Due Diligence Checklist When Buying A Business

Due Diligence Checklist When Buying A Business

The acquisition of a business is often a life changing event involving a large financial commitment and a considerable amount of time.

Performing the proper research is critical to obtaining the necessary facts and information required to make intelligent decisions and mitigate potential risks and unknowns.

From a buyers perspective, due diligence is the term that refers to the investigation and verification of information involved in a potential investment or acquisition.  Doing your “homework” collecting the necessary legal, financial, and operational documents, and confirming the seller representations and material facts pertaining to the business sale are all part of the due diligence process.

While most professionals recognize the due diligence phase commencing after a binding agreement has been executed with earnest money being held in escrow, the process actually begins at the first point of contact with the seller and/or the seller’s intermediary.

Prior to receiving any confidential data about the target, buyers should be prepared to sign a Non-Disclosure Agreement in addition to providing basic personal, financial, and work experience information to the seller.

Most business sellers retain a business intermediary or broker for representation and it will be the business broker’s responsibility to verify that the prospective buyer has the financial capability and business experience to be considered viable.

If third party financing is required, it is recommended that the buyer consult a lender in advance and receive a pre-qualification letter.  A competent business intermediary should be able to provide a number of funding sources that are active in the small business lending arena.

Due Diligence Steps for an Asset Sale:

Step 1:  Exploration:

The initial step of an evaluation should be a review of the business Offering Memorandum often called a ‘Confidential Business Review’ (CBR).  While the content of this document will vary from seller to seller, it will often provide the following:

Detailed description of the business

  • Business Entity (C-Corp, S-Corp, LLC, Partnership, Sole Proprietor)
  • Location & History
  • Products & Services
  • Number of FT & PT Employees

Two to Three years of recast (normalized) financial statements

  • Profit & Loss
  • Balance Sheet

Asset List with Fair Market Prices Listed

Business Valuation & Listing Price

SBA Loan Preliminary Approval

Competitive Information

Operational Details

Photograph(s)

There is a delicate balance in providing the necessary information to the buyer to allow them to make a proper evaluation and protecting the sellers’ need for confidentiality.

In some situations, less information is provided upfront but will increase over time as the relationship between buyer and seller matures.  A review of the CBR should be sufficient to determine if this business meets the basic criteria established by the buyer based upon their goals, skills, and financial resources.

Step 2:  Analysis:

In the majority of cases the process will not extend beyond a review of the CBR.  In the event the buyer has confirmed an interest in pursuing the opportunity further, a teleconference or email exchange with the business broker is generally the recommended next step.

This communication should be used as forum to facilitate a Q&A from the reviewed documents and to perform a more comprehensive and analytical review of the operations, financials, and the business valuation.

Upon receiving clarification to the points of interest, the buyer should re-assess whether this business fulfills their personal acquisition requirements. The broker or seller will more than likely also make an assessment as to whether a mutually beneficial situation exists and will likely verify that the buyer is indeed financially qualified for the particular business.

Step 3:  Site Visit:

Prior to touring the business and sitting down with the owner, the buyer should have a thorough understanding of the business, the products and services offered, the organizational structure and staff, the financial performance and profitability of the company, and a comprehension of the valuation.

Most business owners are heavily involved in the daily operations and management of the company and it is important not to waste time and energy (for all parties involved) should the aforementioned issues not be keenly understood and acceptable prior to arranging a site visit.

The majority of small business sales are ‘confidential’ in nature and therefore the employees are unaware that the company is being marketed for sale, placing greater emphasis on covering as much ground as possible prior to a facilitating a company tour. The site visit and owner meeting is an opportunity for the buyer to make a firsthand assessment of the facility and operations.

Additionally, this meeting serves as an opportunity for both buyer and seller to determine if the proper synergy and chemistry exits for a successful transaction.  Prior to leaving the meeting, the buyer should have a firm understanding of all facets related to the business enabling them to provide a Letter of Intent should a decision be made to move forward.  Should additional information be required prior to the LOI, a data request via email or a brief teleconference can easily be arranged to elicit any remaining details.

Step 4:  Letter of Intent:

Once the buyer determines that they have a serious interest in purchasing the company, a Letter of Intent (LOI) is typically prepared.  An LOI is a written document that expresses the buyers’ serious interest to enter into a formal contract and continue the discovery further.

At its most basic level, the LOI says that, as long as certain criteria specified in the LOI is as represented by the seller, that the buyer will purchase the company and the seller will sell the company consistent with the terms outlined within the LOI. An LOI may also be referred to as a Memorandum of Understanding (MOU) or Term Sheet although the style of these documents can vary considerably.

