This article are provided for information purposes only, and are not intended as legal advice.


Buying a business – why do due diligence?

March 22nd, 2010

When you found a business for sale which you want to put in an offer, you generally prepare a letter of understanding outlining the price and the conditions of what you want to buy.  Typically, a letter of understanding is a non binding document however it does talk about a deposit which is paid and the treatment of the deposit if the deal were to fall apart.  After you agree to the letter of understanding, generally the investor is given a period of time to conduct due diligence. Due diligence is the ability to look at the books and records in order to determine if the information forwarded to you can be relied upon.

 

All too often, I see investors try to save money and conduct the due diligence themselves.  Unless you understand what to look for, you will often miss the important items in due diligence.  Due diligence allows you to determine the accuracy of the information which you based your letter of understanding on and determined the price that you offered for the business.  If the information is incorrect, you have a choice of walking from the transaction or renegotiating the purchase price.

 

Once you continue on beyond the due diligence phase and you close the deal, if you missed something in due diligence, you may have no recourse to the old owner.  Years ago an investor hired an accountant to due diligence and they noticed that the restaurant had revenue in the accounting records on 6 days of the week but was only open five days a week.  Fraudulent sales boosted the earnings and revenue of the business which were fictitious.  This was caught in due diligence and the investor walked from the transaction.  Another investor purchased the business, did not discover the fraud and lost their entire investment in a very short period of time.

 

Another investor purchased a real estate property and the operating business.  The legal documents were not clear and the documents kept changing as the transaction ran into snags.  In the end, the investor did his own due diligence and was not quite sure what he bought.  There were charge backs to tenants and he did not know how any of the calculations were made and what was being charged back.  This is what was supposed to be discovered in due diligence.  If you bought something without understand how it operates, you could have serious issues after the transaction closed.

 

I have seen investors, even sophisticated investors due their own due diligence and they often miss major items.  What happens is the investor is buying from emotion and has to have the business rather than looking at the economic side of the transaction and being independent and free from making judgements based on emotions.  Remember, buying a business is an economic transaction.  You risk a lot of money that you have worked so hard to earn.  It may be the biggest investment you ever made.  You spent a year looking for the right business and you have one to two weeks to review the records to see if you received all the information.  Spending money on an advisor could save you a large amount of money if a fraud was discovered like in my example above.  That investor lost hundreds of thousands of dollars all because they did not want to hire an accountant for a few thousand dollars.  Was that a wise decision?  I leave you to decide that.


Filed under: Due diligence — Gary Landa @ 9:09 am


No Comments »


No comments yet.


RSS feed for comments on this post. TrackBack URL


Leave a comment


You must be logged in to post a comment.