Congratulations. You have just decided to buy a business, merge with another business or invest in someone else’s business. 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 to run it better than the previous owner.
It doesn’t matter if you buy a small mobile phone shop, a big high tech company or invest in a 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?
A (very technical and tedious) definition of a due diligence is: Due diligence can either be narrowly applied to the process of verifying the data presented in a business plan or sales memo, or broadly as ending the research and analysis process underway. ahead of a commitment to Invest. The purpose is to determine the attractiveness, risks and problems of a potential investment transaction. Due diligence should enable investment professionals to carry out an effective decision-making process and optimize the terms of the agreement.
In reality, due diligence is a process where potential buyer (or investor) investigates, analyzes, questions and attempts to learn as much as possible about the purchased business to check 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 important that every buyer will verify this information before making the final commitment to invest.
How “due diligence”?
There are several aspects of the business you control:
Technology and patents owned by the company
Business development and financial situation
Usually, you should contact the company attorney and ask for a letter containing all the legal action and claiming that the company is a party. The goal here is to understand the legal risks the company faces: Are there any lawsuits against the company that could end? in a judgment against it? What is the maximum exposure? How much will the attorneys charge to represent the company?
With the lawyer’s letter and the relevant information, you can go to the next level and hire your own team to review the data and get a different opinion on these legal issues.
You must also request copies of any agreements, contracts or other binding understanding that the company has with third parties. Here is a partial list:
Licenses and royalties
Technology and patents
If you buy the company partly because of its technology or patents, consider the following:
Is the technology or patent actually registered on the company name?
In what jurisdictions?
When does registration expire?
Is it developed by the company or can a third party claim ownership of the technology / patent?
Request copies of all registration applications.
Once you have gathered all the information about the technology / patents, you can:
Retain a specialist who can assess the value of the technology
Keep a patent attorney to ensure the validity of the patents
Business development and financial situation
Most business sales transactions are based on either business income / profit over the last few years or the business assets and liabilities at the date of purchase.
Therefore, it is extremely important to do a financial due diligence on the company before the agreement is concluded.
What to do in a financial due diligence?
1. Check the company’s assets:
Cash – Request all bank statements, small cash, and all other locations where cash is contained. See if the total number matches the seller numbers.
Receivables – Ask for a list of all customers who owe money to the company. See how long they haven’t paid. Ask if there is a dispute with any of the customer and how much of the total amount owed will actually be paid (based on the seller’s beliefs?) Focus on large sums and overdue accounts. If it is over 60 days, it should be checked out. Call customers to check that their balance matches seller balance.
Inventory – Ask for a complete list of inventory. Count the actual inventory and see that it matches the list of business inventory. Ask for usage information how much of each item is shipped each week / month. If the quantity dispatched is very low, it may indicate that this is a slow moving item and that its value is minimal.
Other Assets – Request a complete list of all other assets owned by the company. Identify assets, locations and market value.
2. Check the company’s assets:
Payments – Ask for a list of all suppliers to which the company owes money. Check the validity of the underlying transaction. Make sure the products they supposedly deliver were actually delivered and in good working order. Is installation delivered? What are the payment terms?
Banking and other loans – Ask for loan agreements. Check the payment schedule, go back and track past payment, and check that the outstanding balance is correct. Inquire about the interest rate and terms of the loan and can it be refinanced to a lower interest rate loan? Learn if the loan is collateralized and with what assets?
Other Obligations – Request a complete list of all other obligations. For each one, run the same queries as we have suggested for payments and loans.
Note – A very important goal of due diligence is to find out if there are obligations that are not listed or disclosed by the seller. You must verify that there are no additional debts to suppliers, banks, other loan providers or other undisclosed amounts.
3. Check the company’s revenue and expenditure:
Sales – ask for a list of all sales transactions for the last 3 years. Go through them. Ask for documentation for the largest ones: Customer purchase orders, invoices, shipping notes and receipts. Make sure the transactions have actually been paid by the customer and if not they will be paid according to the company’s credit terms. Compare total sales over the three years to see if the business is growing, falling or stagnating.
Expenses – Ask for a breakdown of each expense. You must first focus on stock purchasing. See how much the products cost, how much it is sold for and what is the profit on each item. Track purchase of sales transaction inventory to see full cycle. After inventory purchases, all other expenses are reviewed to verify the authenticity of each transaction. A partial list of expenses includes:
– Salary and benefits
– Marketing and sales
– Hire and utilities
– Legal and accounting
– Office expenses and supplies
– Interest and finance fees
– Outside service and subcontractors
As with commitments, look for unrecognized expenses to understand the true and actual rate of expense for the business so that you have no future surprises.
Buying a business is a huge investment you make. To ensure that “what you see, what you get”, do a due diligence.
This article describes ways and points to focus on when performing due diligence.
And as always, there is no substitute for retaining a professional who understands due diligence and has the right experience. When buying a business, you really need to consult an accountant and make sure you cover all the bases.