Due diligence: Look before you leap

If you’re buying a business, a due-diligence review can help you tell a good deal from a bad one

"Due diligence" is a process by which the prospective buyer of a business gains detailed information about that business’s operations, financial condition and other factors that must be unearthed and analyzed before proceeding with a purchase.

Due-diligence reviews also enable sellers to evaluate the terms of the sale, the creditworthiness of the buyer, and the tax consequences of how the sale is structured. Buyers and sellers should agree in writing on the scope of the due diligence each party will conduct. The scope is influenced by a number of factors, including:

• the size and complexity of the business involved,
• the experience and knowledge of the respective parties involved in the transaction,
• the ease and timeliness with which that information can be verified,
• the resources available to conduct a thorough review within the time pressure of closing the deal, and
• the method and timing of payment.

Risk of in-house review. Buyers and sellers have the option of conducting their own due-diligence review or engaging an outside professional.

In a complex business environment, it’s nearly impossible for even the most experienced owner or management team to perform a thorough due-diligence assessment. An outside review can help you minimize your potential exposure to losses from a default, lawsuit or disaster.

Whoever conducts the review will need to work closely with your attorney, since financial and legal issues tend to be interrelated. Due diligence also may, more often than not, include an independent business valuation.

Considerations

The following items touch on some – but not all (e.g., tax impact) – of the many important factors you should weigh as part of due diligence.

Industry comparisons. A key component of due diligence is understanding the company’s industry and the market in which it operates. This analysis includes:

• the historical performance of the business versus other members of its industry;
• the likely causes of financial performance that deviates significantly from industry norms; and
• the likelihood that profit trends will continue and improve.

Cash. Due diligence may include an examination of cash, including verifying the existence of cash balances at a given point in time, and examining cash accounts for large transactions and inter-bank transfers near the sale date.

If the sale includes cash balances: (a) obtain new banking resolutions from the owner or board of directors, and (b) give the bank new signature cards and open new bank accounts (preferably at a different financial institution), even before the purchase is completed, so that cash balances can be transferred immediately.

Accounts receivable. If the purchase includes receivables, a number of due-diligence procedures are necessary to evaluate them, such as confirming their age and that they haven’t been pledged to secure a loan.

Inventory. Due diligence includes ascertaining that reported inventory exists, is not obsolete, is not encumbered, is in a salable condition, and can be verified by physical inspection.

Equipment. Due diligence regarding equipment to be included in the purchase involves verifying ownership, condition and value. Examining insurance policies in conjunction with a physical examination of the equipment is a good starting point.

Conclusion

Due diligence must be performed contemporaneous with the transaction. Relying on old studies is the equivalent of not having a due-diligence study at all. A due-diligence review not only provides a level of comfort; it also makes good business sense. It is always less costly to try to prevent problems rather than to deal with problems after the fact.

If you’re contemplating a sale or purchase, we can help you gain a thorough and detailed understanding of the transaction before you commit to it.

Back to Article Index