One of the final phases of buying a business is due diligence. By this point, you’ve made an offer to purchase a business. You’ve already met with the owner, reviewed the financials and the opportunity seems ideal. After negotiating back and forth, the two of you finally agree on a deal. Yet, the deal is subject to certain contingencies before it is finally closed.
What is due diligence when buying a business?
Due diligence is the process of verifying the information about the business, as provided by the seller, is correct and accurate. Due diligence is, in almost all sales, a condition of the buyer’s offer. The business conditions must meet the buyer’s expectations before the deal is finally closed. If there are any problems uncovered, this is the time they must be addressed.
What should be included in a due diligence checklist?
A due diligence checklist should cover several aspects of the prospective business, including financial documents, legal issues, operations, employee relations, as well as all assets, products and customer data. Due diligence is a complex process and should not be conducted without the assistance of your accountant and attorney.
1. Review and verify all financial information.
This includes audited financial statements over the last three years. Keep in mind that most small business financials have been compiled by the seller with the goal of minimizing taxes, so they will need to explain everything in detail, including the owner’s benefit (SDE) and cash flow. Your accountant should meet with the seller’s accountant to review, verify and possibly recast all the numbers.
- Financials: Income statements, cash flow statements, balance sheets, general ledger, accounts payable and receivable
- Credit report
- Tax returns for at least the past three years
- All debts, their terms and any contingent liabilities
- Analysis of gross profit margins
- Analysis of fixed and variable expenses
- Gross profits and rate of return by each product
- Inventory of all products, equipment and real estate, including total value
2. Review and verify the business structure and operations.
Take a closer look at how the business is structured and how it makes its money. Any information about competitors, market penetration or trends in the industry could be useful in determining the company’s future earnings potential. This is your opportunity to review and verify the business model, customer base, products and services, as well as labor, materials and operational costs.
- Company’s articles of incorporation and amendments
- Company’s bylaws and amendments
- Summary of current investors and shareholders
- All company names and trademark brand names
- All states where the company is authorized to do business
- All products and services, including production cost and margins
- Business compliance requirements
- Marketing plan, customer analysis, competitors, industry trends
- Company’s brand identity, including logo, website and domain
3. Review and verify all material contracts.
Does the business have any partnerships or joint ventures with other companies? Does the business have any existing loan agreements, lines of credit, equipment leases or other indentures? Find out what obligations or agreements are in place that you may be expected to comply with or respond to that are part of doing business.
- All nondisclosure or non-compete agreements, any guarantees
- Company purchase orders, quotes, invoices or warranties
- Security agreements, mortgages, collateral pledges
- Letters of intent, contracts, closing transcripts from mergers or acquisitions
- Distribution agreements, sales agreements, subscription agreements
- All loan agreements, material leases, lines of credit or promissory notes
- Contracts between officers, directors or principals of the company
- Stock purchase agreements or other options
4. Review and verify all customer information.
Review all customer lists and databases. Find out who are the largest customers in terms of sales, as well as what they’ve purchased over the last 2-3 years. How are these customers acquired and retained? Are they on renewable subscription agreements?
- All customer databases, subscriber lists and sales records
- Copies of standard communications and correspondence
- All advertising programs, marketing programs and events
- Purchasing policies and refund policies
- Any customer research data, white papers or research
- All attorneys and law firms representing the company, area of practice
- Pending litigation or threats of litigation
- Any unsatisfied judgements
- All insurance coverage and policies
- All professional licenses and permits
5. Review and verify all employee information.
Ask for the company’s employee roster and an organizational chart. Find out who the key employees are and what their responsibilities entail. This may be an important opportunity to find out if any employees plan to leave the company after it’s sold and if you should offer them some sort of incentive to stay.
- Employee roster and organizational chart
- Employee contracts and independent contractor agreements
- Payroll information and employee tax forms
- Human resources policies and procedures
- Employee benefits, retirement plan and insurance
6. Check for any legal issues.
Are there any outstanding legal issues or ongoing litigation that you need to know about? Who represents the company? Does the company have proper insurance in place? Does the company have all the proper licenses and permits in place?
7. Review and verify all physical assets and real estate.
Get a full inventory of all the company’s property and its current market value, including automobiles, equipment, real estate and inventory.
- Real estate, including office locations, warehouses, current leases and titles
- A schedule of all fixed assets, including product inventory, furniture, fixtures and equipment
- Any automobiles or boats
8. Review and verify all intellectual property.
This includes trademarks, copyrights, patents or other exclusive intellectual information that is owned by the company.
- All company’s patents, trademarks and copyrights
- Product inventions, formulas, recipes, or technical know-how
- All rights owned data and digital information
- All work-for-hire or consulting agreements
Due diligence is a very detailed process that will give you a much clearer and more well-rounded picture of the company you are about to purchase, whether or not the asking price is fair, and its future earning potential. With the assistance of an experienced business broker, as well as your attorney and accountant, you should be able to uncover any problems or issues and make a sound decision as to whether or not to purchase the company.
Article written by BizBuySell Team