Buying a Business: Due Diligence Checklist & How to Prepare One

Buying a business can be one of the most profitable ventures that a company or individual can make.

But in either case, it is an investment decision that requires careful consideration.

In mergers and acquisitions, due diligence is the analysis conducted by a buyer of a target company before entering into an agreement to purchase it.

Whether you’re an entrepreneur looking to acquire a company to manage, or you’re the decision maker of a company that’s acquiring a company for growth, you need to understand how to conduct it. This article aims to show you how.

But first, we’ll begin with some of the pros and cons of buying companies.

Buying a Business: The Pros

• The company has a proven business model and client base.
• Some businesses have recurring revenue (e.g. SaaS businesses) offering a contractual guarantee of short-term cash flows.
• The company may have access to other valuable resources (real estate, patents, etc.)
• If the business is in an industry with a lot of transactions, it may be relatively easy to resell at a comparable price in the future.
• For individuals buying companies, it may simply be a case of continuing their existing role in a business where they have ownership (and thus, an increased salary).

Buying a Business: The Cons

• You’ll buy the problems as well as the benefits — e.g. unhappy employees or suppliers.
• It’s tempting to ‘fall in love’ with a business, seeing only its positive side, and end up paying too much to acquire it.
• It can be difficult to ascertain how much of a business’ success is due to its current owner. If (s)he leaves, customers might follow.
• Running a business brings a range of new challenges and responsibilities that not every acquirer is ready for.
• Buying at the wrong time in the market cycle (i.e. before a recession) can make running the business at a profit highly challenging, even for competent management.

Buying a Business: Pre-Due Diligence Basics

• Most important of all. Have a good ‘why’. If you can’t answer the question, ‘why am I/are we buying this business?’, then you shouldn’t be buying it.
• Conduct a valuation of the business using an independent third party. If possible, use two separate parties. Take the lowest value of the two as the value.
• Related to 2., make sure that you or your company are not taking on a potentially unbearable financial burden to acquire the business.
• Write a business plan that justifies to anybody reading where this business is going and how it’s going to get there. Ask a trusted confidant if the plan stands up.
• If possible, talk to some customers of the business. Understand why it is that they buy from the business, and what could be done to improve it.
• Understand the owner’s role in the business. Could this business run ‘by itself’ if they left in the morning? What value do they bring?
• Similar to 5., understand what value each employee brings. Is there one star performer who needs to be kept on board (e.g. a developer) for the business to continue as is?
• Establish if there is anything about the business’s competitive environment (new arrivals on market, new legislation, etc.) that has changed in the past year.
• If applicable, establish if the current owner can remain in place for a transition period, allowing you to get to grips with the running of the business.
• See whether the existing owner would be open to an earn-out — a method of buying a business, where the purchase price is dependent on the business’s cash flows.

Buying a Business Due Diligence Checklist

Assuming the business passed your pre-due diligence analysis, you can move onto due diligence itself. Again, it cannot be stressed enough how important this is.

While answers to the questions posed at the pre-due diligence stage should give you confidence that your original investment hypothesis, due diligence is a way of rubber stamping the decision.

For a thorough breakdown of these lists, talk to DealRoom about how our due diligence offering can provide first time business buyers with the security they require. The following list will get you going.

Finance

Documents to obtain:

1. Audited financial statements for at least three years.
2. Tax returns for at least three years.
3. A credit report of the company and its owner(s).
4. A schedule of inventory, accounts receivable and accounts payable.
5. Notes on any extraordinary accounting issues over the past five years.
6. A copy of the company’s internal control procedures.
7. A copy of the company’s capital budget.
8. A debt schedule for the company.
9. Written statement from owners attesting that financial statements are up-to-date and free from any material omissions.

Capital Assets

Information to obtain:

• Schedule of all long-term assets owned or leased by business (machinery, real estate, etc.).
• Copies of real estate deeds, orders, zoning, etc.
• A lease schedule (including the contracts for leased equipment or machinery).
• A schedule of all sales and purchases of equipment and machinery over the past three years.
• Length and estimated usage (if applicable) of current machinery stock.

Human Resources

Information to obtain:

• Information on all employees, their positions, salaries and benefits.
• Summary of retirement plans, health and welfare benefits, stock options, and stock purchase plans.
• Details of company employee turnover.
• Details of the company’s hiring process.
• Resumes of senior management.
• Any contracts between the company and its employees, including previous and ongoing consulting contracts.
• A copy of the company’s personnel handbook, along with all of the company’s prevailing HR policies.
• Details of any previous or outstanding legal issues with current or previous employees in the last three years.
• Details of workers’ compensation claim history and unemployment insurance claims history.

Tax

Information to obtain:

• All income tax returns (federal, state, etc.) for the past three years.
• Sales tax returns for the past three years.
• Tax settlements or outstanding tax investigations.
• Details of outstanding tax liabilities and tax liens.
• Employment and excise tax filings.

Legal

Information to obtain:

• Copies of agreements or instruments that place restrictions or encumbrances on assets.
• Contracts that restrict the target’s right to conduct its business.
• Contracts with obligations such as covenants and indemnification.
• Summary of the target’s compliance program and copies of all policies, procedures and other related documentation.
• Confirm that the firm is not restricted from doing business under OFAC regulations or similar.
• Confirm whether the target has any direct or indirect presence and/or other engagements.
• Summary of regulations applicable and/or its business, and anticipated changes
• Copies of any letters with any regulatory agencies or authorities.
• List of states and countries in which the target has operations.
• Good-standing certificates or qualification to do business from state of incorporation and states where qualified.

Compliance

Information to obtain:

• How effective are the company’s in-house compliance standards?
• What records are kept?
• How transparent is the company about compliance?
• How much does it spend on compliance every year?
• Are employees given compliance related training?
• Are there areas of overlap between your compliance standards and those of the target company?
• What needs to improve in the target company’s compliance standards?
• How much would an improvement in compliance cost your company and how would this affect the deal structure?
• Are there any ongoing government investigations and what do they concern?
• Were there investigations in the past, and if so, how were they resolved?
• How often does the government check compliance at the target company?

Conclusion

If you’ve read this far, congratulations — maybe you’re taking due diligence seriously enough.

Originally published at https://dealroom.net.