Purchasing a business is a significant investment with inherent risks. Due diligence is the investigation you undertake to understand what you are buying. It is a review of a company’s finances, legal standing, operations, and market position to confirm a seller’s claims and uncover potential liabilities. This allows a buyer to assess the business’s value and mitigate the risk of surprises post-purchase.
Assemble Your Due Diligence Team
A business acquisition requires a team of qualified professionals. The transaction’s complexity dictates your team’s size, but two roles are central: a certified public accountant (CPA) and a business attorney. These experts bring specialized skills to the evaluation.
The accountant’s primary function is to scrutinize financial information. They dive into financial statements, tax records, and accounting practices to verify the seller’s claims of revenue and profitability. This financial verification is important for understanding the business’s health and true value.
Your business attorney focuses on the company’s legal and administrative aspects. They review corporate documents, contracts, leases, and permits to ensure legal compliance. The attorney also searches for existing or potential litigation that could create future liabilities.
Conduct Financial Due Diligence
Financial due diligence verifies the seller’s claims about profitability and ensures the company’s economic stability. Your accountant will lead this effort by examining several years’ worth of financial records. Understanding the following documents is important for you as the buyer.
- Profit and Loss (P&L) Statements: Review P&L statements for the last three to five years, looking for consistent trends in revenue and profitability. Scrutinize expenses for one-time costs or personal owner expenses that should be removed to show true operating costs.
- Balance Sheets: This provides a snapshot of the company’s assets, liabilities, and owner’s equity. Analyze this to understand what the business owns versus what it owes, paying attention to asset quality and outstanding loans.
- Tax Returns: Compare the business’s tax returns to its P&L statements for the same period. Discrepancies can be a sign of unreliable financial reporting and require further investigation.
- Cash Flow Statements: This statement shows the actual cash moving through the business and demonstrates its ability to cover debts, pay expenses, and fund operations. A business can show a profit but still have poor cash flow.
- Accounts Receivable and Payable: Review the accounts receivable aging report to see how long it takes customers to pay. Also, examine accounts payable to understand the company’s obligations to its suppliers.
Perform Legal and Administrative Due Diligence
Legal and administrative due diligence focuses on the company’s corporate structure and adherence to laws, uncovering risks that could become your problem after the purchase. Your attorney will first examine formation documents, like articles of incorporation and bylaws, to confirm the company is compliant with state requirements. This also verifies the seller has the legal authority to transfer ownership.
A review of all existing contracts and agreements is also necessary. This includes property leases, loan agreements, and contracts with customers and suppliers, as their terms will become your obligations. The review should also confirm the business holds all required permits and licenses to operate legally. A search for any past, pending, or threatened litigation is conducted to ensure you are not inheriting a lawsuit.
Review Operations and Physical Assets
This review assesses the tangible and procedural elements of the company, from its daily functions to the condition of its property. The goal is to evaluate the efficiency of its processes and physical assets.
A primary task is to create a detailed inventory of all physical assets, including furniture, equipment, technology, and vehicles. You should inspect these items to assess their condition and whether they may require repair or replacement. For businesses with inventory, review how it is managed and valued to identify any obsolete stock.
This phase also involves examining operational processes. Look at how the company manages its supply chain and the stability of its supplier relationships. Reviewing documented procedures for sales, service delivery, and internal workflows provides insight into the business’s efficiency.
Analyze Customers and Market Position
A business’s value is tied to its revenue streams, making an analysis of its customer base and market position necessary. This investigation assesses the health of customer relationships and the company’s competitive standing to evaluate risks to future sales.
Investigate customer concentration. If a large percentage of revenue comes from a few clients, the business faces a risk if one of those customers leaves. Analyze sales data to identify top customers and understand the strength of those relationships.
It is also important to gauge customer satisfaction and the business’s reputation by reviewing online reviews, testimonials, and complaints. Understanding how the company is perceived provides insight into its brand strength. This helps determine if the customer base is a solid asset or a vulnerability.
Investigate Human Resources
A human resources investigation focuses on the workforce to understand the organizational structure, identify key personnel, and uncover employee-related issues. This review provides a clear picture of the team you would be inheriting.
Start by reviewing the organizational chart to understand roles and reporting structures. Identify any “key employees” whose departure after the sale could impact the business’s performance. Understanding the motivations of these individuals is part of assessing operational risk.
Your review should also cover all employment-related documentation. This includes employment agreements, compensation structures, employee handbooks, and records of any employee disputes. Examining employee benefit plans is also necessary to understand the full cost and administrative burden of the workforce.
Identify Critical Red Flags
Some findings during due diligence are serious enough to be considered deal-breakers. These red flags are warning signs that the business may have deep-seated problems that could make the acquisition a poor investment.
A significant red flag is a seller’s unwillingness to provide requested documents or information. This lack of transparency often suggests they are hiding something. Another major issue is a discrepancy between the financial statements and the company’s tax returns, which can indicate unreliable financial reporting.
Other serious warnings include a heavy concentration of revenue from a single customer without a long-term contract. The discovery of undisclosed lawsuits, significant employee turnover, or key employees who plan to leave upon the sale also represent substantial risks. Recognizing these red flags allows you to renegotiate the deal or walk away.