December 2006
Due diligence a
must when buying a business
It’s up to the
buyer to minimize the many risks associated with the purchase of an
existing business
For anyone considering the purchase of an existing business, the decision
to complete the transaction is often difficult and must never be made
without first conducting a thorough due diligence investigation. The term
“due diligence” is used in this context to refer to an evaluation of the
business, legal and financial affairs of the acquisition target.
There are many reasons for you to conduct a thorough due diligence
investigation. Some of the most important reasons are (a) increasing your
knowledge of the target company’s business, (b) determining the most
appropriate price for the target company or its assets, and (c) minimizing
post-acquisition surprises.
The breadth, scope and content of the due diligence review depends on a
variety of factors, including the size of the transaction, the type of
business involved, and the company’s legal structure (corporation, LLC,
etc.). Beyond these factors, there are certain tasks that should be
included on any due diligence list.
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Identify the seller’s motives. The
owner’s decision to sell may be motivated by any number of factors, such
as retirement (or illness or death), internal disputes, inadequate
capital, poor earnings, or bleak market prospects. By identifying the
seller’s motives, you may obtain valuable information necessary for
assessing the risks involved in the transaction, as well as for
determining an appropriate purchase price for the company.
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Review all financial records. Review
of the target company’s financial records is a key component of any due
diligence investigation because it provides the principle basis for the
business valuation. The financial review should include, but is
generally not limited to, the following: (a) the target company’s income
tax returns for at least five years, if available; (b) its balance sheet
and income statements (current operating budgets and any forecasts of
future company operations; schedules of notes and accounts receivable;
the most recent available schedule of accounts payable, as well as
comparable data from the previous year; and a schedule of all contingent
liabilities, such as guaranties and product or service warranties).
Often, the financial records of a private company are extremely limited
(and, in some egregious situations, nonexistent). In such a situation,
the due diligence investigation should be expanded in an effort to
obtain the financial information necessary for a reasonable valuation.
Limited financial data should impact the terms of the purchase. For
example, in a business that has a large number of accounts receivable
but no reliable financial statements, you may want to place a
substantial discount on the value of these accounts or even require the
seller to guarantee that all or some of the receivables will be
collected. At a minimum, the buyer will want to conduct a more thorough
investigation regarding the nature of the receivables and the customers
owing the debt.
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Review of all third party contracts.
The contractual obligations and rights of the target entity must be
identified for a proper valuation. Therefore, the due diligence effort
at a minimum should include a review of all franchise and licensing
agreements, sales contracts, joint venture or partnership agreements to
which the company is a party, insurance policies, agency, distributor
and advertising contracts, supply contracts, government contracts,
non-compete agreements, and other material agreements to which the
target company is a party.
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Review all employment contracts. In
many companies, the real value lies not in the assets, products or
customer list but rather in the employees of the company. Therefore, the
terms of all employment contracts, company retirement and benefit plans,
and employee manuals and union contracts are crucial to the success of
any business venture and should be reviewed as part of the due diligence
effort.
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Inspect all inventory. An inspection
of company inventory is obviously central to business valuation. The
inspection should include all capital goods, motor vehicles and other
assets needing a recorded conveyance or change of registration.
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Review all leases, deeds, mortgages and
any other loan agreements. Included here, the buyer should review
all documents and agreements evidencing borrowings by the target
company, including loan and credit agreements, promissory notes,
debentures and other evidences of indebtedness; documents evidencing
mortgages, security interests or loans on assets of the business;
guaranties, agreements to maintain net worth, and similar agreements;
agreements confirming lines of credit; leases of real or personal
property to which the company is a party, either as lessor or lessee;
and documents and agreements evidencing other material financing
arrangements, including, without limitation, sale and leaseback
arrangements, letters of credit, and installment purchases.
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Review all litigation files.
Information regarding pending or threatened lawsuits involving the
target company must be carefully examined. You should also review any
administrative proceedings, governmental investigations or inquiries,
and disputes involved in arbitration. All settlement agreements, consent
decrees, judgments and other decrees or court orders should also be
examined.
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Review all required government filings.
State and local government permits and licenses are routinely required
before most companies may lawfully conduct business. You should ensure
that all required permits and licenses have been appropriately
maintained.
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Review all documents establishing the
legal entity for the business. You should review any assumed name
certificates, partnership agreements, shareholder agreements, bylaws,
articles of incorporation and any other document establishing the legal
structure for the target entity.
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Evaluate all intellectual property.
Finally, you should never forget to evaluate all intellectual property,
including any patents, copyrights, trademarks, trade secrets,
protectable processes, and goodwill.
The due diligence process can be extremely complex and usually requires
the involvement of legal, financial and business professionals. Therefore,
before you buy an existing business, take the prudent step of engaging
appropriate counsel. There are many risks associated with the purchase of
an existing business, but with due diligence they can be minimized.
Based in Mesa, Arizona, and serving closely held businesses in the East Valley,
the Phoenix area and throughout Arizona, Schmidt Westergard & Company, PLLC, is
an independent full-service tax, audit, accounting and business advisory firm
focusing on the middle market.
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