The LOI is a relatively straightforward document defining the fundamental terms and conditions of the proposed acquisition including the type of acquisition (stock or asset), purchase price, financing method, contingencies, data required to complete due diligence, and timelines for the Definitive Purchase Agreement submittal and closing. LOI’s are typically not legally binding unless so captioned, however, most will contain certain provisions that are binding as in the case of non-disclosure agreements and no-shop (aka stand-still) provisions.

A no-shop clause will often trigger a request by the seller for an earnest money deposit as compensation for the time the business was off the market in the event of uyers failure to close.  LOI’s are beneficial to both the buyer and seller.

The fundamental goal of the LOI is to confirm that a ‘meeting of the minds’ has been reached prior to both parties making the large investments of time, energy, and expense required to execute a Definitive Purchase Agreement (DPA), aka Asset Purchase Agreement (APA).

It is important to note that in some cases, a buyer will have obtained and examined sufficient company records, financial statements, and tax returns whereby they feel comfortable foregoing the LOI and, in its place, will present the DPA.

Step 5.  In-Depth Due Diligence:

With an LOI in place, due diligence continues.  The purpose of conducting due diligence is for the buyer to have an opportunity to verify representations made by the owner during the selling process.  The process will typically take 2-6 weeks and can often be completed with relative ease when the financials, tax returns, and company documents (leases, permits, licenses, employee manuals, etc.) are clean, well organized, and professionally packaged.

Larger business transactions involving multiple locations, intellectual property, and complex products will require more time.  It is important for the buyer to recognize that some highly confidential information, such as customer databases and contracts, may not be made available until after a binding DPA has been executed and the contingencies removed.

A competent business broker coupled with a CPA, and attorney with business transaction experience will bring enormous value in streamlining the DD process. Buyers who leverage third party financing, will also benefit from the involvement of a loan packager as they will be completing their own independent due diligence serving as another set of eyes for the buyer.

If not done previously, the buyer should be prepared to provide the seller with a loan proposal or commitment letter.  Putting together a realistic timeline in advance will ensure that each party is aware of what documents are required and when they should be produced; avoiding unnecessary frustration and delays.

Business Acquisition due diligence focus areas:

Finance:

  • Revenue, COGS, & Adjusted Earnings
  • Assets & Liabilities
  • Accounts Receivable & Payable
  • Inventory
  • Furniture, Fixtures, & Equipment
  • Real Estate/Lease
  • Capital Expenditures

Legal:

  • Tax Filings
  • Business Entity (Sole Proprietor, LLC, C-Corp, S-Corp)
  • Lawsuits
  • Intellectual Property
  • Environmental
  • Contracts (Employee, Customer, & Vendor)
  • Government Regulation

Operations:

  • Products & Services
  • Customers & Vendors
  • Personnel
  • Technology & Infrastructure
  • Markets & Competition
  • Non-competition Agreement

Throughout the due diligence process, buyers may perceive anomalies in data from information they had received previously.  In most cases, these issues can be successfully resolved through an open dialog between both parties.  The nature of the inconsistency and the financial impact the discrepancy has on the transaction, will determine whether it requires the renegotiation of any points of the transaction documents.

Step 6:  Definitive Purchase Agreement (DPA):

The DPA is a binding contract between a seller of a business or business assets and a buyer.  This document establishes the terms and conditions of the sale and will include contract provisions that discuss the cost of buying the business, contingencies involved, and the legal structure of the transaction.  The DPA is typically formulated upon acceptance of the LOI.

The DPA is a much more comprehensive document than the LOI and will include a variety of representations and warranties (legal assurance that certain facts are true) from the seller about the operations and assets of the company as well as conditions and provisions for indemnity.

The DPA will also contain covenants which are the buyer’s promises to the seller and the seller’s promises to the buyer to either do something or not to do something.   Additionally, it will describe in detail what assets, free and clear of all third party claims (unless specifically stated and agreed upon), are included in the sale or specifically excluded from the sale. This includes inventory, real estate, vehicles, FF&E, contracts, customer lists and anything else that the business actually has at any given time.  Lastly the DPA will contain a variety of boilerplate provisions and the conditions for closing.

The due diligence process continues through the submittal of the DPA.  Several steps that are commonly initiated after the DPA include:

  • Lien & Lawsuit Search
  • Property & Vehicle Title Search
  • Review of leases (assignability)
  • Valuation of sellable Inventory (typically finalized the day before closing) *
  • Accounts receivable & payable analysis
  • Finalization of dealership or franchise applications/approvals
  • Employee, Customer, Vendor contract review

* Occasionally, last minute changes to the inventory are not permitted by a lender.  Therefore, the buyer and seller should have a written arrangement detailing how adjustments to the inventory will be addressed.

