When you decide to buy a business you need to check to see if the information that was provided to you is accurate. The investigation of the sellers accounting and other records iscalled due diligence. This is an extremely important aspect of buying the business and too many people do not invest a lot of time and money to investigate the financial records.
If the records are misleading the due diligence process provides you the opportunity to walk away from the acquisition. It is far less expensive to walk away in due diligence than to close the transaction and find a material error. A material error is an accounting term. No accountant will certify that the financial statements are correct, what they will state is that the financial statements are within a tolerance level of errors that they will accept. Materiality can be based on many different items including total assets, net income, revenue etc. The level of materiality is determined by the accountant’s professional judgement. The materiality is based on each company.
If you are the buyer of the business, you have to decide what is the level of errors in the financials statements provided by the seller that you will accept. If you do not define what happens if you find problems in due diligence, are you able to walk from the transaction? If you have no definition, you may have to go to court to have the courts determine if you breached your contract or not or if you are entitled to get back your deposit. Personally, I like to see a definition in the letter of intent stating for example that if the net profit of the company is different by say 10%, or whatever you are comfortable with, then you have the right to terminate the purchase and are entitled to get your deposit back.
If the error is greater than your tolerance, you have the right to walk but you can also proceed even if you know that the financial statements have errors greater than your tolerance level. If you are buying assets, you are not taking on any liabilities which were not stated in purchase and sale agreement. If you buy the shares of the company, you are acquiring all liabilities, stated or undisclosed at the time of closing. You may have indemnifications from their former owner for any unrecorded liabilities but find him or her after the sale and try to collect. You may end up in the courts trying to collect money that the old owner may be responsible for.
If you have invested all your personnel assets in a business which you just bought if something goes wrong and you want to sue the vendor for misrepresentation, you may not have enough money to launch a lawsuit. There is a comment on one of my recent blogs confirming that this is happened to an investor who they lost their life savings not long after buying a business.
Spending money to safeguard your capital may be a waste of money if there are no problems. If problems take place once in every 100 transactions, do you want to be that one and lose everything because you wanted to save $5,000 to $10,000? Please note that I have never seen any statistics of the frequency of problems found in businesses for sale. Due diligence costs are a function of the size of the business, type of business etc. These figures were used only for illustration purposes only. The costs associated with due diligence can be far greater than the figures noted above. Due diligence on a company with $100 million in sales will be far greater than a business with $100,000 in sales. Please ask your accountant for an estimate or hourly rate that they would charge to conducting the due diligence on your behalf.