You have just decided to purchase a business, merge with another company or invest in someone else’s company. Exciting, isn’t it…but wait?

You have probably been busy learning the business, talking to the seller about the operation, conducting market research and planning on how you can run it more profitably than the previous owner.

It does not matter if you are buying a small cell phone store, a large high-tech company or investing in a friend’s “next big thing”. There is one thing you absolutely must consider: your due diligence.

What is a due diligence and why is it so important?

One (very technical and boring) definition of due diligence is: It can apply either narrowly to the process of verifying the data presented in a business plan or sales memorandum, or broadly as completing the investigation and analytical process that precedes a commitment to invest. The purpose is to determine the attractiveness, risks, and issues regarding a transaction with a potential investment. Due diligence should enable investment professionals to realize an effective decision process and optimize the deal terms.

In reality, due diligence is a process in which the potential buyer (or investor) investigates, analyzes, inquires and tries to learn as much as possible about the proposed business in order to verify the accuracy of the information provided by the seller.

Since the information provided by the seller is the basis for the buyer’s decision to buy (or not) and the purchase price, it is crucial that any buyer verifies that information before making the final commitment to invest.

How do you do the “due diligence?”

There several aspects of the business you should check…such as:

 Legal exposure

Technology and patents the business may own

Business performance and financial position

Usually you need to contact the business’s lawyer and ask for a letter listing all the legal actions and claims the business is a party to. You should also ask for copies off all agreements, contracts or other binding understandings the business has with third parties.

Here is a partial list:

Employment contracts

Shareholders agreement

Leases

Purchasing agreements

Client’s agreements

Licensing and royalties

Loan agreements

Technology and patents

 What do you need to perform a financial due diligence?

 1. Check the company’s assets:

Cash: Ask for all bank statements, petty cash and all other locations in which cash is held. See if the total matches seller’s numbers.

Accounts Receivable: Ask for a list of all customers who owe money to the business. See how long they have not paid. Inquire if there is a dispute with any of the customers.

Inventory: Ask for a complete list of inventory items. Count the actual inventory and see it matches the business inventory list.

Other Assets: Ask for a complete list of all other assets that the business owns. Identify the assets, locations and market value.

2. Check the company’s assets:

Accounts Payable: Ask for a list of all vendors the business owes money to. Verify the validity of the underlying transactions.

Bank and other loans: Ask for loan agreements. Check the payment schedule, go back and track past payment and verify that the listed outstanding balance is correct.

Other liabilities: Ask for a complete list of all other liabilities. For each one, run the same inquiries suggested for Accounts Payable and Loans.

Note: A very important goal of the due diligence is to find out if there are liabilities not listed or disclosed by the seller. You need to verify that there are no additional debts to suppliers, banks, other loan providers or any other undisclosed amounts.

3. Check the company’s income and expenses:

Sales: Scrutinize all sales transactions of the past 3 years.

Expenses: Ask for a breakdown of each expense. A partial list of expenses may include:

Wages and Benefits

Marketing and Sales

Rent and Utilities

Legal and Accounting

Office Expenses and Supplies

Taxes

Travel

Interest and Finance Charges

Outside Service and Subcontractors

As with liabilities you should look for unrecorded expenses to understand the true and actual expenses rate of the business so you will have no future surprises.

Conclusion

Buying a business is a huge investment and decision. To make sure that “what you see is what you get” you should conduct a strong due diligence.

This article describes ways and points you should focus on when conducting your own due diligence. But as always, there is no substitute for retaining an expert or professional who understands due diligence and has the specialized experience. When buying a business you should really consult with an accountant and/or consultant and make sure you cover all bases.

Full article, credits and references:

http://ftspro.net/buying-a-business-think-due-diligence

ZDT Author’s note:

In our ZDT MODEL that contains 4 steps, due diligence is the first (and most vital) step. Without proper due diligence, there is really no reason to proceed. This is an app for buying a business, but any important decision should have the same level of scrutiny. Point is, doing your homework on any heavy decision has no substitute.

As always…you decide.