Due Diligence: What It Is and What You Need to Know
When we talk about buying or selling a business one of the first topics is the due diligence process. What does that mean for the seller? What should the buyer be looking for? The answer is contained in a long and thorough checklist.
As a seller, it means you must be prepared to present paperwork or reports that answer due diligence inquiries, and that any area where you are not prepared can potentially delay the sale or worse derail it altogether.
As a buyer, what it means is that you want to investigate a business thoroughly before you buy, making sure there are no hidden costs or surprises that will cost you in either the short or long run. The process can be a long one, and if the seller is unprepared in certain areas, that may be a red flag for you.
What is due diligence made up of, exactly? Here are some key elements of due diligence and what you need to know about each.
Organization and Good Standing
How a company is organized, from an LLC to an S-Corp, and whether or not that company is in good standing determines whether it will sell or not, and how easy that process will be. There are several parts to preparing this information, and it is best to have a professional help you, as a seller, get it ready.
As a buyer, this is the foundation of other things you will ask for. If an organization is not in good standing, or the business organization does not fit the business type, that could mean a lot of work on your part.
This first step is one of the most important in the due diligence process and is vital for both sides to get right.
As business brokers, we often also talk about recasting your books. This item of due diligence is why. The reason is that most small business owners have their books set up for the best tax benefit, not to show the true income potential of the business.
The buyer wants to know what the business truly makes and the growth potential. These are both big selling points and are a big part of the business valuation process. If you, as a buyer, are going to purchase a business, you need to know that it is worth what you are paying for it.
You also want to know about those taxes, and what the tax liability of the business has been. That will also help you determine if this is the right business for you to purchase.
This part of due diligence talks about what assets the business owns. This includes property and equipment, but also what upgrades you might have made recently, and what leases the buyer can expect to continue.
As a buyer, this is a surprisingly common deal-breaker. If the current landlord does not wish to continue the lease with you or wants to negotiate for higher rates, this can affect the viability of the business you are purchasing.
This process is often separate from the business valuation process and is vitally important in the due diligence phase.
You’ve heard location, location, location? What locations does the business have? Are they owned or leased?
As a buyer, you need to understand if business locations are secure for at least the near future. Moving a business after you take over adds both responsibility and risk. Be sure you know and understand both.
As a seller, are there patents that go with your business? Is your business name trademarked and do you own any copyrighted items? Do you have proprietary knowledge and expertise? How do you protect those things?
As a buyer, you have to understand that it is often an intellectual property that sets you apart from your competition, not physical property. If some of it is not included in the business sale, that could spell trouble. This is often why it is a good idea to make sure the outgoing owner will not be just starting a new business that competes with yours.
Employees and Employee Benefits
This is an area that can be challenging when buying a business. The reason? Sometimes the business owner does not want to let employees or even family members know when they are selling a business for fear they will leave, and the business might be disrupted.
But a buyer does need to know some things, especially about key employees. You must negotiate and determine what that looks like early on. If many employees leave as a result of the business sale, the resulting issues can be difficult or impossible to recover from.
Licenses and Permits
This is especially important with the contractor and service-type businesses or if you are selling a medical practice. Not all licenses and permits are transferrable. In fact, in California, not many are at all. The buyer must obtain their own licensing and, in some cases, new permits.
As a buyer, you will need to determine those licenses and what they are going to cost you on your own. That helps you determine how much the business will truly cost you.
There are two common types of environmental issues. The first is environmental studies of your property or property that you rent or lease to make sure there are no issues that could cause them to be fined or at worst shut down.
The second aspect is the materials you use to conduct your business and the effect they have on the environment. If you have a landscaping, pest control business, or other business where you handle chemicals and other potential pollutants, this includes everything about those materials including how you dispose of them, and MSDS sheets and other documentation on all of them.
Whatever contracts the company has, especially those that will continue to be binding even after the company is sold, should be shared as well. This means with employees, contractors, suppliers, customers (more on this in a moment), and more.
The buyer will also want to see your past contracts at least for the last few years. They want to make sure those contracts have been fulfilled, but it also gives them insight into how the business is being run.
As a business owner, you may be reluctant to release your current and even past customer and client lists.
However, they are important to the buyer so they know that first, they can continue doing business with your current customers. Secondly, they also show customer history and lifetime customer value.
When buying any business, it is important to know that you will have ongoing customers. However, it is also important to the seller that you do not share those client lists with anyone. At this point, you must be under a non-disclosure agreement, and this information must be kept secure.
This is often done digitally, in virtual data rooms in the cloud that can only be accessed by certain people with the proper credentials.
Products and Services
This only makes sense, but it bears repeating here because you need to show not only what you offer now, but products or services under development: things that could be coming in the future.
In addition, though, the buyer wants to know what problems you have had in the past. The products and services that a seller provides and that a buyer will continue to provide are the heart of the business and are what keep customers loyal.
The buyer wants to know if the business is being sued, has been sued, or might be sued soon.
As a buyer, this means you need to dig a little. If anything at all feels off in this area, consult your attorney. Have them check the business out completely.
This is another common place where a sale will derail. Honesty and transparency from the beginning on both sides are critical.
If you sell your business, one of the items you will need to know and be comfortable with is a Covenant Not To Compete.
Insurance and Professional Contacts
As a seller, it is important to show that you are insured, and who provides your coverage. This makes it easy for the buyer to see those costs. It also makes it easy for them to see that you are insured, and what coverage they will need.
As a buyer, you’ll also want to know who the seller uses for things like accounting, an attorney or attorneys, and others. You can either continue the relationships with those who already understand the business, or you can bring in your own choices, but at least you know what you need and how much, approximately, it will cost.
Articles and Publicity
What kind of press and attention is the company for sale getting? Are their articles, television appearances or ads, radio spots, or other public appearances scheduled? Is the new owner expected to continue doing all of those things?
As a buyer, this helps you to see what kind of marketing work the company is already doing, and can give you ideas about what to do next and what has not worked in the past.
Does all of this sound very time-consuming and in some cases costly? It can be. This due diligence process is one of the reasons it takes a long time to sell a business. It is also the reason that you should not try to sell a business on your own.
If you are focused on all of these tasks, you will probably not have time to run your business as it should be. You should enlist the help of a business broker, who will not only help you with a business valuation but will also assist you in coordinating this process. It will involve your attorney, accountant, and others you will engage in helping you get your business ready to sell and complete this process.
Do you have questions about selling your business? This link offers 5 tips to follow when selling a business.
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Want to understand due diligence better? Contact us at Rogerson Business Services. We’d love to discuss how we can help connect you with the right buyer at the right time to sell your business faster.