It’s all about “Due Diligence, or is it?
Due Diligence is basically the process of evaluating a prospective business purchase by checking that all the financial figures are verifiable and correct, together the 18 items on the checklist below.
But that’s only part of it. The figures themselves maybe accurate but is that really a full and proper picture of the business? Or are there hidden traps that might bring you undone? This is where our expertise comes in – having sold so many businesses over the years we can often see things that others can’t. There are some examples at the bottom of this page.
Practically speaking, for any business acquisition, due diligence includes fully understanding all of the obligations of the company: debts, pending and potential lawsuits, leases, warranties, long-term customer agreements, employment contracts, distribution agreements, compensation arrangements, and so forth.
A due diligence checklist is important when starting your investigation of that special business for sale. Below is a check list of some of the items you will need and which we will make sure are provided and are accurate. But that’s just the beginning.
Due Diligence Checklist:
- 3 Years Tax Returns relating to the business
- 3 Years of Past Complete Financial Statements - Profit & Loss Statements, Balance Sheets, BAS (Business Activity Statements)
- Current Interim Financials plus BAS
- List of Assets Being Sold With the Business
- Current Accounts Receivable Report
- Current Accounts Payable Report
- Cheque book Register for Last 3 Years
- Client/customer overview - Look For Account Concentration Issues, that is, too much business with just one customer can be dangerous
- List of Employees - Current & Past Payroll Records
- A Current Copy of all franchise agreements, licenses, loan documents. contracts or agreements utilised by the Business
- Current Copy of the premises lease
- Any past Environmental appraisals and requirements, legal reports & information
- A Current, Complete Supplier List - Review Contracts & Relationships
- Copy of All Contracts, including phone, vehicle, equipment, advertising etc.
- Details of all current marketing in place
- Does the business have an Operations Manual and a Business Plan
- What is the breakup of the turnover of the business e.g. sales, service etc
- Compare turnovers and nett profits from year to year and look for any substantial fluctuations
Now here’s the tricky bit. You absolutely must know that the financial information you are using in your decision-making process to buy a business is reliable and that it gives you the full picture. Most buyers think that checking whether information is reliable is the same as checking whether it is accurate. Not necessarily so.
In fact, accurate financial information is often unreliable and only paints part of the picture. Reliable data and a proper analysis of the full scope of the business is the only truly accurate measure of a business’s true performance .
The following are examples from due diligence reviews that illustrate this important point:
- Substantial dead or slow-moving stock not disclosed by the seller. The buyer was presented with a large warehouse with well-organised and detailed stock report. The buyer’s purchase contract included full payment for the entire stock. However, over time, most businesses accumulate stock that doesn’t sell and some sellers feel that selling the business is a good means of getting rid of accumulated, slow-moving stock at its full value. Buyers shouldn’t have to pay for sellers’ past mistakes. Once the true nature of the value of the stock was uncovered, the purchase price was adjusted downward to cover the lines that were just sitting there.
- The buyer was enticed by the rapid growth of a construction business doing work primarily for the government; however it took between 60 and 90 days to collect its receivables from the government. There had been substantial growth in the net income in line with the growth in sales. The purchase price included the value of some of this projected growth. But proper cash flow forecasts to the buyer showed that a substantial amount of the cash generated by the business would be required to fund the receivables in order to achieve the anticipated level of growth. This meant that, while the net income and tax liability would be high, the buyer would not be able to withdraw any salary from the business. The buyer had been concentrating on the net income without understanding the business’ cash flow cycle. The buyer ended up organising additional financing and incorporating this previously unidentified cost into his analysis and successful offer.
- Our examination of a retailer revealed a surprisingly low delivery expense compared with what we knew was the industry norm. Further investigation revealed that a related business made many of the deliveries without any charge. The buyer would not have such a relationship and would need to factor in these additional costs in order to sustain the operations of the business. The tax returns had overstated the earnings relative to this expense. Sorting through the appropriateness of each of the disclosed adjustments and identifying any undisclosed adjustments were critical to a meaningful valuation. The seller agreed to revise the selling price based on the adjustment to normalise the delivery expense.
These examples and countless others demonstrate the importance of professional due diligence but more importantly they illustrate the importance of having a bigger view of the business and being able to spot these pitfalls.