Due Diligence: The devil is in the detail

May 24, 2018

Industry News

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Due diligenceDue Diligence: A reasonable investigation of a proposed investment deal and of the principals offering it before the transaction is finalised to check out an investment’s worthiness.

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 (remember, this is not a complete list, but it does offer a good place to start):

  • 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.
  • 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 specialises in intellectual property.
  • 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 may have to read between the lines to determine the actual net worth of the company.
  • Financial statements: 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 an accountant or qualified professional familiar with this type of business.
  • 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/accountant or a similar professional 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. They 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?
  • 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.
  • The business’s reputation: This is a very important step when conducting Due Diligence. 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.

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