We are often asked “What is a due diligence?”, in the process of purchasing a business. Generally the value of the purchase price will also relate to the complexity of the due diligence. This is generally conducted once you have signed a Heads of Agreement or confidentiality statement, you can usually get access to more detailed information.
Recently I came across this detailed list of processes that may be undertaken:
1. Speak to customers and establish existing customer perceptions:
• Who is their main contact at the business? If this is the owner, then the owner’s continued involvement during the transition will be more valuable.
• What are the strengths and weaknesses of the business’s products or services?
• Do the customers use competitors? If so, what are competitors’ advantages?
• To what extent will they continue to support the business after a changeover?
2. Ask suppliers to get a feel for the business’s credit history:
• Does the business pay on time?
• How does it compare with competitors?
• Analyse results and trends Analyse historical information and trends
• Look at sales growth, profit margins, overheads and working capital (review debtors, creditors, stock and work-in-progress).
• Is there scope for improvement? What specific value can you add to this business based on your skills and experience?
3. Look for changes or inconsistencies:
• Has the business recently changed its accounting policy to show better profits?
• Compare the business’s financial projections with other evidence you have. Do the forecasts tally with the historical trends?
• Is the sales forecast achievable given the current order book and what you’ve learned from customers?
• Does the forecast reflect the outlook for the industry and the whole economy?
• You may need to revise any projections that are out of step with these indicators.
4. Check the finances
• Does the business have an efficient accounting system in place and does the owner monitor key performance indicators regularly?
• Check the major balance sheet items:
• When was the last full audit? If it was over six months ago, ask for another one.
• What are stock levels? Rising stock levels may be a dangerous sign, especially in manufacturing, seasonal or fashion industries.
• How large are the bad debts and why did they happen?
5. Conduct an employee audit
If you’re allowed access to the business, consider an employee audit:
• Identify the key employees so you can plan how to run the business.
• Compare the general skill levels, employee turnover and pay with industry averages.
• Ask employees how they feel about a change of ownership.
• Would you expect any to leave? If so, would the key people stay?
6. Uncover any legal issues by completing a legal due diligence:
• Confirm legal ownership of all key assets. This might include property, equipment, vehicles and intellectual property (such as registered patents, designs and trade marks). Is the ownership clearly defined in all cases?
• Check for any past, current or pending lawsuits.
• Examine all contractual obligations. This includes employment issues and contracts with third parties such as customers and suppliers. Look for any contingent liabilities.
• Consider what effect a change of ownership will have. Are you likely to lose any contracts?
7. Review the risk and consider your level of risk. The risk is higher if the target business:
• Has assets (stock and equipment) worth less than your offer price
• Relies on one or two major customers – or suppliers or key employees
• Is currently unprofitable or has a history of losses. In this case, you may have to fund losses for some time to come.
Though it sounds obvious, making a lower offer and increasing it if required is always a better strategy than going in high at the start. Ultimately, the business is only worth what someone will pay for it. The seller might have to lower their expectations.