How to Do Due Diligence on a Business You Want to Buy

Before you decide to buy an existing business, you must do the research necessary to ensure that the business is what it appears to be and that everything is in order. You want to avoid any unpleasant surprises, including significant problems, liabilities or contingencies, and you want to be reasonably confident that the price you are considering paying is right. This process is called due diligence and involves a general duty to exercise care in the transaction.

Who should be involved in the due diligence?

The scope and nature of the due diligence process will depend on the size and nature of the business you are investigating. Who is involved will depend on whether you are working alone or have partners and staff to help you. You should generally also consider obtaining advice and assistance from an accountant, attorney, and other professionals, based on the nature of the business.

When is the due diligence performed?

You will probably already have done some investigation and research on the business you are interested in buying. But the detailed due diligence process typically begins when you have reached a preliminary agreement with the owner of the business that a deal should be done. You may have made an offer or signed a letter of intent. Due diligence is done before signing a binding contract to buy the business.

What are some of the common aspects involved in due diligence?

The due diligence process will generally involve reviewing documentation and records, some from public sources and much of it internal to the business you are investigating. The due diligence may also involve interviews and site visits. As indicated in an article on AllBusiness, some of the areas involved in due diligence are finances, legal issues, employees, business structure, and operations.

In general, you should review the financial statements, preferably audited, and the tax returns filed by the business for the past three to five years. You should review the current lease and other types of contracts, and other documents, such as property records, equipment maintenance logs and records, customer lists, sales records, and information regarding the business’s employees, management and legal structure. You should also review the status of intellectual property rights, such as patents or copyrights, if applicable.

Your potential exposure to liabilities and contingencies will depend to a large extent on how you structure the business acquisition, for example whether you are buying just the business assets or the entire business, liabilities included. If you are buying just the assets, you should find out whether there are any liens on those assets, as collateral for loans or due to a tax collection or other legal process. If you are making an equity acquisition of the entire business, you should review outstanding accounts payable, debts, pending or potential litigation, or any other contingencies.

As Gavin Johnson points out on the iVLG blog, you can go to the public office where liens and security interests are recorded, or you could contract a company that provides that service. If there are outstanding liens, you should ensure they are paid off and the liens are released before you close the purchase and sale of the business. Or you can obtain an agreement from the seller to transfer the assets free from all liens and encumbrances. If the seller of the business needs the proceeds from the sale to pay off the loan, you can get a payoff letter. Then you as the purchaser of the business will pay the bank or other creditor directly, rather than relying on the seller to pay the debt.

As indicated by the U.S. Small Business Administration (SBA), you should check to see whether the business has all the necessary licenses and permits to operate. These licenses and permits vary depending on the type of business and location. You should also be aware of the zoning requirements and any environmental regulations that apply. The SBA provides tools to find more information on these types of requirements.

Sample due diligence checklists are available that can be used as a guideline and can be adapted to your particular circumstances. These include the checklists on the Accounting Tools website and on FindLaw.

What types of agreements are necessary to do due diligence?

In addition to the letter of intent or offer to buy the business, you may need to sign a confidentiality agreement with the owner of the business, to ensure that the information revealed during the course of the due diligence is protected.

Sources:

Acquisition Due Diligence Checklist | Acquisition Analysis, Accounting Tools

Buying a Business: Due Diligence Checklist, FindLaw

Buying Existing Businesses, U.S. Small Business Administration

Brian Rogers, Avoid Unwanted Liabilities When You Buy a Business, iVLG

How to Perform Due Diligence Before Buying a Business, AllBusiness