Rule 3: Due Diligence Is Required for All Deals, Big and Small
Due diligence is a fancy term for “checking underneath the hood” of the business.
A buyer needs to learn everything about the company from internal sources, and then cross-check the information against external sources. For instance, a buyer will obtain company tax returns and financial statements. Part of the cross-checking would involve comparing the SBE’s numbers to published industry data. While you may not have immediate access to such information, you may be able to obtain that data through trade associations for that industry, data published in a guide called the RMA Statement Studies, data available through your local library or through the SBDC.
Your CPA or business advisor will also suggest you do a spreadsheet comparing a series of years of income statements. Look at the comparable historical data and make inquiry of the owner about any trends or unusual fluctuations in revenue or expenses. Determine if those fluctuations make sense, or whether there is something requiring further inquiry. For instance, if you see a sudden increase in legal expenses, does it mean the company is being sued?
If the receivables ( uncollected sales) seem to be growing at a faster rate than sales, does it mean that some customers are not paying their bills? If so, why? Initial analysis of the data for an SBE usually is a 4 to 10 hour process by a skilled CPA or advisor, but this is only a “quick read” or analysis of the numbers. Pre-purchase inquiry and investigation into the company’s history and likely future is a time-consuming process that must be done to prevent the buyer from purchasing a bad business. A skilled CPA or advisor will usually have a list of documents and information to request early in the process.
There is no such thing as a “simple deal” in today’s world. A buyer should be willing to hire qualified help to evaluate the deal, and should make sure they have some money aside to cover the cost of expert help. Some buyers like to rely on friends and acquaintances for advice on an acquisition. But, the buyer should always remember an old adage: “ Advice is generally worth what you pay for it”.
A seller who wants to maximize profits from the sale of the business will actually want to cooperate in the due diligence process by making documents and information available to the buyer’s advisors. Most sellers will anticipate the problem areas in the acquisition and transition, and may want to be reasonably open about issues.
His motive for being open is that he wants the deal to go through, and not get held up at the tail end for “newly discovered” negative information. Such bad news can either cause a buyer to walk from the deal, ask for extra indemnifications ( promises by the seller to make good on previously undiscovered bad news, like an environmental hazard) or ask the seller to take a reduced purchase price. If a seller is holding back information or reluctant to make disclosures, a buyer will usually feel that he is not getting the whole story.