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CONDUCTING DUE DILIGENCE
WHEN BUYING A BUSINESS
Why Should I Do It?
or
How Much Can I Afford To Lose?
Due diligence is the process of obtaining sufficient reliable information about the proposed acquisition to help you uncover any fact, circumstance or set of conditions that would have a reasonable likelihood of influencing your offer or decision to acquire the business.
The internally-generated information obtained during the due diligence process will help you:
- verify seller representations
- assist in the determination of value (assets and liabilities)
- uncover problems, issues and concerns (current and future)
- gain a better understanding of the business and industry
- key customers
- trends
- regulatory requirements
- evaluate management and key employees
Externally-generated information will focus on:
- public information regarding the company, its principals and key employees
- key customers
- market research to gain a better understanding of the dynamics of the marketplace
Many buyers of small to medium sized business do not conduct any due diligence, or conduct an insufficient amount because they feel the amount of the purchase price does not justify their time and effort, as well as, the cost of the professionals they might engage. Some buyers feel they lack the knowledge of how to conduct a due diligence investigation. They are not sure about what to look for or where to look.
If you are not sure how to effectively conduct a due diligence investigation, get help.
You need to balance the cost of the investigation against your total risk exposure, both now and in the future. Just because the purchase price is small or the seller is offering terms doesn't mean that the risk exposure can not be large. An undiscovered contingent or pending liability could wipe out your total investment not to mention the psychological trauma it can cause. And don't expect the courts to bail you out. A legal remedy could be costly, time consuming and of little value by the time you come to collect.
The nature, scope and timing of the due diligence investigation will depend on many factors. Among the more prominent factors are the price of the deal, the perceived risk, the urgency of consummating the deal (buyer or seller) and the cooperation of the seller.
Before getting bogged down in the detail of the due diligence investigation you should conduct a preliminary investigation that would focus on:
- getting a comfort feeling about those significant factors that make the opportunity attractive to you
- the business practices, values and reputation of the company to be acquired
- make sure these are consistent with your approach to doing business
- changing a company's way of doing business or trying to improve its reputation can be time consuming and costly
- an indication of price and terms (the following can all be used as a preliminary guideline before engaging in a more sophisticated valuation)
- industry "rule of thumb"
- basic return on investment calculations (price/earnings)
- cash flow.
Once you have completed this preliminary investigation you will be in a better position to decide whether or not the deal is worth pursuing.
Tips for conducting a successful due diligence investigation:
- professional judgment and experience is critical
- if you are lacking in certain areas get help
- use a questionnaire to help guide you through the process
- questionnaires are available in books and from major accounting and law firms
- document the findings of your investigation
- be aware of how the nature of the information impacts its reliability
- internal vs external
- how and from who it is obtained
- is it independently verifiable
- be on the lookout for inconsistencies in verbal representations or information
- that are either individually or cumulatively material
- ask open-ended questions
- rather than asking for the confirmation of a fact, ask a question that leads you to the same answer
- remember that in many instances past behavior can be a good predictor of future performance
- this can be crucial in evaluating management's and employee's values, practices and performance
CAUTION: Due diligence may not and probably will not uncover fraud or a conspiracy to commit fraud.
ALWAYS HAVE THE SELLER SIGN A REPRESENTATION LETTER PRIOR TO THE CLOSING.
POSITIVE - Confirming all the material representations the seller has made which you have relied upon.
NEGATIVE - Confirming that there are no known material facts or circumstances which could influence your decision to buy the company.
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