What Is 'Due Diligence' by oY93rp


									                                                                         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,

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

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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