Buying a Business: Due Diligence
03 April 2023: Buying a Business: Due Diligence
The title of this post – Buying a Business – may be a little misleading. It’s certainly a little limiting.
Because due diligence during the acquisition process – an very important aspect of the process if the buyer is to be successful – is an arduous and extremely invasive undertaking that is likely to significantly impact the seller’s experience and the broker’s success. For business owners and for brokers aspiring to work in the big kids’ playground – businesses worth in the $5M to $30M range – understanding the breadth and depth of how a buyer is likely to comb through even the most arcane aspects of the business is imperative if the deal is to stay on track.
For brokers in our network and others who have taken our courses, this topic falls under the possibly simplistic heading of managing the client’s expectations. And if the broker doesn’t understand – or isn’t able to explain to the client – either the due diligence process or the concept of managing expectations, the chances of getting a deal from LOI or “under contract” to “close” diminish significantly.
We offer a comprehensive coaching program – both group coaching in our Brokers’ Roundtable℠ community as well as one-on-one coaching – tailored to Realtors, business owners, buyers and anyone interested in valuing, buying or selling a business.
If you’d like to learn more, email me at jo*@Wo*******************.com
As it happens, this subject – due diligence and preparing the business owner for it – was a topic of a recent FAWU in our network. (“FAWU” is the in-house acronym for our weekly Friday Afternoon Wrap Up, our live, online discussion among our brokers wrapping up the week by discussing various and sundry valuation and brokering issues and challenges.) That session also included the closely-related topic of cleaning up the balance sheet to increase clarity and reduce questions… and suspicions.
Buying a Business: The “Study Period”
Due diligence is – and should be, at least from the buyer’s perspective – tantamount to turning over every single rock in sight – and looking over the horizon for storm clouds.
It’s not enough to get the financial statements and tax returns. It’s not enough to tour the target business’ facilities. It’s not enough to confirm that the business is “in good standing” with the jurisdictional and licensing authorities. A thorough due diligence is a deep-dive into the target business’ every aspect. The idea is to ferret out the most mundane and arcane details in the hope of averting a future disaster exploding in the new owner’s face.
At the risk of putting you gentle readers into a linguistic-induced coma, let me state up front that the multitude of areas or issues that some buyers often gloss over is far too numerous for a single blog post and that this particular journalistic triumph will focus on the more critical.
Our course, “Learn How to Value and SUCCESSFULLY Sell Businesses“, teaches you how to accurately value and successfully sell businesses.
Tales From The Front Lines
From the simple to the more esoteric, here are some examples of what some buyers will never think to investigate or ask about – and what smart buyers will dig into. Sellers take note.
Are the assets priced properly? This would seem to be the proverbial “no brainer” but in our experience, it’s not. Beyond the ever present and easy-to-spot “price-that-bears-no-resemblance-to-value,” there are the less easy to spot errors in establishing that value.
An example of the former is the restaurant and gift shop generating $200,000 in discretionary income brought to market with a nose-bleed asking price of $1.75 million. An example of the latter is a business valued at $800,000 but which value was arrived at by using a deeply flawed expense number that, without a deep dive investigation, would never have been uncovered. (Both of these examples are from our files and both came to us via the real estate agents that listed them and couldn’t sell them.)
The first example was easy to see. Absent eight million barrels of crude oil underneath it, nobody with a three-digit IQ would pay $1.75M for a business generating a return, including owner’s salary, of $200k.
The second example, however, required a Sherlockian mindset to discover that the owners also owned the real estate and were charging the restaurant a rental rate that was only 40% of the market rate. Had the restaurant been paying market rent, its value would have been halved. Discovering this very significant and hidden problem required someone who knew what they were doing taking the time to analyze the lease – and ALL the expenses.
The List is Long
But those are relatively mundane examples. Here’s a few that a buyer will miss at his or her peril.
- Examine ALL contracts the business is a party to, not just the lease for the space. Are there equipment leases? Purchase contracts? Customer contracts? Understand what obligations the business has and, more importantly, what revenue can be counted on. Make sure all terms of such contracts are accounted for in the valuation of the business’ future earnings.
- Equipment and vehicle condition and the remaining term of any warranties must be known. Is the seller stating that X piece of equipment is in excellent shape and will last at least Y-number more years? Without confirming this information, the buyer could be hit with a sizable and unexpected capital expense in the near term.
- If there is significant value in the target business’ IP or tech assets, the buyer should be certain that there are no restrictions on the use or the transfer of ownership of those assets.
- Are the most important employees under contract? Employee files must be examined because if a critical manager or star salesperson can simply move on, the overall business performance could tank.
- If the business is in a highly regulated industry or jurisdiction, does the buyer understand the restrictions and is the buyer confident that such restrictions will not become more onerous over the near term?
- For many businesses, bank records – account statements and cancelled checks – could be requested. Buyers want to match payments to invoices. (This, of course, means that invoices will be requested.)
- If the business is consumer-oriented, there’s a high probability that the owner(s) has helped him/herself to some product. How much? How can it be valued? How can it be confirmed?
- Are there limits to growth or expansion imposed by either the third-party owner of some right (a franchisor, for example) or by a geographic or competition restriction (often a concern in Western European countries).
- Is some proportion of the inventory outdated? If it hasn’t sold in the last 3-4 months, is there any reason to be optimistic that it’ll sell in the next month?
- Are all employment taxes current?
- Is the seller actually able to sell this business? Have you confirmed that there are no other owners (silent partners)?
Serious thought has to be given to every aspect of a business’ operation, the regulatory environment it operates in, its ownership, its financial statements, the ownership of its assets, etc., etc., etc.
The Bottom Line
Buying a business involves due diligence and due diligence involves the buyer verifying everything the seller and broker claim about the business. As you might imagine, exaggeration is not an uncommon occurrence in our business. The seller, after all, often believes – sometimes understandably – that his or her business is the proverbial gold mine and any buyer would be damn lucky have it.
But we must consider that the buyer, in contemplating acquiring a business, is committing to put the financial future of his or her family at risk. The buyer’s needs confidence that all the doors have been opened. They need to be reasonably sure there are no ghosts.
As you can probably imagine, pulling the trigger on a business acquisition is an act of faith and courage in the face of much apprehension perceived risk. Sellers need to be cognizant of this as the buyer requests more and more data, sometimes to the point of angering the seller. Business brokers have got to explain this early on – before any due diligence even begins. To keep a deal from going south, sellers have to know what to expect.
I’d like to hear from you. What topics would you like me to cover? How can we tailor these posts to be more useful to you and your business. Let me know in the comments box, below, or email me at jo*@Wo*******************.com.
If you have any questions or comments on this topic – or any topic related to business – I’d like to hear from you. Put them in the comments box below. Start the conversation and I’ll get back to you with answers or my own comments. If I get enough on one topic, I’ll address them in a future post or podcast.
I’ll be back with you again next Monday. In the meantime, I hope you have a safe and profitable week.
We received an inquiry from a U.S.-based private investment and equity firm looking for opportunities to acquire software and tech-enabled B2B businesses businesses anywhere in North America with a minimum of $1 million in EBITDA.
If any of you know of something that might fit, please let me know.
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The author is the founder, in 2001, of Worldwide Business Brokers and holds a certification from the International Business Brokers Association (IBBA) as a Certified Business Intermediary (CBI) of which there are fewer than 500 in the world. He can be reached at jo*@Wo*******************.com