Updated July 5, 2022
How important is due diligence when buying a business? It’s the most important step in the process.
Due diligence is a fancy term. In practical use, it can be summarized as that phase in the purchase of a business when (1) you verify the accuracy of the information that you’ve previously been furnished and (2) you make sure that there are no serious, undisclosed problems with the business.
In this step, you will inspect the books and records of the company to verify the financial information. You will also check whatever appropriate sources are necessary to make sure there are no undisclosed problems lurking around the corner that would adversely affect the business.
We’re assuming that you have made a written contingent offer to buy the business and that you and the seller have agreed on price and terms, possibly after some back and forth negotiations. Now the transaction is contingent upon your due diligence investigation.
The “Books and Records”
After the seller has accepted your contingent offer, you are entitled to all the books and records of the business. Since you’re this far along in the transaction, you most likely already have the profit and loss statements and the tax returns. At this point, you can ask the seller any questions you want about information contained in any of these records. In fact, you will probably need his assistance in interpreting some of these financial reports. Don’t be shy. Ask for any clarification you need.
You may also want to look at other documents such as the bank statements to verify deposits, the monthly sales tax reports if there is a question about sales revenue or the seasonality of sales during different times of the year. Also the quarterly payroll reports should be available for your inspection if there is any question about wages.
Again, this is the time for you to satisfy yourself as to the accuracy of the information you were previously given and upon which you based your contingent offer to purchase the business.
The Other Issues
The other points to be covered during due diligence involve questions about key employees and the legal, regulatory, and environmental issues plus the lease if the business is in a leased location. Checklists for each of these areas of inquiry are readily available online. Just be aware that this is not General Motors buying Ford. Those kinds of checklists will fill a library!
Remember, in an asset sale, you are buying selected assets of the business and assuming none of the liabilities. (In a corporate stock sale or LLC membership sale, all issues would definitely remain for the new owner.) However, even in an asset sale, there are some issues that might legally follow the assets, so you need to be aware of any problems that might exist, and make sure they are handled to your satisfaction. For example, unpaid payroll taxes follow the assets regardless of the type of sale.
Now if everything checks out all right – and in the majority of cases it does – then you are almost to the finish line. As the astronauts say near the end of the countdown to blastoff, “We’re good to go.”
If I can answer any questions or assist in any issues involved in buying or selling a business, please don’t hesitate to contact me at (251) 990-5934 or Will@WilliamBruce.org. To subscribe to this blog, please see the top right portion of this page for the place to insert your email address. (Don’t worry, we will not sell or use your email address for any other purpose!)
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A few year back I ran into a real issue when purchasing a small business. It was a coffee shop in the Atlanta area. Every thing looked great and the books showed a small but constant positive cash flow. What I did not see was money being received as sales receipts that was really a roll-over from the owners to make sales look better.
How do you catch something like that?
Good question. If the business had a POS system, the daily printouts may have given a clue. Also the bank statements might have shown names on the deposit slips. In any event, that sounds like fraud on their part.
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Plz email the book, thank you sir
Wesley, thanks for dropping in. The booklet is on the way. Good luck with your project. ~William
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I am looking to buy a restaurant and it is my first business transaction. Do I need to hire an accountant and lawyer to verify documents presented by seller or their broker?
Manjit, thanks for stopping by. Yes, it’s always recommended to obtain professional advice. Make sure you get the federal income tax returns for the business under consideration. The tax returns are the most authoritative documents to review during due diligence. Good luck with your project. -William