Transitional Activities:

During the diligence period it is recommended that the buyer develop a personal transition plan for the business to ensure that they are adequately prepared once the closing takes place.  Some of the more critical items recommended for the transition plan involve establishing the following:

Functional:

  • Legal Entity / DBA / Assumed Name Certificate
  • Business Checking Account
  • Business Insurance
  • Licenses / Permits

Operational:

  • Owner training/consulting schedule
  • Revise/Develop business plan

Financial:

  • Pro-forma financial analysis

Step 7.  Closing:

Closing procedures will vary based upon the custom in specific geographies and the protocol of the individual attorneys.  The transaction closing is the time at which the appropriate documents are signed by all parties, often at the buyer’s attorney’s office, and is recognized as the date that the buyer becomes the new owner of the business.

Dependent upon the buyer’s last visit to the business, a final ‘walk though’ can be performed immediately prior to closing.

Provided that no unforeseen issues arise on the day of closing, the buyer/seller contingencies have been satisfied, the buyer’s funds have been deposited in the attorney’s escrow account and both parties are prepared to sign a considerable number of documents, the funds of the buyers will be released to the seller and the buyer receives legal title and the keys to the assets of the business.

Detailed below is a comprehensive due diligence checklist.  The number of items recommended for completion could vary based upon:  whether it is an asset or stock sale, a main-street or middle-market business, and the nature and parameters of the sale.

DUE DILIGENCE CHECKLIST

Finance

  • 2 – 3 Years of re-casted Profit & Loss Statements
  • 2 – 3 Years of re-casted Balance Sheets
  • 2 – 3 Years of Tax Returns
  • Complete list of all assets with current market (replacement) value and condition.
  • Schedule of any indebtedness and contingent liabilities
  • Complete inventory list
  • Copy – Any other material contracts relating to the business

Analysis

  • Analyze the P&L’s and Balance Sheets and compare them against the business tax returns.  Are the adjustments and add-backs realistic?  Are there material differences in the income and expense categories, and if so, are there reasonable explanations?
  • Determine whether the company has ever been in bankruptcy.
  • What have the trends been in the revenue, COGS, and expenses over the last three years?
  • What steps can be taken to increase revenue and profitability?
  • Does the company provide adequate cash flow and earnings to support potential debt service payments and the buyer’s income requirements?
  • Is there a high concentration of business with a limited number of customers?  How secure are the customer relationships?  Are there contracts involved?
  • Is the company in good standing with all of the vendors in the supply chain?
  • Analyze the inventory and determine what percentage, if any, is obsolete, damaged, or unsellable.  How does the level of inventory compare with the industry averages?
  • Analyze the real estate (if applicable) tax value and compare with the property selling price or appraisal.  Are the taxes paid up to date?
  • Review the property and equipment leases (if applicable).  Is the lease assignable, and if so, under what terms and conditions.  If a new lease is required, make arrangements to meet with the landlord and determine the terms and conditions to execute a new lease.  What is the value of any leasehold improvements?
  • Review the Opinion of Value or Business Valuation.  What method or methods were used to calculate the value?  How does the valuation compare with other companies in the industry or region?
  • Compile a Pro-forma P&L and Balance Sheet based upon the company’s financial projections coupled with the buyer’s anticipated debt service, capital expenditures, expenses, etc.
  • Evaluate those recurring expenses that the buyer will be responsible for after purchase.
  • Compare the FMV of the business assets with the depreciated value on the Balance Sheet.  How was the FMV derived?
  • Understand the nature of any company debt.  While debt is not often assumed in an asset sale, it will be important to understand how debt was utilized in the daily operations of the business.  Does the company have to rely on short-term debt or a line of credit for working capital purposes?
  • Determine whether there are any prepaid or accrued expenses.

Operations

Details on the company’s physical location and whether it is leased or owned.  If there is more than one location, obtain the specifics on each location  and when each were opened

  • Copy – Brochures, product/service descriptions, marketing materials
  • Description of policies, procedures, and job functions
  • Copy – Organizational Chart
  • List of employees including positions, current salaries, vacation entitlement, deferred compensation, bonus structures, and benefit programs
  • Description of health and insurance policies and details on payment or matching programs
  • Copy – Employee handbooks
  • Copy – Company business plan
  • Copy – Agreements with vendors, service providers, insurance companies
  • Description of product/service guarantees or warranty
  • Description of advertising campaigns and promotion programs
  • Details on all intangible assets including website URL’s, assumed/trade names, email addresses

