What Is Due Diligence?

Due Diligence Explained in 5 Minutes or Less

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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, the research and analysis done before you sign a purchase agreement for a business.

An article from tax software brand Taxify tells the story of the sale of an Amazon reseller 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.

Definition of Due Diligence 

Due diligence in general is the care that a reasonable person takes to avoid harm to others or their property. In business, due diligence is a specific process that someone goes through to examine a business transaction before the deal closes.

Types of Due Diligence

The most common type of due diligence is part of the process of buying a business. Here are some other situations in which a due diligence process might be necessary:

  • Private equity funding through venture capitalists.
  • Purchase of real estate, particularly in checking the legal history of the property.
  • Environmental due diligence to assess the business's environmental impact and liabilities.

How the Due Diligence Process Works

The process of due diligence requires the involvement of both the the buyer or investor and their accountant and attorney. It's usually performed after an intent-to-purchase agreement has been signed, but before a formal purchase agreement with exchange of assets and funds is entered into. The letter of intent is a non-binding document that each party signs to allow the due diligence process to begin.

As due diligence begins, it's time to get external advisors involved in the process. You may want to hire a business appraiser to look through all business records to give you an estimate of the business value, an attorney to look at legal matters, and a CPA to review accounting records.

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.

Here's an overview of the areas of the business to be reviewed during the due diligence process. The specifics of the process will vary for each specific situation.

Lawsuits and Court Rulings

Check documents or other information that might incur liability for the company, including judgments (court rulings) against the company or liens on assets or taxes. In addition, examine documents relating to ongoing or potential lawsuits and recent litigation in which there might be a contingent liability (one that has the potential to be costly to the business).

Financial Processes and Documents

In terms of financial processes and document analysis, here are some steps to follow:

  • Get at least three years of information about financial statements, accounting practices, income. liabilities, and inventory management.
  • Pay particular attention to accounts receivable (money owed to the company by customers).
  • Look at previous tax returns.
  • Verify financial data against common financial ratios, as well as shareholder dividends and distributions to owners,

Company Management and Employees

When you're doing due diligence on a company's workforce, try to get an organization chart, 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.

Do background checks on all top executives and board members.

Review the employee policy manual and other documents relating to employee pay and benefits, 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 Structure

From a legal perspective, it's key to view copies of the articles of incorporation, bylaws, minutes of meetings, and other formation documents that have been filed with the state. As part of your analysis, also review other legal documents like contracts and agreements that bind the company and warranties/service agreements on company products.

Products and Services

If the company sells products, you'll need a catalog or listing along with information regarding the competitiveness of these products. Also, look at brochures and price listings for products and services, and get pricing strategies, service availability, and terms of service if possible. Documents relating to company patents, copyrights, and trademarks, are important, as is remembering to include licenses from others and licenses given to others.

Marketing and Competition Information

Review the company's marketing plan, market analysis, growth opportunities, and purchase agreements.

The customer base of a business is a key factor in its value, so take time to be sure that the customer list is up to date and only includes active, paying customers. Check accounts receivable aging reports to see how much customers owe.

In addition, perform a SWOT analysis, and get information about the competition and lists of major competitors.

Facility, Supply, and Inventory Analysis

Last but not least, review fixed assets, facilities, equipment, product quality assurance, and safety, suppliers, and contracts. Meanwhile, inventory is often taken and last-in, first-out (LIFO) and first-in, first-out (FIFO) costing methods should be considered.

Key Takeaways

  • Due diligence is a process of evaluating a company or real estate before purchase.
  • To begin the process, the parties sign a non-binding letter of intent.
  • All areas of the company are included in the due diligence process.
  • It's important to look for discrepancies and potential liability and to verify value.