Buying a Business? Do Your Diligence!
Buying a business involves, among other things, a great deal of study and investigation, In short, you need to go through an in depth process of due diligence to make sure you know what you’re buying.
If you’re using a mergers and acquisitions firm or business broker to assist you, such professionals will do much of this research for you. If the sellers have hired a professional business broker to represent their side, the odds are pretty good that most of the data you need will be readily available and maybe even in the offering memorandum that you receive from the broker. But if you’re going one-on-one with the sellers, how do you accomplish this investigative ballet and what data do you need to do it? Let’s talk about some of the issues and then I’ll describe how we approach this.
There are any number of things that need to be addressed during the due diligence period. Here are a few of them.
- Financials. Needless to say, you have to be able to confirm the the revenue and expense numbers, the expense categories, the business’ hard assets, the cash flow and the “true” net earnings (discretionary earnings). This requires a close examination of the profit and loss statements, tax returns, the business’ balance sheet, leases (especially real estate leases for ongoing rent increases), etc.
- Inventory. Does the actual inventory match the inventory claimed by the sellers? What amount of the claimed inventory is obsolete? Does any need to be written down?
- Corporate Status. Is the company current and compliant with all governmental requirements? Is it “in good standing” with its state’s corporation commission?
- Corporate Structure. Who has the authority to sign transaction documents? If there are multiple owners, has there been a corporate resolution to sell the company?
- Management. What and who makes up the management team? What is the management structure? This is particularly important if retention of some or all of the management team is part of the deal.
- Employees. You should ask for a roster of employees, their titles or positions, their salaries or wage rates. We like to know their tenure, as well.
- Tax Payments. Is the company current on its tax payments, particularly withholding tax? Payroll and wage taxes that are not current at the time the business is transferred will often come back to bite the new business owner – you!
- Contracts and Leases. Supply contracts, sales contracts, equipment leases, real estate leases; each must be examined, particularly for any changes in terms or financial impacts that may be triggered by a sale of the business.
- Work in Progress. Verification of the status of all work in progress is critical. Such work would include the percentage of a service contract that has been completed. For example, if the target company is providing HR services under contract, how much of that contract has been completed and how much paid for? In another example, if the target company is providing laser sights for the military as part of a three-year, one million unit contract, how much of that product has been delivered, how much accepted and how much paid for? In still another example, if the company manufactures widgets from components bought from various outside suppliers and keeps a widget inventory ready to fill orders, how much of its production is complete (see Inventory, above, and how much is complete to certain percentages?
- Debt. Confirm what is claimed – call the lenders and creditors – but also have a UCC search done to make sure nothing is filed that even the sellers don’t know about.
So, what does a mergers and acquisitions firm or a professional business broker do for you? Most of that and more.
Representing the Buyer
Though Mergers and Acquisitions – M&A – professionals can work for either the buyer or seller, as a rule, in middle market transactions the buyer is the client. When we are engaged in an M&A assignment, we know most, if not all, of the data that needs to be collected and analyzed by our client. Research must be done to find potential acquisition targets that fit the client’s strategic objectives and that are compatible financially.
When clients hire a M&A firm, one of the reasons they do so is so that a specialist will thoroughly analyze the target industry with the objective of finding a couple of qualified targets. To do this means the M&A firm will gather and analyze information about industry competitors, growth trends, market share, company culture, management structure, compatibility and other metrics to determine whether the various potential targets will make good strategic fits. In addition to this, they also review company fundamentals, financial statements and reputation. The M&A firm’s objective is to develop a roster of targets that meet most or all of the client’s criteria.
An additional benefit of all this research is that the M&A firm will be able to provide the client target-company valuations, guidance on deal structure and assist in the negotiations that, hopefully, will result in a deal.
Another reason that a company will hire an M&A firm is for confidentiality. In many cases the buyer wants to keep its interest in acquiring a business from becoming public. For example, imagine if Coca Cola believed that there would be a large market for cannabis-infused diet drinks in five years and wanted to position itself as the first-to-market with such a product. It would likely consider buying a cannabis producer. But if word got out that the buyer was Coca Cola, imagine what would happen to asking prices for such businesses.
(As a sidebar here, the mere concept of a cannabis-infused diet drink must set knowledgeable (or maybe “experienced” is a better word) pot smokers to paroxysms of laughter after years of being inflicted with the “munchies”. But that’s a story for another day…)
Representing the Seller
If the owners of the company being sold have hired a professional business broker/advisor, in all likelihood the information you need has already been gathered and put into a clear, understandable format meant for buyers. We call this the Offering Memorandum and, as a rule, it includes the pertinent data described above as well as photos, location maps and pretty much any information a serious buyer would need in order to make a decision. Our goal with the Offering Memorandum is to provide the potential buyer with all the information it needs to make a decision pending only a site visit to inspect the facilities and hard assets, and to confirm the data provided in the Offering Memorandum.
Professional business brokers, especially those who have earned the Certified Business Intermediary (“CBI”) designation, understand what a buyer needs in order to perform proper due diligence in anticipation of acquiring a business. If you’re considering buying a business and this data is not readily available through the broker, the sellers have probably hired the wrong form to assist in the marketing and sale of the business.
“Main Street” Due Diligence
If you’re considering buying a Main Street business – sometimes referred to as a “Mom and Pop” business – your journey will be less complicated; which is not to say that due diligence is not just as critical. But the due diligence process for a Main Street business is unlikely to involve lengthy management and employee reviews, complex work-in-progress assessments, lengthy contract and lease documents, elaborate debt structures, etc. The due diligence process for the acquisition of a Main Street business should be relatively smooth, easy and not as time-consuming when compared to the process required in a middle market acquisition.
In fact, if you’re interested in buying a Main Street business, I’ve prepared a list of some of the documents that are likely to be part of any such purchase. This list is not meant to be exhaustive and will not replace the important advisors that the acquisition of any business requires but it will give you a better understanding of the scope of the effort required to do your homework. This will be, after all, probably the largest investment you will ever make. The list is free and will be delivered to your in-box immediately upon telling me in the box below where to send it.
If you have any questions, comments or feedback, I want to hear from you. Put them in the Comments box below. 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 profitable week!