Due Diligence

When you’re in the process of buying a business and you’re atthe stage where due diligence occurs, you’ll most likely have tosign a confidentiality agreement with the seller and assure him orher that you won’t contact anyone for additional information aboutthe business without his or her prior approval. The last thing aseller wants to do is disrupt or threaten important relationshipswith staff or suppliers by prematurely announcing the sale of thebusiness.

As you begin evaluating businesses for sale, verify the valuesand examine the status of the following items:

Inventory. Inventory refers to all products and materialson hand for resale to or use by a client. You or a qualifiedrepresentative should be present at any inventory valuationproceeding and determine what’s on hand at present, how long it’sbeen there, and what was on hand at the end of the last fiscal yearand the one preceding that. What condition is the inventory in? Isit salable? Are you interested in selling it? Inventory valuationis usually subject to negotiation.

Furniture, fixtures, equipment and building. Get a listfrom the seller that includes the name and model number for eachpiece of equipment. Then determine its present condition, marketvalue when purchased, present market value, and whether theequipment was purchased or leased. Find out how much the seller hasinvested in leasehold improvements and maintenance to keep thefacility in good condition. Determine what modifications you’llhave to make to the space to suit your needs

Copies of all contracts and legal documents. Theseinclude leases, purchase agreements, distribution agreements,subcontractor agreements, sales contracts, union contracts,business employee agreements, and any other legal documentsconcerning the business, such as fictitious business namestatements, articles of incorporation, registered trademarks,copyrights and patents. For any leases (equipment, office space,etc.), find out whether they’re transferable and whether thelessor’s permission is necessary to assign the lease. If thebusiness you’re considering has valuable intellectual property suchas a trade name, patent, or trade secret, make sure to consult withan attorney who specializes in intellectual property.

Incorporation. If the company is a corporation, check tosee what state it’s registered in.

Tax return. Make sure you have access to the previousfive years’ returns. Many business owners make use of the businessfor personal needs. They may buy products they personally use andcharge them to the business or take vacations through the company,go to trade shows with their spouses, and so on. You and your CPAmay have to read between the lines to determine the actual networth of the company.

Financial statement. You want to evaluate the books andfinancial statements for the past five years to determine theearning power of the business. Examine the sales and operatingratios with a CPA familiar with this type of business. Theoperation ratios should also be compared to industry ratios, whichcan be found in annual reports produced by Robert Morris &Associates as well as by Dun & Bradstreet.

Sales records. Although sales will be logged in thefinancial statements, take a careful look at the monthly salesrecords for at least the past 36 months. Break down sales byproduct lines, if several products are involved, as well as by cashand credit sales. This provides you with some understanding ofcycles that the business may go through, and you can compare theindustry norms of seasonal patterns with what you see in thebusiness. Also, obtain the sales figures of the 10 largest accountsfor the past 12 months. If the seller doesn’t want to release hisor her largest accounts by name, it’s acceptable for the seller tocode them. What you’re interested in is the pattern of sales.

Complete list of liabilities. Consult an independentattorney and CPA to examine the list of liabilities and determinethe potential costs and legal ramifications. These may be itemslike lawsuits, liens by creditors against assets, or the use ofassets such as capital equipment or receivables as collateral tosecure short-term loans. Your CPA should also be on the lookout forunrecorded liabilities, such as employee benefit claims andout-of-court settlements.

All accounts receivable. Break these down by 30, 60, 90days and more than 90 days. Checking the age of receivables isimportant because the longer they’re outstanding, the lower thevalue of the account. You should also make a list of the top 10accounts and check their creditworthiness. If the clientele iscreditworthy and the majority of the accounts are outstandingbeyond 60 days, a stricter credit collection policy may speed upcollection of receivables.

All accounts payable. Like accounts receivable, accountspayable should be broken down by 30, 60, 90 days and more than 90days to determine how well cash flows through the company. Forpayables older than 90 days, check to see if any creditors haveplaced liens on the company’s assets.

Debt disclosure. This includes all outstanding notes,loans, and any other debt to which the business has agreed. Are anybusiness investments on the books that may have taken place outsideof the normal area? Any loans made to customers?

Merchandise returns. Does the business have a high rateof returns? Has it gone up in the past year? If so, can you isolatethe reasons for returns and will you be able to correct theproblem(s)?

Customer patterns. If this business can track customers,define the current customers: How many are first-time buyers? Wereany customers lost over the past year? When are the peak buyingseasons? When does consumer demand slacken? What type ofmerchandise is the most popular? At what price?

Marketing strategies. How does the business solicitcustomers? Are discounts offered? What PR campaigns are carriedout? Is there aggressive advertising? Get copies of all salesliterature and assess the type of image being projected. Pretendyou’re a customer being solicited by the company to get a feelingfor how the company is perceived by its market.

Advertising costs. Analyze costs to see if they came inas budgeted and scrutinize the results of the advertising. Didsales go up? Foot traffic increase? If not, find out why.

Prices. Evaluate current price lists and discountschedules of all products, the date of the last price increases,and the percentage of increase. Determine when you’re likely to beable to raise prices again. Compare what you see in this businessto standards in the industry.

Industry and market history. Analyze the industry as wellas the specific market segments the business targets to evaluatethe business’ profit potential. Determine whether sales in theindustry, as well as those in the business’ market, are growing,declining, or remaining stagnant.

Location and market area. Conduct a thorough analysis ofthe business’ location, taking into account the surrounding tradingareas’ demographics, the general economic outlook, and thebusiness’ nearby competition. See if there are any difficultieswith receiving products from vendors or delivering products tomarkets.

The business’s reputation. How is the business perceivedby customers as well as suppliers? Image is extremely important andcan be an asset or a liability. Interview customers, suppliers, thebank and owners of other businesses in the area to gatherinformation about the reputation of the business.

Seller-customer ties. Are any customers related orconnected in a special way to the present owner? How long has suchan account been with the company? What percentage of the company’sbusiness is accounted for by this particular customer or set ofcustomers? Will this customer continue to purchase from the companyif ownership changes?

Salaries. Make sure salaries are realistic and consistentwith industry and market standards.

List of current employees and organizational chart. Learnwho’s who in the business, who reports to whom, and who’s beenearning what for how long. Key personnel are an especially valuableasset. Get an understanding of the management practices of thecompany. Examine any management-employee contracts that exist asidefrom a union agreement, as well as details of employee benefitplans; profit-sharing; health, life and accident insurance;vacation policies; personnel policies; and any employee-relatedlawsuits against the company.

Occupational Safety and Health Administration (OSHA)requirements. If a manufacturing plant is involved, find outwhether the plant has been inspected and meets all occupationalsafety and health requirements. If you feel the seller is hedgingand that some things on the premises may be unsafe, you may, as aprospective buyer of a business that may come under OSHA scrutiny,ask the agency to help you with a check. Some sellers may be lessthan thrilled with this idea. But you need to protect yourinterests.

Insurance. Find out what type of insurance coverage thecompany has, who the underwriter and local company representativeare, and how much premiums cost. Some businesses are underinsuredand operating under potentially disastrous situations in case offire or other catastrophe. Make sure the business is adequatelyprotected.

Product liability. Product liability insurance isimportant for manufacturing companies. Certain insurance coveragesdramatically change from year to year, which can have a big effecton the company’s cash flow.