Analysis

  • Obtain a solid understanding of the history of the business.  When was the company originally founded and by whom?  Understand the reasons for why the owner is selling the business?
  • Perform a market analysis on the business.  Understand the market that the company serves: The products and services (and any seasonality) produced or sold, the geographic boundaries and demographics of the market, the percent market share the business controls and the competing companies in the same or similar business.  Determine if there is any future direct and/or indirect competition.  Determine if there are there any industry trends that could affect the company – positively or negatively.
  • Determine the role that the owner performs at the company.  Is it actively managed or run as an absentee owner business?  What are the primary duties and hours that the owner currently works per week? If the owner will need to be replaced with new management, understand the position, required salary, and benefits it would take to replace the owner.
  • Understand the entire spectrum of products and services sold by the company.   What are the top performing products and who are the customers.  Determine the profile and demographics of a typical customer.  Understand the pricing structure and future pricing considerations, and bidding process, if any, for obtaining sales.
  • Determine the accounting process and identify who is responsible for managing the books, filing the taxes, and performing the payroll functions.
  • Confirm the businesses insurance provides the proper amount of coverage and that  the payments are up to date, including property, liability, fleet, fire, workmen’s comp etc.
  • Determine the financial exposure for impending employee bonuses and vacation obligations.
  • Obtain a list of the contract administrators for the company retirement plans, health insurance, and payroll.  Determine whether these accounts can be transferred and calculate the cost of future administration.
  • Are the facilities leased or owned?

If Leased:

How long is the Lease?

What is the base rent?

What are the CAM charges?

Is it a triple net lease?

When was it signed?

Are there extension options

Is the lease assignable

Are there annual rate increases, and if so, obtain the details.

If Owned:

When was it purchased?

What was the purchase price?

If there is a note what is the balance?

Is the facility available for purchase, if so, at what price?  Could the facility be leased, if so, on what terms?

Is there a current appraisal on the building?

  • What capital expenditures/improvements are necessary to meet the business forecasts?
  • Review the vehicle and equipment maintenance records to ensure that all service work is up to date.
  • Understand the technology that is utilized in the business operations.  Is this technology up to date?  Would newer technology increase efficiency? If so, what/how specifically?
  • Does the company have e-commerce functionality on its website?  Is e-commerce a viable expansion opportunity?

Legal

Company’s Articles of Incorporations, Bylaws, and all amendments

List of shareholders, owners, partners, or members and percentages owned.

List of all states where the Business is authorized to operate

List of U.C.C filings

Copy – Any dealership or Franchise Disclosure Documents (FDD)

Copy – Material contracts relating to the business

Details related to employment agreements, non-compete agreements, and non-disclosure agreements

History of employee worker’s compensation and unemployment claims

List of all intellectual property including:  licenses, patents, & copyrights,

Copy – Real Property Agreement title policies, deeds, plats, zoning approvals, variance or use permits, and appraisals

Copy – All other lease agreements including equipment lease(s)

Copy of any Local, State, or Federal Tax Audits within the last 5 years

Details on any hazardous substances used in the business operations and specifics on any prior, pending, or contingent environmental liabilities.

Details on any prior, pending, or contingent business investigations, litigation, or indemnification obligations.

Copy – Environmental survey’s completed in the past including notices, files, or correspondence related to EPA, state, or local regulatory agencies.

Analysis

Note: It is recommended that competent legal council is retained. An experienced transaction attorney will be of enormous assistance in addressing all legal aspects of the due diligence process, the LOI, DPA, and closing.

  • If the business is a dealership or a franchise, understand what the process is and the fees involved for a new buyer to purchase the company.  Franchises will typically have royalty and advertising fees.  In some cases a franchisor will charge the seller/buyer a transfer fee and could have a contractual clause stipulating that the franchisor has first right of refusal to purchase the business or match an offer.  The specifics of these issues will be detailed in either the dealership agreement or franchise disclosure document, which should be thoroughly reviewed.
  • Thorough review of all contracts, agreements, leases, deeds, titles, surveys, plats, and environmental documents.
  • Conduct a UCC filing and public records search to determine if there are any outstanding liens against assets that are being transferred in the sale and/or pending litigation.
  • Determine what the buyer’s future exposure is to warranties and service guarantees on products sold by the owner.
  • Ensure that the appropriate Representations, Warranties, and Covenants are contained in the DPA.

About the Author

Michael Fekkes is a Certified Business Intermediary (CBI®) at ENLIGN Business Brokers. Tel. 910.691.2202 ● Email: mfekkes@enlign.comWeb: www.enlign.com

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