If you’re someone who hated homework in high school - we’ve got some bad news for you.
The expression “what you don’t know can’t hurt you” might be valid for a lot of things, but when it comes to buying a business, what you don’t know is precisely what could bite you in the ass.
Performing due diligence is one of the most critical steps when purchasing a business. I don’t care if the dude you’re buying from is your brother’s best friend’s sister’s step-uncle, who you’ve known since you were in diapers. You should always, ALWAYS, do your homework before making anything official. A misrepresentation of facts or figures - intentional or otherwise - is always a possibility. Protect yourself from agreeing to a crap deal. Remember, it's not personal - it’s business.
When is it done?
Due diligence is typically one of the final phases of your business acquisition journey. You’ve already scoped out what you want to buy, spoken with the owner, made an offer, and negotiated the price and terms. All of that, however, is contingent upon said owner providing you with accurate facts and figures about the overall health of the business he’s selling you. Enter Due Diligence.
Why is it so important?
When you’re buying a company, you assume ownership of everything. EVERYTHING. That might include profits, valuable contracts, and inventory. (yay!) That might also include back taxes, outdated equipment, and terrible profit margins. (not yay.)
You should never take anything at face value, which is why you must perform your due diligence to confirm that what you’re paying for is what you’re getting. You may discover they’re in better shape than you thought. Or you might find it’s a sinking ship, and you didn’t pack any life vests.
When conducting due diligence, you want to focus on three main areas: Finances, Operations, and Legal.
Review Profit and Loss Statements: Review revenue, gains, expenses, and losses and compare quarter by quarter over the last five years. Do you notice any trends? Their numbers might be “good” right now, but has there been a steady decline over the last year that indicates a problem of things to come? Are their expenses increasing? Are profit margins holding steady? Or are there noticeable (and unexplained) dips?
Review their Cash Flow: Positive cash flow means the business has more money coming in than going out. Negative cash flow means the company is spending more than what they’re bringing in. While it’s unlikely that you’ll acquire the actual cash when you buy the business, it should still be reviewed and analyzed to understand better what you can expect once ownership transfers over. Depending on your own financial situation, you might need to rely on a certain amount of cash flow in the early days. Make sure there will be enough.
Balance Sheets: This is where all the business’s assets, liabilities, and equity will be listed. Assets bring value to the company (inventory, equipment, trademarks, patents, etc.). Liabilities are what the business owes (unpaid invoices, loans, etc.). And equity is simply the difference between the two.
Taxes: It’s not fun (unless you’re in the accounting sector), but it’s not something you should skip over. While the IRS loves making sure they get every cent they’re owed, people still manage to cheat (or disregard) the system, and any back taxes or tax liens the business has will become your problem. (And believe us, the IRS will figure it out eventually). You’ll want to make sure all tax payments are current and review things like payroll, property, and employment taxes for any discrepancies.
Time to see how the sausage gets made. This is an opportunity to deep-dive into the inner workings of the operation itself. Depending on the type of business you’re buying, you may want to review the following:
Surprises are only fun when they’re good surprises, and the last thing you want to do is uncover a shitty lease agreement or contract three months into being the new owner. If you haven’t already, you may want to involve an attorney in this process, as it can get pretty technical and cumbersome. Some of the things you should be looking at include the following:
You should expect to spend anywhere from 45 - 180 days on due diligence. Perhaps less if it’s a smaller deal - or up to six months if you’re taking on a large or complex business. Either way, it’s important not to rush the process. Be efficient, but don’t get sloppy.
Again, it might be your brother’s best friend’s sister’s step-uncle who you’re buying from, but you should never just “take their word for it.” What you uncover during due diligence can not only give you room to renegotiate terms and costs with the seller - it can also keep you from making a huge mistake. Don’t go into it blindly. Put in the time, do the homework, and make the best deal possible.