How to do due diligence when buying a business
Due diligence is a vital step to take when buying a business. A thorough review of the target’s business prospects, finances and legal issues is critical to ensure your acquisition is a success.
The process lets you confirm your understanding of the target’s value, and set up a smooth transition. It may also uncover key information that changes your perception of the deal and could even make you walk away.
“Due diligence allows you to understand the target business better, confirm your investment thesis and identify the risks involved and how you might mitigate them,” says Mark Meloche, Director, Growth & Transition Capital at BDC.
Due diligence allows you to test your initial expectations, make sure there are no major red flags and confirm that your initial valuation and letter of intent still make sense.
What does due diligence mean?
Due diligence is the last of a business acquisition’s three key steps before you negotiate a purchase agreement. (The two earlier steps are identifying the target company and signing both a letter of intent—LOI—to buy it and a confidentiality agreement to allow any sensitive information to be shared.)
As part of the LOI discussions, the vendor typically shares basic information about the business to let the buyer see if the target fits their business strategy.
Why conduct due diligence?
Due diligence allows 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 the buyer 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.
There are three types of due diligence (detailed explanations below):
- Commercial due diligence, sometimes called business due diligence
- Financial due diligence, often referred to as accounting due diligence
- 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.”
You will want to set expectations with the vendor on where you’re going to spend time during due diligence.
Due diligence checklist
Due diligence can be broken down into three steps for you to take.
1. Outline the process
Start by setting out the process you’ll follow for due diligence. Due diligence shouldn’t be done quickly. Expect to take at least a month or two. Don’t make the mistake of hurrying the process or trying to cut corners or costs. “It’s going to take some time to do it properly,” Meloche says.
Look at the time and money spent on due diligence as an investment that could yield significant dividends: It helps ensure a beneficial transaction and easy transition. You may also come across information that changes your understanding of such areas as the company’s financial prospects or its market position.
The LOI typically outlines a framework for the acquisition, including due diligence. Provisions generally include a timeline for the due diligence and a process that allows 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 questions such as:
- 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 what key information you will require,” Meloche says.
2. Assemble a team
It’s important to involve a team of qualified experts to help with due diligence. Doing so can help ensure the acquisition achieves expected returns and 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.
Among the experts should be an accountant to help you analyze the company’s financial records and a lawyer to 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. An expert without such experience may miss important issues.
When you look at the experts’ fees, they’re negligible compared to the size of the deal and potential downside.
“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, 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 due diligence
You need to do all three types of due diligence on the target company: commercial, financial and legal. Depending on the transaction, you may decide to focus more deeply on one or another of these areas. 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
It’s especially important to keep an eye out for:
Customer concentration. Gain an understanding of who the customers are and whether any of those individual customers 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. You can also validate what the vendor has 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?”
Research or 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 if there’s anything that can be improved and 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 and if there are any potential risks that this business could be significantly disrupted,” Meloche says.
Vendor involvement and key employees. It’s important to understand the vendor’s role in the company and who in the business holds key customer relationships. “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 change 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. “These meetings can happen later on in the process, but sometimes there isn’t another way to properly asses key risks like customer concentration or transition risk without meeting the key people.”
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
- records on product margins, revenue by customer, inventory aging, accounts receivable and accounts payable aging, employee turnover, a list of all assets and any 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 required normalization
What you should also look for:
Trends in sales, profit margins and other data. “Are they ahead or behind where they were last year?” Meloche says. “It’s important to know how the business is trending. 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. This is a thorough analysis of the finances to assess the accuracy and quality of the historical results as well as the sustainability of future earnings.
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
- 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.
You’re never going to have a deal without risk. The goal is to try to minimize the surprises post-close.
How do you use due diligence when buying a business?
1. Take it seriously
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.”
2. Look for ways to mitigate any risks
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.
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. Or could the owner simply like a particular supplier, while many alternative suppliers are available?
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.
3. Negotiate the purchase agreement
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 craft representations and warranties, which are provisions covering such things as:
- responsibility for tax liabilities
- knowledge of assets being in good working order
- the assigning of contracts
If someone is doing due diligence on you, what should you expect?
Understand that due diligence isn’t going to be quick. You’ll be asked for a lot of information. “They’re going to try and turn over every rock,” Meloche says. He recommends you have your financial statements and other business records ready to share with the potential buyer.
Spend some time with your accountant and lawyer before launching the sale process to make sure records are clean, up to date and properly signed and filed. “The best thing you can do as a vendor is to be well prepared,” Meloche says.
It helps to anticipate potential questions and how to best address them. 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 them, Meloche says. “Try and look at your business from the perspective of a potential buyer.”