Due Diligence

By Entrepreneur Staff


Due Diligence Definition:

A reasonable investigation of a proposed investment deal and of the principals offering it before the transaction is finalized to check out an investment's worthiness; generally performed by the investor's attorney and accountant.

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

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

Inventory. Inventory refers to all products and materials on hand for resale to or use by a client. You or a qualified representative should be present at any inventory valuation proceeding and determine what's on hand at present, how long it's been there, and what was on hand at the end of the last fiscal year and the one preceding that. What condition is the inventory in? Is it salable? Are you interested in selling it? Inventory valuation is usually subject to negotiation.

Furniture, fixtures, equipment and building. Get a list from the seller that includes the name and model number for each piece of equipment. Then determine its present condition, market value when purchased, present market value, and whether the equipment was purchased or leased. Find out how much the seller has invested in leasehold improvements and maintenance to keep the facility in good condition. Determine what modifications you'll have to make to the space to suit your needs

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

Incorporation. If the company is a corporation, check to see what state it's registered in.

Tax return. Make sure you have access to the previous five years' returns. Many business owners make use of the business for personal needs. They may buy products they personally use and charge them to the business or take vacations through the company, go to trade shows with their spouses, and so on. You and your CPA may have to read between the lines to determine the actual net worth of the company.

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

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

Complete list of liabilities. Consult an independent attorney and CPA to examine the list of liabilities and determine the potential costs and legal ramifications. These may be items like lawsuits, liens by creditors against assets, or the use of assets such as capital equipment or receivables as collateral to secure short-term loans. Your CPA should also be on the lookout for unrecorded liabilities, such as employee benefit claims and out-of-court settlements.

All accounts receivable. Break these down by 30, 60, 90 days and more than 90 days. Checking the age of receivables is important because the longer they're outstanding, the lower the value of the account. You should also make a list of the top 10 accounts and check their creditworthiness. If the clientele is creditworthy and the majority of the accounts are outstanding beyond 60 days, a stricter credit collection policy may speed up collection of receivables.

All accounts payable. Like accounts receivable, accounts payable should be broken down by 30, 60, 90 days and more than 90 days to determine how well cash flows through the company. For payables older than 90 days, check to see if any creditors have placed 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 any business investments on the books that may have taken place outside of the normal area? Any loans made to customers?

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

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

Marketing strategies. How does the business solicit customers? Are discounts offered? What PR campaigns are carried out? Is there aggressive advertising? Get copies of all sales literature and assess the type of image being projected. Pretend you're a customer being solicited by the company to get a feeling for how the company is perceived by its market.

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

Prices. Evaluate current price lists and discount schedules of all products, the date of the last price increases, and the percentage of increase. Determine when you're likely to be able to raise prices again. Compare what you see in this business to standards in the industry.

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

Location and market area. Conduct a thorough analysis of the business' location, taking into account the surrounding trading areas' demographics, the general economic outlook, and the business' nearby competition. See if there are any difficulties with receiving products from vendors or delivering products to markets.

The business's reputation. How is the business perceived by customers as well as suppliers? Image is extremely important and can be an asset or a liability. Interview customers, suppliers, the bank and owners of other businesses in the area to gather information about the reputation of the business.

Seller-customer ties. Are any customers related or connected in a special way to the present owner? How long has such an account been with the company? What percentage of the company's business is accounted for by this particular customer or set of customers? Will this customer continue to purchase from the company if ownership changes?

Salaries. Make sure salaries are realistic and consistent with industry and market standards.

List of current employees and organizational chart. Learn who's who in the business, who reports to whom, and who's been earning what for how long. Key personnel are an especially valuable asset. Get an understanding of the management practices of the company. Examine any management-employee contracts that exist aside from a union agreement, as well as details of employee benefit plans; profit-sharing; health, life and accident insurance; vacation policies; personnel policies; and any employee-related lawsuits against the company.

Occupational Safety and Health Administration (OSHA) requirements. If a manufacturing plant is involved, find out whether the plant has been inspected and meets all occupational safety and health requirements. If you feel the seller is hedging and that some things on the premises may be unsafe, you may, as a prospective buyer of a business that may come under OSHA scrutiny, ask the agency to help you with a check. Some sellers may be less than thrilled with this idea. But you need to protect your interests.

Insurance. Find out what type of insurance coverage the company has, who the underwriter and local company representative are, and how much premiums cost. Some businesses are underinsured and operating under potentially disastrous situations in case of fire or other catastrophe. Make sure the business is adequately protected.

Product liability. Product liability insurance is important for manufacturing companies. Certain insurance coverages dramatically change from year to year, which can have a big effect on the company's cash flow.

More from Investing

Individual Retirement Account (IRA)

An interest-earning retirement savings account in which the allowable contributions and earnings aren't taxed until the funds are withdrawn, after age 59 1/2.

See full definition

Dollar-Cost Averaging

To invest, as in shares of stock, fixed amounts of money at regular intervals so as to buy more at lower prices ad less at higher prices

See full definition

Due Diligence

A reasonable investigation of a proposed investment deal and of the principals offering it before the transaction is finalized to check out an investment's worthiness; generally performed by the investor's attorney and accountant.

See full definition

Roth IRA

A personal retirement savings vehicle created by the Tax Payer Relief Act of 1997. A Roth IRA allows certain investors to make non-deductible contributions of up to $4,000 annually and, provided certain requirements are met, offers tax-free and penalty-free withdrawals for important financial needs in addition to retirement.

See full definition

Latest Articles

Side Hustle

She Grew Her Side Hustle Sales From $0 to Over $6 Million in Just 6 Months — and an 'Old-School' Mindset Helped Her Do It

Cynthia Sakai, designer and founder of the luxury personal care company evolvetogether, felt compelled to help people during the pandemic.

Money & Finance

How to Leverage Credit Cards for Business Growth (the Right Way)

By being aware of the risks and embracing best practices, entrepreneurs can make the most of credit cards.

Business News

Google's AI Is Now Appearing in Gmail and Docs

AI is being introduced to some of Google's most popular products.