What is Due Diligence? Why is Due Diligence Necessary? I am Buying a Business, How do I Perform Due Diligence?

What is Due Diligence?

When you are buying a business you are contracting with a third party to buy either 1) the shares associated with the business; or 2) the assets of the business.  In both cases, the buyer will normally not be familiar with the business and will have to rely to some extent on the representations made by the seller.  For example, the seller may claim that the business is positioned to make $1,000,000 per year or that the business has assets worth $500,000.  While in an ideal world, it would be nice to just rely on what the seller says about the business, prudence would dictate that an independent verification is in order. This independent verification is called due diligence. That is, due diligence is an assessment that is done before the closing of a sale where the buyer independently verifies the assertions and representations made by the seller.  The purpose of the exercise is to get a better understanding of the veracity of the claims and to see if the business is worth what the vendor says it is.

You can find out more about what is contained in a purchase sale agreement by clicking here.

You can find out more about the differences between buying shares or assets by clicking here.

Which Documents are needed for a Due Diligence Review?  

When you are buying a business, you should present the seller with a list of documents that you require in order to perform a due diligence review.  As a starting point, you should review the purchase/sale agreement and take note of any claims that the seller is making.  If they claimed something on paper, you should ask for supporting documentation to support the claim.  If the documentation does not exist, you should ignore the claim when deciding on the purchase price.  For example, if the purchase sale agreements indicates that the company had sales of $500,000 in the prior year, ask for the tax return documents to support that.

Here is a list of standard due diligence documents that we often request and the reasons we request them.

1. A list that details all Accounts Receivable (A/R) balances with detail of who owes the company money and how long they have owed the money for (aging schedule).
   • The schedule gives the buyer a good idea of what percentage of sales are on credit and also how quickly people are paying off the debt.  The schedule may also show the buyer that some of the A/R debt will likely not be collected (eg. if they have been owed for a long period of time).  Depending on what the A/R aging schedule says (or if it exists), the buyer should validate the information on the schedule.  Eg. you should review sales invoices and/or deposit payments that correspond to the A/R schedule.  You may also want to ask for the aging schedule from 3 months ago to perform further validation.
2. Schedule of large contracts with clients/customers and with commitment amounts (suppliers and obligations) along with documentation showing the committed amounts.
   • Seller at times assert that they have significant contracts with customers to buy their goods and services over time. You should ask for a copy of the contracts to validate that the revenue source will continue in to the future. Similarly, it is important to see any future commitments and obligations that you may have if you buy the business so that you can assess the impact on the business and the purchase prices.
3. A list of intellectual property (IP) included in the sale and any information on the value of that property. You should also obtain any formal valuations done on the IP and any trademark, copyright or patent information associated with the IP.
   • Although IP is an intangible asset, it can have significant value. On the other side, a seller may inflate the actual value of the IP so you should verify what it is worth.
4. A list of employees with job titles and current salaries, start dates.  You should also obtain confirmation of the salary of the owner and this should be separate from this information. You should also ask for payroll summaries and W-2 and 1099 information for the last few years.
   • Salary costs are often the biggest expense a company will have so you should understand what it takes to run the company as well as be familiar with who possible key employees are.
5. Description of any employee benefit or pension plan that exists and any contracts that exist with employees
   • You should have a full understanding of your obligations to employees above salary. Also, some employees may have contracts that the company is obligated to honor (eg. bonus payments and/or other benefits) so it is beneficial to know about these beforehand.
6. A complete list of all assets and the value assigned to each asset. (and how the value was calculated).
   • Assets could make up a significant part of the purchase price and you should know which assets you are getting and what value has been assigned to them. In one due diligence exercise we did, there was a truck on the asset list with a $50,000 value but that was the price that was paid for the truck 8 years ago.  The actual value of the truck was closer to $5,000.
7. A list of customers
8. A list of suppliers
9. A list of any debts (tax or other)
   • If you are buying the shares of a company, you are also buying the debts and obligations.  As such, these should be factored in to the purchase price.
10. List of insurance policies
11. Financial information including:
    • 3 years of balance sheet
    • 3 years of income statement
    • 3 years of cash flow statements
    • It is preferable if the f/s are audited but at a minimum the seller should include a letter from CPA indicating that the company’s books and all financial information provided are in order and they follow Generally Accepted Accounting Principals. (GAAP)
12. 3 year of company tax returns.  Sellers will often say that their business is a “cash” business but this assertion is almost impossible to validate so you may end up paying a premium just based on the word of the seller.
13. The company’s organizational documents including the documents filed with the Department of State to set up the company, the company Operating Agreement and any other entity documents (eg. share certificate, share register, shareholder agreement, etc.)
14. A description of valuation methodology used to come to the fair market value of the assets or company?

At times additional documents are required after the review of these documents but this is a good start.

At Scott Legal, we have an M.B.A. and C.P.A. on staff so we can help you with your asset purchase and due diligence needs! Contact us today.

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