How do you know that the seller of a business is telling the truth?

How do you know if he has or he hasn’t “cooked the books”?

The simple answer is a not so simple phrase; due diligence.

Due diligence is the investigation that needs to be completed before buying a business. It is done to protect your interests and to ensure that the business is in the condition that the seller says it is.

Simply put, performing your due diligence means taking a highly detailed look at the business you are considering to buy,  paying special attention to the following:

* financial performance

* inventory and assets

* employees

* how the business actually operates

* who their customers are

* how they get their customers

* supplier relationships

* competition information

Beyond just confirming that what the seller has told you is accurate information, due diligence also allows you to look a little deeper into the business and find out how it really works, where its strengths lie, what weaknesses it may have and how you could or could not make a difference if you were running the show.

Do You Need To Do Due Diligence?

According to my legal friends, you would have to be as mad as a hatter not to!

True, it is common practice to include clauses in the purchase agreement to ensure that what the seller has told you concerning the business are comprehensive and true.

True, this even includes provisions in the contract that allow you the option to back out of the purchase after signing the agreement if he is shown to not have been as candid and honest as he should have been.

But wouldn’t you agree that prevention is a much more sensible practice than cure?

Can you imagine the headaches you are going to have trying to put things right after you have completed the purchase of the business?

And it also seems that knowing a prospective buyer will be carrying out due diligence, scrutinizing every detail of the business before going ahead, encourages buyers to tell all and not to try and hide something they know they should not.

So due diligence it is.

Every Business Type is Different

While it would be nice to have a ‘one size fits all’ process, unfortunately you will find out very quickly that how you conduct your due diligence for buying a particular type of business really depends on the industry the business is in.

For example, due diligence for purchasing a construction firm is not even close to the due diligence required for purchasing a bar.

As an example, if you look at a cash in hand based business, asking for tax returns for the last 5 years is probably not going to show you anything worthwhile about the business. The biggest attraction of being in a cash in hand business is that not all the takings are always recorded.

You will need to know what type of information will show you the proof of what is really going on in the business and its history. Often this is done through working backwards from  invoice records to come up with the correct figures.

You may find that a retail business will often require that you observe the customer’s comings and goings in and out for a given period of time to judge with any accuracy what the true state of the business is.

Working alongside the seller in his business for a week or so would be an ideal way of getting a good idea of what is happening.

How Long Does it Take?

Well you can never start too soon in the buying process.

From the moment that you decide “this could be the one for me”,  start writing down any questions that come into your head about the business.

There are no right or wrong things to ask about, it’s all fair game.

Start by checking out the company through any and all sources. Go to the selling broker if there is one, use Google and the internet, check out the archives of the local newspapers.

You can also start gauging local reaction to the business. Have people heard of it, what is their opinion of it?

You should not be tempted to contact current customers or clients of the business at this time if there is any chance of it getting back to the seller.

It may cause problems for him with the business if people know he is considering selling and it isn’t going to make him feel too generous towards you when it comes to negotiation time if he knows that you were the one that let the cat out of the bag!

In agreeing that starting your due diligence as soon as you have any true interest in acquiring a business is the best time to start, the contractual due diligence period will normally run from between two and six weeks.

Dependent on the industry, this could be longer, especially if it is a very complicated type of business.

Be aware, you may find that vendors and their brokers will try and push things through as quickly as possible, asking for only 2 to 3 weeks.

Although you are under no obligation to agree, it is often sufficient time enough to complete due diligence of most smaller businesses if you are well prepared.

But sticking out for the time you require to do the job properly should be your prime concern.

To avoid the situation whereby the seller can ‘sit on his hands’ a bit, not providing papers asked for, delaying meetings or replying to emails or phone calls, you should also agree that the due diligence period does not commence until you have the specified documents in your possession.

So now you know what due diligence is and some of the pitfalls to be aware of, next week will look more closely at the due diligence process itself.

Remember, knowledge is power and you are accumulating new knowledge at an amazing rate. By reading these articles and carrying out this research you are placing yourself in the top 5% of entrepreneurs.

Feel good about that? You should!

This article was written by Brian K Fitzgibbon CPA.

Brian is an experienced accountant and small business consultant. He runs his own business, lectures extensively on small business topics and has checked out and valued many hundreds of small businesses for buyers.

Brian is also the author of the highly acclaimed and invaluable
"How To Value A Business And Buy It Without Fear"
A do-it-yourself guide for first-time and experienced buyers alike.

To download a FREE Chapter from Brian's book please follow this link: "HowToValueBusiness.com"

May 13th, 2009 | Tags: buy a business, buying a business tips, check the books, due diligence | Category: articles | Subscribe to comments | Leave a comment | Trackback URL  |