Are you considering buying a business to start your journey into small business ownership? Or, do you want to acquire another small business to expand your existing one? Or, do you want to acquire a product to add it to your business? If you answered yes to any of these questions, you need to know about due diligence and how it can inform your purchasing decision.
What is due diligence?
Due diligence is an investigation into the business or product you are interested in buying. You will conduct your due diligence before the transaction is finalized to verify if the acquisition is worth it.
When conducting due diligence, you will look at key issues of the business or product, including profits, financial risks, legal issues, and potential deal breakers. You will examine historical records and future projections.
How to do due diligence
Small business due diligence can be a long, complicated process. It involves digging through a business’s records, checking references, ensuring everything checks out, and searching for items the business might have hidden.
Don’t conduct business due diligence alone. Hire an accountant and a lawyer who have experience in this area. While you can certainly be involved and look over documents, it’s best to have professionals on your side. They know how to look for red flags that you may have missed on your own.
When you start the business due diligence process, you will sign a confidentiality agreement with the other business owner. By signing, you agree not to contact people or businesses for additional information about the business or product without the other business owner’s approval. This prevents others from prematurely finding out about the sale before it is finalized.
Next, go through a due diligence checklist with your accountant and lawyer to ensure you hit all parts of the due diligence process. Your lawyer or accountant might have a checklist, but you can create your own.
Due diligence checklist
When you do due diligence, you will look at several aspects of the prospective business or product. Below is a business due diligence checklist to help you work through the process. This checklist is geared more toward acquiring a business, but you can easily adapt this for acquiring a product. Also, make sure you work with your accountant and lawyer to make sure you add or remove any necessary steps.
Financial due diligence
Financial due diligence, also called accounting due diligence, looks at the business’s economic situation. You’ll look for consistency among accounts, assets, and liabilities. You’ll also look at historical trends, projections, and tax risks.
- Look at past annual and quarterly financial information, including:
- Review sales and gross profits by product.
- Look up the rates of return by product.
- Look at the accounts receivable.
- Get a breakdown of the business’s inventory.
- How much inventory is on hand?
- What is the value of the current inventory?
- Make a breakdown of real estate and equipment.
- List the name, model number, and valuation of all equipment and furniture.
- Note the size and current market value of land or buildings.
- Review past projections and actual results.
- Take a look at the owner’s future projections, including:
- Quarterly and annual projections
- Projections by product
- Inquire about the assumptions the owner used to make projections.
- Get a history of pricing policies and past increases.
- Ask for all business tax details.
- Retrieve a summary of debts and their terms.
- Get a summary of all current investors.
- Get a summary of all shareholders.
Legal due diligence
Legal due diligence looks at legal contracts and other documents to look for hidden risks and lawsuits.
- Look at all copies of contracts, including:
- Leases
- Purchase agreements
- Distribution agreements
- Sales contracts
- Employee and contractor agreements
- Trademarks, copyrights, trade secrets, and patents
- Articles of incorporation
- Business registration documents
Operational due diligence
Operational due diligence investigates the actual operations of the business, such as the business model, the market, and competition.
- Identify customer patterns.
- Compare the number of first-time buyers compared to repeat customers.
- Determine peak purchasing times.
- Find out what the popular items or services are.
- Learn what the popular price points are.
- Study the business’s marketing.
- Look at past and current marketing tactics.
- Review the business’s previous sales and discounts, along with how well the promotions did.
- Go over how much the business spends on marketing and calculate the ROI.
- Learn the results of past marketing efforts.
- Conduct a market analysis.
- Research the demographics of the surrounding area and the business’s target customers.
- Study the geographic economic outlook.
- Find out who are the business’s competitors.
- Find out how people perceive the business.
- Learn what customers and potential customers, suppliers, and lenders think about the business.
- Research industry trends.
- Find out if the business’s industry is growing or slowing.
- Research profit margins for the industry.
- Learn more about the business’s competitors.
- Look at each competitor’s strengths and weaknesses.
- Compare the competitor’s products, costs, and earnings to those of the business you want to acquire.
- Determine any threats competitors pose to the business.
- Find out how much market share each competitor holds.
Product due diligence
Product due diligence allows you to learn more about the product the business provides.
- Get a list of all provided products.
- Learn the cost to create each product.
- Determine how profitable each product is.
- Look at past and projected growth rates.
- Investigate what enhancements have been made to products and what future enhancements are possible.
Human capital due diligence
Human capital due diligence looks at a business’s staff and management. It’ll investigate skills and qualifications, and any gaps.
- Get an organizational chart.
- Curate a list of current employees, including their positions, earnings, skills, and qualifications.
- Determine how employee wages compare to wages of people in similar positions in the industry and region.
- Get a breakdown of the company’s benefit plans.
- Learn about the business’s time off policies.
- Get estimates of the business’s projected staffing needs.
Consequences of not doing your due diligence
If you don’t do your due diligence, you might make a purchasing mistake. The person you are buying from might try to leave out details or fudge numbers to hook you. Without verifying the details you receive and searching for more information, you might buy a business or product that isn’t a good financial investment.
Making a bad investment can cause you to lose money on the business or product. The business or product might need a major overhaul. Or, you might inherit an unknown debt or lawsuit.
Also, the product or business might not fit your existing business or goals as well as you originally thought.
Conduct due diligence so you don’t get stuck with a business or product that has no future.
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This article has been updated from its original publication date of January 5, 2018.
This is not intended as legal advice; for more information, please click here.