Buyer Due Diligence (DD) on a business (going concern) acquisition is the process of verifying that a prospective buyer is purchasing what he THINKS he is purchasing, and that the information he has been provided by brokers and sellers is accurate within a reasonable degree of tolerance to the buyer. Due to serious concerns about confidentiality, disruption of current and future business, and time and expense, in depth DD is generally conducted after a binding agreement is in place and earnest money has been provided.
Some degree of exploration and analysis of the business, its viability, its fit with the buyer prospect’s experience, skills, and financial resources should begin the minute a buyer starts considering the opportunity. No one in the process wants to waste time, money and energy on a deal that cannot or will not happen. Many times the exploration process will not get past the first look at the offering prospectus or first meeting, as one side or the other recognizes this deal is not mutually beneficial. The process will go step by step with additional information provided as a buyer is apparently more qualified and serious. This article focuses on the DD that will occur when a buyer gets past the initial stages and has come to some terms with the seller.
Once there is an agreement in place, DD is a mandatory step in purchasing any business. Put simply, a buyer must do his homework, and know precisely what he is buying. This may be relatively painless with an honest seller and well organized business, presented by a professional broker. But, it can be a trying process, especially if a business is not well organized, the seller has something to hide, and/or a buyer is not both reasonable and prepared for the investigation. Buyers are encouraged to engage the assistance of a CPA with some small business experience to make the process far more efficient and productive. In depth due diligence is not a ‘free look period’ in which a buyer can decide if he likes or does not like “anything at all” about the business. Extensive DD simply cannot occur with every prospect on a business. The seller cannot be asked to commit the kind of time and energy, and expense for advisors, potential exposure to employees, vendors and customers required for due diligence of his ongoing business unless a buyer is committed to the purchase. Measurable contingencies and due diligence requests should be precisely listed at the outset of the process, often in the LOI or Offer document, or through the provision of a DD list.
The objective is to ensure the buyer gets all the material facts required to make a fully informed decision and assessment of the true condition of the business while not disrupting the seller’s business unduly. It is best to work out some type of planned schedule in advance so everyone’s expectations are met and we do not have disagreements or unnecessary delays.
Pre-Offer or LOI, most buyers will already have obtained and reviewed financial statements and tax returns in order to define the price and terms that will work for the deal. If not, this is step one. Many businesses require outside financing, and no deal will take place without this, so at least a loan proposal is commonly required before any other DD that involves the seller’s time begins.
Once a buyer has a loan proposal, or even better, a loan commitment, the parts of due diligence that open the seller up to exposure and potential business damage, can begin. If there are any other major contingencies, these should be tackled next. For example, insurance is an issue for many businesses—workers’ comp, liability, fleet, contractors’. Financial DD should be scheduled during this time, as it will generally entail coordinating meetings with several people. If any reports, customer or vendor accounts appear unusual in any way, a paper trail can be followed to track orders, billings, deposits, etc. Financial DD on most small businesses can be accomplished in 1-2 days of focused work if everyone co-operates.
The closing attorney or buyer’s attorney will do a lien and law suit search, and work with the seller to clear any old liens that may be incorrectly showing as active. Other liens will generally be cleared at Closing with payments made directly to lenders or creditors by the Closing attorney with funds from the transaction. If any problems are uncovered, the buyer will be informed.
Employment, asset, and operations questions not answered prior to DD should be addressed to the seller and/or their broker for responses. If the business has sellable inventory, this will need to be counted or the final amount being purchased somehow agreed-upon. The method needs to be decided ASAP so that an outside firm can be retained if needed.
If there are key employees or customers that must be interviewed prior to closing, these meetings will only take place when all other contingencies have been met, unless the seller has already informed these people in advance of his intentions. The seller does not want the potential of a major change to disrupt his business unless the deal is virtually certain to close. Buyers should have time to evaluate all employees in the working environment before deciding to terminate existing staff, especially since often times the new owner does not know how to run the business without those employees.
Customers of a business are typically only concerned about one thing: are their needs being met? They do not care if Joe or Sam owns the business, so long as your plans do not upset their prior working relationship with the business. Quality, service, on-time, at the price they were quoted, etc. is why they deal with the business in question. If there is an existing written contract, it may or may not be invalidated by a sale. Buyers should have their attorneys advise them as to the nature of the contract, with input from the seller. Many times, the contract will continue under new owners; or it may be assumable, or the buyer may need a new contract.
The buyer also has many “transitional” tasks that are not so much DD on the business as set-up requirements to ensure that the business will run smoothly the day after closing. These often involve an accountant and/or attorney who assists with the establishment of a new legal entity to purchase and hold the business assets, and all related tax ID’s, licenses, bank accounts, etc. The seller and broker will also be a good resource for what accounts need to be contacted to ensure continuity of services, utilities, and purchases for the going concern.
During due diligence, buyers may find some inconsistencies with what they previously were told or understood, or perhaps some anomalies in the business records. Naturally, these must be questioned, but a buyer should not over-react and assume this is fatal to a deal. Communication errors can and do occur with many parties to a deal, and small businesses often have “do it yourself” bookkeeping, which can lead to some interesting issues. However, many of these can be resolved. Neither principal should over-react to a DD hurdle or there will be no deal, and neither party gets what they want. Buyers and their advisors should speak with the seller and their advisors about their concerns so that the problems can hopefully be addressed. If a business turns out not to be as originally presented in terms of revenue, profits, personnel, contracts with customers, or assets—factors which affect the value of a business—then a renegotiation of price and terms will often be called for. On the other hand, no business is perfect (as the cliché goes) and a buyer cannot expect to renegotiate based on a non-material difference. Normally, both sides of the deal will have spent a lot of time, energy and money getting to this point, and will have a true desire to make the deal work.
As a buyer, you and your advisors should come up with a due diligence list that will satisfy your concerns, at a level appropriate to you and to the specific business. Take into consideration the systems in the business and the reasonableness of your requests. The seller and broker will need to be consulted as to when and how your list will be addressed. The parties should devise an actual schedule of meetings to meet the DD deadlines defined in the purchase agreement. If all goes well, and everyone’s expectations are fairly met, you should have a deal!
NOTE: BROKERS DO NOT WARRANT ACCURACY OR COMPLETENESS OF FINANCIAL OR BUSINESS INFO PROVIDED BY SELLERS. CONSULTKAP RECOMMENDS THAT ALL PARTIES TO BUSINESS TRANSACTIONS SEEK APPROPRIATE FINANCIAL, LEGAL, ACCOUNTING, AND TAX ADVICE FROM PROFESSIONALS IN THESE FIELDS. PROSPECTIVE BUYERS OR USERS OF INFORMATION PRESENTED BY BROKERS ARE RESPONSIBLE FOR THE PERFORMANCE AND THE EXPENSE OF DUE DILIGENCE REVIEW PRIOR TO ANY FINANCING, MERGER OR ACQUISITION CONSIDERATIONS.
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