The Importance of Due Diligence When You're Buying a Business

You don't want any nasty surprises.

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Buying a business involves a lot of twists and turns, but no part of the process is more important than completing due diligence. 

An article from Taxify tells the story of the sale of an Amazon business. The sale was going well when the due diligence process revealed a critical problem—the business had failed to collect sales taxes from buyers.

The liability was $70,000 in uncollected sales tax for which the buyer would have been liable. Needless to say, that stopped the deal in its tracks until the sellers agreed to pay the sales taxes out of pocket. 

Due Diligence—An Overview 

Due diligence is the process of evaluating a business from all aspects before making a purchase decision. It's often performed when buying a business but there are many other situations in which due diligence might be necessary as well. It's a big factor in private equity funding through venture capitalists and it's part of the purchase of real estate, particularly in checking the legal history of the property. 

Due diligence is not a general investigation. It includes specific elements that can vary based on the situation and the nature of the business. Due diligence protects both parties but primarily the purchaser. It can uncover potential liabilities and financial matters and make sure nothing is hidden.

What Does the Due Diligence Process Involve?

The process of due diligence requires the involvement of both the principal—the buyer or investor—and his accountant and attorney. It's usually performed after the intent-to-purchase documents have been signed but before a formal purchase agreement is entered into. 

You should examine all business records and documents during due diligence. Look at all those that might incur liability for the company, including sales agreements, purchase agreements, and liens on assets. Examine documents relating to any ongoing or potential lawsuits and recent litigation that has concluded. Your attorney can help with this. 

Spend time at the business location talking to managers, executives, and employees. Check sales against customer lists to verify that the business does indeed have the customers it says it does.

Look at potential future plans for expansion as well as the condition of facilities and property. This might include equipment, furniture, and fixtures. Verify that they're as reported.

The most important aspect of the due diligence process is taking note of discrepancies between what is reported and what is actually going on. Ask lots of questions. If you don't get satisfactory answers, ask again and ask why. It's sometimes necessary to prove the negative as well as the positive. Remember, if something doesn't seem right, it probably isn't.

What's Included in the Process

Although the subjects involved in the due diligence process can change based on the situation, they often include the following.

General Company Information

A history of the company, its original and any succeeding business plans, the company's mission statement, and short-term and long-term goals and objectives should all be made available for your review.

Company Management and Employees

Who is in charge of the company? What are their credentials? What experience do they have? Are they honest and trustworthy? 

Try to get an organization chart. Get the resumes of executives and board members as well as copies of any employment contracts. Information about company advisors—legal, financial, insurance, and other—should be disclosed. Background checks should be performed on all top executives and board members.

The employee handbook and other documents relating to employee pay and benefits should be reviewed, as well as employment tax reports including Forms 941, Form 940, and others for both federal and state taxing authorities. Check the status of independent contractors to make sure they're correctly classified.

Legal Matters

An investigation of the legal structure of the business might include viewing copies of the articles of incorporation, bylaws, minutes of meetings, and other formation documents that have been filed with the state. Other legal documents would include copies of contracts and agreements that bind the company, warranties/service agreements on company products, and any product liability documents.

A discussion of current or pending litigation should also be undertaken, as well as any relationships with regulatory agencies like OSHA for worker safety law, Americans with Disabilities law, or industry-specific organizations.

Products and Services

If the company sells products, you'll need a catalog or listing along with information regarding the competitiveness of these products. Brochures and price listings for products and services must also be reviewed. Pricing strategies, service availability, and terms of service are necessary. Documents relating to company patents, copyrights, and trademarks must be provided, as well as licenses owned by the company and agreements with licensees.

Marketing and Competition Information

These documents include the company's marketing plan, market analysis, growth opportunities, a SWOT analysis, and purchase agreements. Information about the competition might include lists of major competitors and an analysis of the competition, present and future.

Customers: Information about customers includes a review of agreements with major customers and accounts receivable aging reports.

Operations: Review fixed assets, facilities, equipment, product quality assurance and safety, suppliers, and contracts. Inventory is often taken and inventory costing LIFO and FIFO should be considered.

Financial matters: Most important to the due diligence process are the company's financial records. These include balance sheets and income statements for past years, projected financial statements, insurance coverage, tax filings, and sources and uses of funds statements.

Verify profitability and check company financial data against common financial ratios. Check owner income against business profits. If the business is a corporation, verify shareholder dividends and K-1 forms.