Due diligence is the process of thoroughly vetting financial and operational details about a business. For potential buyers, this means reviewing a business’s financial statements, legal documents and other records to evaluate its stability, confirm its valuation, and uncover any red flags that might require further investigation.
As you navigate due diligence, you can expect to learn a lot about the business you’re considering. Some of this new information will be better than you expected, and it’s likely that some of it will not be as good as you had hoped. Either way, due diligence gives you the data you need to finalize negotiations and take another step closer to the closing table.
Due diligence is all about the details, so let’s jump right into them.
How to conduct due diligence
First, put your team together. There are three key professionals you should involve in your due diligence process:
- a business broker
- a business attorney
- an accountant
Your business broker can help gather all the key documents. While you will certainly want to look at the information yourself, your attorney and accountant will provide objective eyes and be better able to spot red flags or irregularities that require more explanation.
You will sign a non-disclosure agreement with the seller at the start of due diligence. This will protect sensitive information and prevent others from finding out about the sale before the transaction is finalized.
When does due diligence begin?
Each transaction is different, but in general, due diligence begins once the buyer and seller have signed a letter of intent. This document outlines the broad strokes of the deal, including an expected timeline and scope of due diligence.
The length of time it takes to complete due diligence varies depending on the size and complexity of the transaction, as well as the level of detail you require. On average, the due diligence process can take anywhere from a few weeks to several months to complete. Your attorney and business broker can help you determine how much time to allow.
Due diligence checklist
Consult your broker, lawyer and accountant to make a checklist of items that should be part of due diligence. While the specific checklist might vary based on the type of business you want to buy, here are some suggestions to get you started.
[DOWNLOAD OUR DUE DILIGENCE CHECKLIST]
- Balance sheets
- Income statements
- Cash flow statement
- General ledger
- Tax returns
- Bank statements
- Loan agreements, bank financing arrangements, line of credit, or promissory notes
- Accounts payable and receivable reports
- Budget and forecasting documents
- Capital structure
- Audited financial statements
- Cost and expense reports
- Gross profit margin analysis
- Breakdown of revenue and profit by product or service
- Fixed/variable expense analysis
- Depreciation, amortization, and accounting methods
- Schedule of all assets, including real estate, equipment, vehicles, technology, and inventory on hand
Business structure documents
- Copy of business entity registration
- For a corporation
- Articles of incorporation and amendments
- Bylaws and amendments
- Meeting minutes
- For an LLC or partnership
- Articles of organization or statement of partnership
- Operating or partnership agreement
- Minute of member meetings
- List of shareholders or other investors
- Any names the company uses now or has used in the past
- List of the jurisdictions where the company does business, has employees or owns assets
- Annual reports
- Organizational chart
Legal documents and contracts
- Local/state/federal licenses
- Leases or mortgages
- Purchase agreements
- Distribution agreements
- Sales contracts
- Vendor contracts
- Supplier contracts
- Master service agreements
- Standard quote, purchase order, invoice, and warranty forms
- Employee and contractor agreements
- Franchising agreements
- Noncompete agreements
- Building, zoning or land-use permits
- Power of attorney documents
- Copies of documents showing compliance with government authorities
- Intellectual property documents, including copyrights, patents, trademarks and service marks
- Any other material contracts
- Insurance documents
- Seller’s disclosure statement
- UCC (Uniform Commercial Code) search results
- Details of any threatened or pending litigation
- Outline of existing and in-development products and services
- Schedule of unfilled orders
- List of critical suppliers
- Manufacturing specifications sheets
- Details of purchase, return, warranty, and credit policies
- Outline of inventory management procedures and reports
- Details of key technology systems, including back-office, production, and customer-facing systems
- List of service providers and current contracts or leases
Sales and marketing
- Sales and gross margin reports by product or service
- Projected sales by product or service
- Status of relationships with major customers
- Details of sales and marketing strategy
- Pipeline analysis
- Information about customer base
- Description of key distribution channels
- Surveys and market research reports
- Analysis of major competitors
- Historical and projected growth rate
- Description of brand assets, including logo website, email lists and social media accounts
- Intangible assets, such as reputation and good will
- List of current employees, independent contractors, and consultants, including position, work performed and earnings
- Employee handbook
- Details of past, pending or threatened employee disputes
- Worker’s compensation or unemployment claims history
- Outline of compensation structure, paid time off and other benefits
- Outline of training programs
[DOWNLOAD OUR DUE DILIGENCE CHECKLIST]
What happens after due diligence?
The goal of due diligence is to gain an understanding of the risks associated with the purchase of a business and whether the business fits your requirements. As the buyer, you’ll have certain contingencies that must be met during due diligence, and those should be included in your letter of intent.
In general, if the contingencies are not met. you have the right to walk away from the deal or renegotiate based on the information uncovered during due diligence. This represents something of a point of no return. Once your investigation is finished and you’ve made a decision to move forward, getting out of the deal becomes much more difficult (and expensive)..
Tips for navigating due diligence
Keep an open mind
You never know what you’re going to learn during due diligence. It’s fine to have some expectations, but there will be surprises along the way. If you start the process with too many preconceived notions, you might miss a red flag or worse — an opportunity. Do your best to stay emotionally neutral so you can negotiate with a clear head.
Compare the information you have received to your initial expectations
Are the financials in line with what you expected? Are there any major discrepancies between what you were told and what you see in the records? If so, you may need to request more information.
Use the opportunity to learn how to run the business
If you are planning to run your business yourself, due diligence is the time to learn how things work. You might get a chance to talk to current managers and key employees who can give you insight into day-to-day operations.
Don’t be afraid to ask questions
Sometimes, buyers don’t want to ask tough questions because they don’t want to offend the seller or put the deal in jeopardy. Just keep in mind that the whole purpose of due diligence is to learn all the information you can before making the purchase. If you don’t feel comfortable asking a question yourself, talk to your attorney, accountant, or business broker. One of them will ensure the concern is addressed.
Use the information to renegotiate
If something is out of line with your expectations or requirements, use that information to negotiate more favorable terms or to request that the seller address certain issues before the sale.
Engage your team
We talked earlier about gathering the members of your team — your business broker, attorney and accountant — at the beginning of due diligence. Listen to their impressions and findings as they review the data, and be sure to ask questions or express concerns if they arise.
The business attorneys at Joyce & Bary Law are ready to help guide you through the due diligence part of your business transaction. Contact us today to tell us more about your plans!