Tips on how to perform due diligence on a business you want to buy. Plus: What it takes to close the deal.
Now that you've made your offer, it's time to get your hands dirty. This is the stage before you close the deal where you take your detailed checklist to make sure that you can verify every aspect of the business about which the seller has told you. Your lawyer and accountant should also play a role in helping you uncover anything unusual about the business that the seller didn't disclose, such as any pending lawsuits or liens against the business's assets. You typically will have about two to four weeks to complete the process.
This can be the most important stage of buying a business, according to Anja Bernier, president of Efficient Evolutions, a business brokerage in Newton, Massachusetts. "You are truly putting your net worth on the line if you fail to take the time to dig beyond the P&L," she says. A typical due diligence process can involve as many as 150 different items covering the legal, finance, and human resource components of the business, she says.
The following guide details how to perform due diligence on a business you want to buy, as well as what it takes to finally close the deal and take over your new business.
Performing Due Diligence
Key Areas That Get Overlooked
While most sellers wouldn't knowingly withhold information from you, the onus is still on the buyer to uncover any potential pitfalls. It's also why some 90 percent of business sales fall apart at this stage of the process. Some of the more prickly areas to dig into during the due diligence phase include:
- Consistency of Financials: One of the most noticeable red flags in a business is a sharp increase in profitability in the year or two leading up to a sale. Sellers will often scale back their expenses or at least shift them around to increase the profitability of the business in preparation for a sale. Since many business owners use their expenses to shield their tax exposure, it is very common to see these up ticks, especially in terms of Seller's Discretionary Cash Flow (SDCF). On the other hand, if the seller has been cutting back on expenses like marketing or personnel, the seller might have been cutting more muscle than fat.
- What to do: To get a better sense of the potential mess, compare expenses as a percent of sales over the past few years to see what trends emerge: if the ratio of expenses has been in a deep decline you might be looking at trouble. The balance sheet might also provide other financial warning signs such as if the business is taking longer to pay its bills, has cut back on its inventory or even if there are shareholder loans on the books, Bernier says. "This would mean that the seller may have been forced to inject some of their personal capital into the business," she says.
- Lease Details: One of the most overlooked assets of any business is its lease. "Sometimes businesses are bought simply for their location or the attractiveness of the terms of their lease, which might be sub-market," says Peter Berg of Transworld Business Brokers in Florida. At the same time, he says, lease problems are the No. 1 killer of deals because buyers usually wait too long to examine them. Leases can be problematic if they aren't automatically transferable to the new owner or, if the landlord isn't comfortable with the buyer's credit rating, he can double the rent or even refuse to accept the new tenant altogether.
- What to do: If the business operates out of a large shopping mall run by a national company, securing a new lease could take up to three months as well. Any leases on equipment like cars or trucks also need to be sorted out, since "we often run into problems trying to get the seller off the lease guarantee," Berg says. Banks like adding guarantors on loans, he says, but they don't like taking them off.
- Reliability of Customers: While everything about the financials of your new business might look clean, they could be at risk because of the financial state of the business's customers. With so many companies struggling these days, it's worth digging deeper into who your customer base might be and how the economic downturn might be affecting their ability to pay their bills.
- What to do: That means taking a look at the accounts receivables to see if the outstanding balances of key customers are growing larger over time. It's also worth evaluating the quality of the firm's customers: If one customer accounts for 60 percent of sales, it's worth doing some research on how that customer's industry is weathering the current storm.
- Employee Stability: If the business you want to buy has employees, it's important to understand who the top performers are and whether you have any guarantee that they will remain with the company after you take over. Make sure you don't overlook the current owner's role in the business.
- What to do: Take note of what percent of the business the current owner accounts for: If they are the firm's top seller, you might need to build in some kind of non-compete agreement to ensure that when they sell the company to you, they don't in turn walk away with your top customers as well. Also ask for details about any employment contracts that business has with its top performing employees.
- Inventory: The last component of the due diligence process is inventory -- something the seller and buyer do together either the night before or the morning of the close. Any differences in inventory levels from their earlier estimates are typically settled in cash at the time of the close.
- What to do: Of course, that creates a final discussion point about what the inventory is actually worth, something that should be agreed upon before both parties show up for the close.
Closing the Deal
Signing Your Life Away
Try to ignore those cold feet of yours. All that hopefully remains is for you to affix your signature to all the documents and paperwork you'll need to make your ownership official, a list that will include things like:
- Lease assignments
- A promissory note to your lender
- An agreement to cooperate with the seller.
Your lawyer will also have you and the seller sign documents attesting to the fact that the business's assets are now free and clear. At the same time, your accountant will have you sign the purchase price allocation agreement, a document that breaks down the value of the company's tangible assets like inventory and contracts and intangible assets like good will. How those numbers are allocated will determine how much tax each you and the seller owe based on the transaction, so, when possible, let your accountant negotiate the relevant terms with the seller's accountant to minimize any further negotiating tension. This also speaks to the value of having third-party representatives like brokers to help speed the end game along, says Andrew Rogerson, a business transfer agent with Murphy Business, in Sacramento, California.
As much as you might have tried to iron out wrinkles with the seller before now, though, you may need to be prepared to deal with a few more. That's why Berg recommends that as one of the first things you do when you show up at the close is to put down a cashier's check or equivalent right in the middle of the table, just where the seller can see it and stare at it. "I often find that when a seller sees their money, they become much more conciliatory when it comes to finding middle ground," he says. After that, of course, it's safe to pop open that bottle of champagne.
Post-Mortem: Prepare a 30-day Plan
As a new business owner, there are a series of steps you should take within the first month to start your new investment on the right foot.
- Take care of employees:One of your first priorities should be to set up an introduction with your employees, most of whom might have had little or no clue about their status during the negotiation process. It can also be a good idea to give your employees, especially your those you identified as being most valuable during the due diligence phase, a raise after the first 30 days following the sale to show how much you value them and want them to stick around. You can use this time to "interview" your new employees, asking them for input and ideas about how they might help the company grow into the future. These can also be good opportunities to gauge how well new employees will fit into your vision of the company.
- Learn what you can from the seller:Depending on your agreement with the seller, you will also have between 30 and 90 days in which the seller will serve as a consultant to help the new buyer through the transition of learning how to operate the business. But, again depending on your agreement, you might also have the opportunity to hire the seller for an extended period of time -- particularly if the seller financed part of the price or if they have an equity stake in the future profits of the business.
- Meet the firm's key customer and business partners:During that first 30 days, it will be critical to work with the seller to get introductions to all the firm's key clients, vendors and suppliers. It is through these meetings that you'll be shaping the future course of your company.
After the first 30 days, however, once you've grown comfortable in your new role, you'll most likely look forward to taking the reigns yourself and doing some thing your own way. As Peter Siegel, founder of USABizMart.com, says, "You're moving into growth mode while the seller is sliding into golf mode."