Due Diligence for New Business Purchases – Why It’s Necessary and What’s Involved

Buying any business whether large or small is a gamble and one that can come with significant risk. Get it wrong and you could end up thousands of dollars out of pocket. This is why it’s important to carry out thorough due diligence before parting with your hard-earned cash.

Even businesses that – on paper, sound investible, can still harbour hidden issues, problems or stumbling blocks that aren’t initially obvious unless you take a peek beneath the surface. It’s important, therefore, to get a good handle on factors like company financials, customer retention rates, sales history/data, existing stock/inventory, marketing plans and ongoing or existing contracts if you are looking to invest. This is where due diligence can help.

So what is due diligence?

Due diligence is the process of investigating and exercising a level of care before entering into a contract or agreement with the selling party. As a holistic management accounting team, we regularly provide due diligence accounting and have assisted in the detailed financial analysis of many businesses. We know from experience that proper due diligence is the cornerstone to a solid and trustworthy acquisition and handover.

Where do you start?

Before any due diligence takes place, it’s prudent to first consider why the current owner is selling their business? Naturally, people sell businesses for a variety of reasons but the answer may well have an impact on how well the company has been operating.

If for instance, the owner is selling because of ill health or retirement, then it could be that the business has lacked sufficient energy of late and this may well be reflected in any recent bottom-line figures.

Alternatively, an owner may already know that a decline in profitability is just around the corner so although current business financials may appear healthy, there is a chance that the incumbent will be looking to exit before the expected decline starts. Hence the impending sale!

Market conditions that can cause a decline may include factors like new industry legislation or governmental laws or a forthcoming legal change in essential product supplies or suppliers. Either way, this is something that a potential buyer needs to be wary of.

The key point here is to take your time and conduct thorough research before taking the next step. Any decent vendor should allow a potential buyer the time needed to carry out proper investigation and should be available to answer any questions or concerns they may have.

Once a potential buyer is confident that everything appears above board and would like to proceed further, then the next step is to consider initiating the due diligence process itself.

Initiating due diligence

The process of due diligence usually proceeds after the potential buyer has carried out their initial investigation. The buyer would normally then sign a letter of intent. This is a contractual agreement signed (usually in the presence of a lawyer) indicating that the purchaser will buy the business, provided it meets expectations.

It also indicates that the seller should provide access to all business financials including:

  • the last 3 years tax returns
  • income statements
  • balance sheets
  • accounts receivable and payable and if available,
  • financial forecasts.

In addition, they should also give you access to a whole host of legal and operational information such as

  • current stock holding and assets
  • building leases
  • inventories and equipment leasing
  • customer databases and
  • website information including traffic, social media presence and profitability.

Given the detailed nature of this information, a potential buyer will normally be asked to sign a non-disclosure agreement (NDA). However, it’s well worth it because it gives the buyer an in-depth picture of a businesses’ overall health.

What about from the sellers perspective?

We’ve talked in detail about the buyer but how can the process of due diligence help the vendor?

In essence, the due diligence process is also a good time for the vendor to assess the financial stability and competence of a buyer. This is especially true if the payment plan is

  • based on some type of loan from the seller
  • there is a trial period before full and final payment or
  • if the seller expects to remain as part of the business in some way.

Whatever the circumstances of an arrangement, it remains a good opportunity for the seller to ensure that the buyer has a sound financial status.

The importance of the due diligence process

The due diligence process eliminates much of the risk when buying an existing business and if carried out correctly, gives both the potential buyer and the vendor confidence and complete peace-of-mind when taking the next step.

If you are considering purchasing an existing business and need some assistance with impartial and detailed financial examination, come and talk the team at JSM Accounting. We can help you through the complexities of the due diligence process so call today to book an appointment