Persons reviewing documents as part of the due diligence process.

The Importance of Due Diligence in a Business Acquisitions

If you are buying a business, it is essential to engage in proper due diligence. Many people do not fully understand the purpose of due diligence or what it entails. In a business acquisition, due diligence may be the critical factor that allows you to determine whether you're buying a profitable business or a lemon.

What is Due Diligence?

Due diligence is a relatively simple concept. It is the process of evaluating or investigating something to determine one's level of risk, usually before engaging in the transaction itself.

Due diligence is about being able to find out everything necessary to know about a potential acquisition. Before any agreement or contract to purchase a business is signed, a purchaser should conduct an independent investigation into its operations, finances, and key personnel. This process allows potential buyers to determine if there are any issues or red flags that may hinder the value and future profitability of the business being considered for acquisition.

A thorough investigation into a business may turn up "deal-breaker" issues that make the contemplated purchase undesirable. It's important to understand going in that no matter how badly you may want something, due diligence is vitally important to safeguard your interests.

Who Should Be on Your Due Diligence Team

Your due diligence team should be composed of subject matter experts that can provide you with opinions relating to their areas of expertise.

A lawyer can provide legal counsel and look at all contracts and documents to ensure that the contracts are lawful, valid, and enforceable.

An accountant should review the financial statements, tax returns, and related accounting documentation and identify possible cash flow issues that could affect your company in the future. They will also advise on valuation matters if needed.

Bankers can review any loan agreements or other outstanding debt to ensure the company owns those entities; otherwise, you may be held accountable for them after taking over ownership of the company. Make sure they provide a fresh set of eyes on all aspects of your deal so they can determine risks and liabilities before providing financing references.

What Should You Look For?

Good due diligence should include detailed information regarding:

  • Licenses and Permits. Does the company have all its licenses and permits in place? If they deal in goods that require any licensing or approvals from local, provincial, or federal agencies, then get copies of each license for each location. In addition to ensuring they are valid, determine if there are any restrictions on businesses operating at certain hours.
  • Employees. Is the company in good standing with its employees? Many companies require workers to sign non-compete agreements because such agreements are viewed as an added incentive for the employee to stay loyal and as additional protection for the business. However, in some instances, such non-compete provisions are unenforceable and could create a liability for the business being acquired.
  • Intellectual Property. What intellectual property does this business currently own? To conduct due diligence on a business acquisition, you need to determine what patents, trademarks, or copyrights that company has registered under its name. If it owns none at all, you will want to know ahead of time; otherwise, you may face legal issues down the road.
  • Contingent/ Future Liabilities. Are there any future liabilities that could come into it? If the business you are acquiring already has loans or any other outstanding debts, you need to understand. You also want to be aware of any pending lawsuits.
  • Financial matters. Has a third party prepared the financial statements? If they have not, you will want to check them as best as you can.
  • Legal Issues. Is the company in conflict with any government agencies, or has it been sued recently? These are essential questions that need to be answered and require further research if necessary.
  • Business Operations. Is the business operating at full capacity, or is it capable of expanding its production levels in the future?
  • Real Estate Issues. Does the building that houses this business meet your requirements, or will you need to purchase a new one? If there are any issues with the present location, how costly would it be to fix them, and what might they affect if not resolved quickly (i.e., rent costs)?
  • Company Documents. Ensure to get copies of all financial statements, balance sheets, income statements, ownership agreements, leases, and any other documentation related to the acquired business.
  • Tax issues. Are all taxes up to date? When is the deadline for filing taxes? Could there be any withholding tax liability for this company, and if so, who holds the payment responsibility?

Contracts. Are all current contracts, licenses, or agreements in place with suppliers, customers, partners, or landlords? Have any recent changes affected operations?

Due Diligence Red Flags

As you progress through your due diligence, keep an eye out for red flags. Some common red flags include:

  • A poorly performing business with no growth potential
  • Excessive debt owed to individuals or institutions
  • Inadequate cash flow from operations to pay bills
  • Red flags in employment contracts or other legal documents
  • Intellectual property rights issues
  • Issues with suppliers or customers that might affect cash flow
  • Inadequate or inaccessible financial records
  • The presence of ongoing lawsuits, multiple judgments against the business, or other similar issues.
  • The business owner is uncooperative and/or defensive about your questions and concerns.
  • There is a lack of company oversight and accountability for actions taken by employees or management.
  • The company is not willing to provide full access to all current and past employees.
  • New hires are frequently taking on more significant responsibilities than necessary, creating shortfalls in other business areas.
  • The company has unprofitable contracts or agreements that can't be renegotiated or terminated.
  • A general feeling that something does not seem "right" about the business.

Identifying red flags through the due diligence process is quite common and normal. In most instances, a red flag should raise enough concern to prompt you to take more time to investigate the business thoroughly and may lead you to renegotiate the purchase price or other factors of the acquisitions. The more red flags you identify, however, the more cautious you should be in your decision to acquire the business. When in doubt, err on the side of caution and walk away.

Contact Beganyi Professional Corporation Law Firm If You Are Considering a Business Acquisition

When contemplating a business acquisition, you should be sure you have the right advisors to guide you through due diligence and the entire purchase process. Beganyi Professional Corporation Law Firm has the experience and expertise to provide that advice, guidance, and assistance. Whether it's a small retail or service business or a multi-location dental practice, our advice is practical, realistic, direct, and to the point. We provide you with extensive guidance on negotiations with sellers. At Beganyi Professional Corporation Law Firm, we understand how business transactions occur in the real world, and we assist our clients in achieving their goals by working closely with their lenders, accountants, business brokers, other professionals. Our approach is practical yet eminently thorough as we work with you at every stage to help you void risks or pitfalls along the way.

Contact us us, and we will be happy to assist you.