions and formulas, and review the rights-owned data. This step helps ensure the company owns the data it's using.
8. Learn employee information
Employee relations are vital for any business, so examining the company's employee roster and organizational chart is necessary. This will reveal any employee and independent contractor agreements in place while providing insight on payroll, human resources policies, and employee benefits.
As you can see, due diligence is a detailed process that verifies a significant amount of company information. The purpose is to provide you with a well-rounded view of the organization before you purchase it, making your success more likely.
Get the due diligence assistance you need
You want to feel confident with your investment, and completing thorough due diligence can give you peace of mind. However, researching a company from top to bottom takes time and expertise, which you might not have. Fortunately, investors looking to purchase small and medium-sized businesses can get help.
Guardian Due Diligence has the knowledge and experience to assist with the due diligence process. We focus on providing these services to first-time and self-funded buyers, minimizing your risk as you make this life-changing decision. To learn more about the process, download a sample due diligence report. You can also reserve a free deal and letter of intent review session at www.offerfromelliott.com.