How to conduct due diligence when buying a business

What is due diligence?

Due diligence normally refers to the care and effort a reasonable person would take to avoid harm to other persons or their property. But in business, it can best be defined by the research and analysis that a company or organization does in preparation for a business transaction.This would be for an action such as a corporate merger or purchase of securities.

The investigation is usually carried out by the party looking to complete a business transaction. Due diligence helps the buyer evaluate the advantages and risks involved.

If you’re doing the buying, due diligence is the last of a business acquisition’s three key steps before you negotiate a purchase agreement.

2 steps before due dilligence

There are two earlier steps, identifying the target company, and signing a letter of intent (LOI) and confidentiality agreement.

The LOI reassures the seller of your willingness to submit a potential bid. It also helps lay down the key elements of the transaction and, if needed, assures you a period of exclusivity during negotiations.

The confidentiality agreement is essential for you as a potential buyer. It gives you access to the information you need to formulate a letter of intent, to submit an offer or, if necessary, to withdraw interest.

In this phase of your discussions, the vendor typically shares basic information about the business. This is to let you see if the target fits with your business strategy.

Why conduct due diligence?

Due diligence allows you, as the buyer, to gain a much more detailed understanding of the business and confirm that the acquisition is a good idea. The vendor provides comprehensive commercial, financial, legal and other information so you can understand how the business works.

“Due diligence allows you to test your initial expectations, make sure there are no major red flags and confirm that your initial valuation and LOI still makes sense,” Meloche says.

It also acts as a form of risk mitigation. Due diligence helps you mitigate risk by identifying potential threats and assessing their potential impact. It also helps in implementing strategies and controls to reduce the likelihood and/or severity of those risks.

There are three types of due diligence (detailed explanations below):

1. Commercial due diligence, sometimes called business due diligence
2. Financial due diligence, often referred to as accounting due diligence
3. Legal due diligence

A key part of the process is validating the vendor’s information about the company. “Due diligence is about trust—and verification,” Meloche says. “You’re trusting what you’re being told by the other side. But you're also verifying, making sure the numbers match the reality on the ground.”

Due diligence in 3 steps

1. Outline the process

Do not rush your due diligence process. “It’s going to take some time to do it properly,” Meloche says, adding that you should expect it to last at least a month or two.

Try not to cut corners or costs. The time and money you spend on due diligence is an investment that could yield significant dividends. You may also come across information such as the company’s financial prospects or its market position.

The LOI typically outlines a framework for the acquisition, including due diligence. Its provisions generally include a timeline for the due diligence. It also  gives the buyer access to the premises, records and, in some cases, key suppliers, customers and employees.

The buyer’s research prior to issuing the LOI may identify areas to zero in on during due diligence. This initial research should consider the following questions:

• What are the market, technology and other trends that affect companies in this industry? For example, is the industry growing or in decline?
• What risks do companies typically face in this industry?
• How easy are these risks to mitigate?
• Do most of the company’s sales come from a small number of customers, or does the business rely heavily on one supplier?

If you have initial concerns, it’s important to address them with the vendor at the LOI stage. “You will want to set expectations with the vendor on where you’ll spend time during due diligence and the key information you’ll require,” Meloche says.

2. Assemble a team

It’s important to involve a team of qualified experts to help with due diligence. That helps ensure the acquisition achieves expected returns. It also reduces the risk of costly surprises.

“When you look at the experts’ fees, they’re negligible compared to the size of the deal and potential downside,” Meloche says.

An accountant can help you analyze the company’s financial records. Meanwhile, a lawyer can assist with the LOI, draft the purchase agreement and conduct legal due diligence.

It’s important to bring in experts who have experience with transactions of similar complexity. If not, they could miss important issues.

“An acquisition is very different from preparing a will or buying a piece of real estate,” Meloche says. “Someone unfamiliar with acquisitions may focus on things that aren’t as relevant. They may not know certain commercial terms or fail to ask for things that are important.”

There are other experts who can also be helpful:

• IT specialists to check tech assets and validate any intellectual property
• Environmental consultants to study contaminants and hazardous materials

Plan to have your team involved early on. “Don’t wait until the last minute to bring in your lawyer because you’re trying to save on fees. They may find something that kills the deal, and now you’ve just wasted all that time,” Meloche says. “Or they come in and it looks like you’re trying to renegotiate the deal at the last minute, versus discussing the issues earlier in the process”

At the same time, Meloche says, the buyer shouldn’t leave all the due diligence to others; they should be closely involved in the process. “You can't rely on outside experts for everything,” he says. “They won't make an investment decision for you.”

