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


What do you look for when doing due diligence when you buy a business?

March 24th, 2010

Most if not all investors who buy a business are given the opportunity to conduct due diligence when they buy a business but many do not fully understand what this opportunity provides, when they are entitled to see and how to use the information that they have now discovered.

 

When you buy a house, many people now are getting home inspectors to look at the house for them to tell them all the defects in the house and what needs to be fixed in the house.  Conducting due diligence is the same thing, it provides you the opportunity to look for problems in the business, confirm if the information that was provided to you was correct etc.  Let’s go back to my house scenario – a home inspector tells you all the things that you did not look at or see.  The home owner did not tell you what the defects in the house were – this is not different than buying a business. The primary purpose, in my opinion, of due diligence is to confirm that the information provided to you was correct but more importantly to find information which was not provided to you.  If you can find the hidden problems, lawsuits not mentioned etc, then you may have found a reason to either walk from the investment before losing your entire investment, renegotiating the purchase and sale agreement and price, or proceed and complete the purchase and sales agreement as originally contemplated.  Those are your three choices.

 

Due diligence provides you the opportunity to see if things make sense.  In my example yesterday, a restaurant was open 5 days per week but the revenue indicated that they operated six days per week.  Although this company showed healthy profits, all suppliers payments including government taxes and withholding taxes were in arrears.  The information provided and the reality of suppliers not being paid did not make sense.  That is how the fraud was discovered, phantom sales to make the business look much healthier than it actually was. 

 

If you have no training in accounting and what to look for, you should hire an accountant to assist you in the due diligence.  Many investors try to keep their costs down but a small investment of a few thousand dollars may be far cheaper than losing your entire business. Unfortunately many investors do not think that way.  Some investors are very trusting and if everything works out, they will say, see, I told you I did not need to waste their money on due diligence.  I do not know the statistics of how many people run into a problem after the business has been purchased.  If these problems are large or small , I do not believe that this information is readily available to the public. 

 

A small investment to save your entire life savings – that is the cost of not conducting due diligence properly.  I would guess that in the majority of cases there are no problems but in others there are savings.  I am aware now of an investor who bought a real estate business, did not conduct due diligence, the cost of figuring out what happened subsequent to closing has been extremely costly but the investor was lucky, he found out that the old owners did not read their contract and in fact under charged the tenants for years. This may have ended up as a windfall for an investor who trusted the vendor who signed a statement that there were no problems.  Unfortunately, the document and what really happened in the business were not the same, there were many problems which were never identified by the vendor which the new investor inherited.  Some favourable, others not.  In this case, which is rare, the investor may have been better off but the problems should have been discovered in due diligence, not after the fact when some of the information was not provided by the old owner subsequent to closing.


Filed under: Due diligence — Gary Landa @ 8:28 am


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