Gunflint Capital What Is Due Diligence? A buyer has both an obligation and, most likely, the right under the terms of any Purchase Agreement to inspect the accuracy of information provided, and the claims made about, a business. This validation process is known as performing “due diligence.” The basic objective of due diligence is to validate that the representations made about the business are accurate, and that there are no other factors outside those representations that the buyer should taken into consideration. Understanding Due Diligence Due diligence is a buyer activity, but it is critical for sellers to understand what a buyer may want to review in the process of buying a business. Sellers must also support the buyer’s reasonable requests for information and business access. When Does Due Diligence Take Place? Deals may proceed in a number of ways, but a typical deal might begin with provision of several years of financial statements and a visit to the business. Once questions about the business and financial information are answered and a buyer decides to make an offer via Letter of Intent, the final negotiations will result in a binding Purchase Agreement with earnest money. At this point, the buyer will engage in a deeper investigation for a set period of time designated in the Purchase Agreement to validate the accuracy of the claims made, as well as understanding the underlying quality of those claims. What To Expect The most obvious part of due diligence buyers want to focus on is the financial information of the business, particularly as it relates to sales, profits and cash flow. For example, up to the point of a binding agreement, the buyer has taken sales information essentially at face value. During due diligence, however, “trust but verify” is the theme. A buyer may want to see bank statements to verify that deposits support sales claims, review cash register “Z” tapes or see sales tax reports, validate customer account information, review sales orders, etc. Other financial statement items like cost of goods sold might be validated with invoices, checks written, payroll records, inventory reports, etc. The quality and stability of cash flow is also subject to validation. For example, the company’s most profitable customer may be having financial difficulty, a fact that may be uncovered in due diligence and which lowers the buyer’s perception of the quality or dependability of the company’s current and future cash flow. Gunflint Capital The quality of the assets of the business may also be assessed. Maintenance logs might be reviewed or inspection personnel brought in to make sure the tangible equipment of the business is in good working condition. Gunflint Capital Examples of other due diligence areas are: Customer contracts Supplier contracts Employment contracts Union agreements Invoices Regulatory matters Status of intellectual property Customer concentration Customer relationships Liens and other liabilities Contingent liabilities (like warranties) At some point buyers may need to talk with key employees as well. Clearly, because of the possibility a deal may not go through, this needs to happen at the very end of due diligence after all other items have been resolved. Otherwise, employees may be needlessly alarmed about a sale that ends up not taking place. Ultimately, how complicated the business is will drive how detailed and far-reaching due diligence must be to satisfy the buyer’s needs for validation. The Last Hurdle Once the primary terms of the deal are agreed to, due diligence is one of the last big hurdles to get over on the way to closing. Problems may arise in due diligence, but they don’t have to scuttle a deal. If the issues are legitimate, be flexible in finding acceptable solutions or engaging in additional negotiations based on discoveries made during the process. Business owners should keep future due diligence in mind as they are preparing their business for sale: keep financial records clean, accurate and up-to-date, maintain good operational processes, and keep equipment in good working condition.
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