3. Conduct the due diligence

There are three types of due diligence you’ll need to perform on the target company: commercial, financial and legal. Depending on the transaction, you may decide to focus more deeply on one. For example, if the company has high customer concentration (an issue falling under commercial due diligence), you may want to carefully investigate the reasons, risks and any possible mitigations.

a. Commercial due diligence

Commercial due diligence involves understanding how the target company makes money, its competitive environment, and its future goals and strategy. This includes:

• the company’s business model and strategic plan
• the market landscape and important trends affecting the company, such as technological change, regulations, customer trends and industry disruption
• key customers, suppliers and employees
• significant risks, such as customer or supplier concentration
• the company’s corporate social responsibility record, including its inclusion, diversity and sustainability initiatives

Elements to consider during commercial due diligence

During commercial due diligence, it’s especially important to keep an eye out for:

• Customer concentration
  Who are its customers and do any make up a large portion of sales?
  
  In cases of high customer concentration, it’s helpful to meet those key clients. Ask about the relationship and if there’s any reason to believe their level of purchases will change in the future. What has the vendor told you about the customer’s past and expected future purchases?
• Supplier concentration
  Does the company rely on a single supplier? “If they get all of their raw materials or key inputs from one company overseas, that’s a material risk,” Meloche says. “What if that company goes under or suddenly changes the price significantly? Would you be able to switch to another supplier without a major disruption to the business?”
  
  Ask to meet key suppliers, especially if there is high supplier concentration. This can help you better understand the supplier relationship and potential risk.
  
  You can also start to build your own relationship with the supplier to ensure a successful transition. Ask what the business could do better.
• Business model risks
  Is the business model at risk from technological or market disruption? “You want to figure out how likely it is that this business is going to continue as is. Are there are any potential risks that could significantly disrupt this business?” Meloche asks.
• Vendor involvement, key employees, vendor financing and earnouts
  It’s important to understand the vendor’s role in the company. Who in the business holds key customer relationships? What other involvements does the vendor want to retain following the sale?
  
  “The biggest risk in an acquisition is typically the transition risk,” Meloche says.
  
  “When the vendor leaves, do the customers leave too? Who’s actually running the business day-to-day? Is it the vendor or are there key employees who will remain with the business post-close?”
  
  You may need to meet key employees to get more information about their role and whether they see themselves continuing at the company. This can also be a good time to start building a relationship with them to ensure post-transaction retention.
  
  “They’re going to probably want to meet with you too because a new owner can sometimes mean big changes for them,” Meloche says. “It’s a scary time for employees when they find out that the company is being sold. Anything you can do to assuage those fears is going to be helpful for a smooth transition, especially if they are a key employee.”
  
  Some vendors may hesitate about letting you meet customers, suppliers and employees. But the meetings are worth pushing for, if you are unclear on risks in any of these areas.
  
  “It’s hard to get a good handle on these questions without a meeting,” Meloche says. “Sometimes there isn’t another way to properly asses key risks like customer concentration or transition risk without meeting the key people.”
  
  If you need to make up for a shortfall of capital, the vendor may be more involved than you originally thought.
  
  Vendor financing (also known as vendor take-back or VTB) is a form of business acquisition debt that allows you to hold back a portion of the purchase price as a debt to the vendor. Essentially, the current owner of the business is loaning you some of the money you need to buy the business.
  
  That could come with certain strings attached, such as earnouts. Earnouts are a contractual clauses in a business sale where part of the purchase price is paid to the seller after the deal closes. They’re often tied to your achieving specific performance targets.
  
  You will need to decide before the sale is decided upon whether or not you’ll participate in vendor financing or any earnout scenarios.

b. Financial due diligence

Studying the company’s financial records is another critical step in due diligence. You and your accountant should be given the following to review:

• accountant-prepared year-end financial statements for at least the past three to five years
• interim year-to-date statements and statements for the comparable period from the prior year
• trial balances
• financial forecasts
• tax returns
• bank statements
• budgets
• records on
  • product margins
  • revenue by customer
  • inventory aging
  • accounts receivable and accounts payable aging
  • employee turnover
  • all assets
  • other information needed to understand the numbers and the assumptions behind them

What you and your accountant should be looking for:

• any tax liabilities
• poor product margins
• needed equipment repairs or investments
• slow-paying customers
• operational inefficiencies
• high employee turnover
• sluggish inventory turnover or any obsolescence
• working capital levels
• financial ratios
• owner compensation
• impact of potential normalizations

What you should also look for:

• Trends in sales, profit margins and other data
  Meloche says it’s important to know how the business is trending. “Are they ahead or behind where they were last year?” He adds that you’re typically paying a purchase price based on previous results. ”But your return and success of owning that business is based on the future.”

• Validation of information
  See if the numbers add up. For example, do the figures match the information you’re getting from the owner? Do tax returns match the financial statements?
  
  “Does the story make sense?” Meloche says. “If they say they’re really busy and have a strong order book, do the year-to-date results reflect that?”

To get a more detailed look at the finances, you can have an accountant prepare a quality of earnings report. That’s a thorough analysis of the finances performed by a third party. It assesses the accuracy and quality of the historical results as well as the sustainability of future earnings. It goes beyond standard financial statements to identify and adjust for non-recurring items, accounting irregularities and risks.

c. Legal due diligence

It’s also important to review legal issues affecting the business. These can include:

• ongoing, pending or threatened litigation
• past lawsuits that may have affected the business
• employment contracts
• leases
• customer and supplier agreements and warranties
• laws and regulations affecting the company
• licences and permits
• real estate and intellectual property issues
• corporate documents (e.g., certificates of incorporation, company bylaws, shareholder agreements)

You should also make sure key contracts, such as leases, regulatory agreements and customer contracts, can be assigned to you if necessary.

d. Customer due diligence

This mostly affects businesses that work in the financial sector. Customer due diligence helps protect against bad actors, such as those who are involved in money laundering or terrorist financing. Some businesses are required to follow due diligence procedures, which include identifying your customer, the nature of their business and ownership, and reporting any suspicious activities.

Due diligence for a building purchase

Business acquisitions often involve the purchase of a commercial building. As part of your due diligence for a building purchase, you’ll need to examine the following elements:

• physical condition
• history
• legal status
• financial situation (for condo purchases)
• environmental impact

What do you need to do before purchasing a building?

• Take 30 days to perform due diligence after reaching an agreement with the seller
  This will give you time to review all the documents related to the building, such as leases, maintenance contracts, insurance policies and title documents. If the seller cannot provide these documents, you may have a chance to renegotiate the price.
• Assign tasks to your acquisition team, including staff members and outside consultants
  Make sure each task has a clear deadline and follow up frequently. Some of the tasks may include checking the survey markers, the boiler maintenance contract, the roof repair guarantee, and so on.
• Review your business plan and cash flow projections with your accountant to determine what you can afford
  Prepare a synopsis of your financing needs, financial planning and assets for presentation to a lender. Compare interest rates, repayment options and personal guarantees required by different lenders. Try to get a preapproved loan before you start your search for a building. Be realistic about your financial forecasts and account for unforeseen costs.

What should you be looking for before signing a deal?

Poor explanations, conflicting information

It’s important to take your due diligence findings seriously. Some buyers make the mistake of dismissing information that challenges their enthusiasm about the transaction, only to regret it later.

If sales are trending downward and the vendor can’t convincingly explain why, you may need to rethink the transaction.

At the same time, it’s normal for some conflicting information to arise. “It's never going to be perfect,” Meloche says. “You’re never going to have a deal without risk. The goal is to try to minimize the surprises post-close as much as possible, especially any potentially fatal surprises.”

Solutions to recently discovered risks, industry-wide challenges

Consider ways to mitigate any risks your due diligence uncovered. For example, if there are key employees, think about how to make sure they stay on. That could include drafting employment contracts with incentives for them to remain.

Is there declining revenue?

If the company has high supplier concentration, look into whether it’s affected just this business or is an industry-wide phenomenon. If the competition has the same issue, then the target isn’t at a disadvantage.

At the same time, it’s important to recognize when a risk can’t be mitigated. “If one customer represents 80% of sales, that risk is likely impossible to mitigate,” Meloche says.

Purchase price is still fair (after due diligence), liabilities are transparent

With your lawyer’s help, use your due diligence to finalize the purchase agreement. Your financial due diligence will help you validate the purchase price. Legal and commercial due diligence will allow you to account for any of the following red flags:

• pending litigation
• tax liabilities
• assets being in less than good working order
• unsigned contracts

What to expect when someone is doing their due diligence on you?

If you’re the object of someone’s due diligence, expect it to not be a quick exercise. Be ready for a lot of information to be requested from the potential buyer. “They’re going to try and turn over every rock,” Meloche says. He recommends being ready to share with them your financial statements and other business records.

Before launching the selling process, spend time with your accountant and lawyer to make sure records are clean, up to date, and properly signed and completed. “The best thing you can do as a vendor is to be well prepared,” Meloche says.

It helps to anticipate potential questions. For example, if you have a few key customers, you should be prepared to address the buyer’s concerns. If you have key employees, be ready for the buyer to ask to meet with them. “Try and look at your business from the perspective of a potential buyer,” Meloche says.

How long is the due diligence period?

“Real estate transactions can require at least 30 days for due diligence following an agreement with the seller,” Meloche says, adding that larger business acquisitions usually take longer. “Due diligence for a business acquisition can range from six to 12 weeks or longer, depending on the complexity of the company and transaction.”

Next steps

Download this free due diligence checklist that can help you ensure your follow the right steps when evaluating a business to purchase. 

Find out what it takes to successfully purchase a business in Canada by downloading the free BDC guide, Buying a Business in Canada. 

Discover the tools and resources to help you find the right business to buy and discover solutions to finance the transaction by downloading BDC’s free Business acquisition toolkit.

The basic concepts of corporate governance and assembling a board of directors are available to you for free by downloading the BDC guide, The Science and Art of Good Corporate Governance.