Primer on Business Due Diligence

Business Due DiligenceDue diligence is the process of finding out undisclosed information and confirming that the information provided is accurate. For a business buyer, it is the process of working through all the details provided by the business seller.

During the due diligence phase the business buyer must access to all the businesses books, financials statements and other records. The due diligence phase provides the business buyer with a window to determine if the information provided is accurate. The process can take several days and sometimes up to a month. The Due diligence process is broad and must include financials, marketing and strategy amongst other things. Financial due diligence also includes business-valuation, identifying undisclosed liabilities and a lot more.

Due Diligence Approach

Due diligence is the process of systematically evaluating the target company’s documents and other artifacts. If significant discrepancies are found it can result in being a deal breaker or result in the deal being re-negotiated.

Overall, due diligence can be classified in the following categories:

• Management Due Diligence
• Legal Due Diligence
• Financial Due Diligence
• Marketing Due Diligence
• Operational Due Diligence

Information required within each category must be acquired through interviews, financial statements and legal and other documents. The person conducting the due diligence may need to contact the target businesses lawyers, bankers, accountants, clients and suppliers to gather details about the business.

Financial Due Diligence

Financial due diligence requires the business buyer to look into the financial health of the company. It provides the business investor or acquirer information on the debt of the company, capacity to expand and more. Understanding the capital structure of the business is a critical element of financial due diligence because too much debt or poor cash flow can prevent growth and sustainability of a business.

Typically financial due diligence involves review the following documents:

  1. All published financial statements for the last 4 to 5 years including balance sheets, income statements and cash flow statements. This includes interim financial statements for the current quarter.
  2. All tax returns and tax payment schedules
  3. Appraisals on tangible assets including real estate owned by the business

Cash Flow (Financial) Due Diligence

Cash flow is the amount of cash being generated or spent during a specific period of time. It is the change in cash position or in the cash account due to revenue, expenses, operating costs and investments. Cash flow is typically impacted by:

• Accounts Receivable  (AR)
• Accounts Payable (AP)
• Capital Expenditures (CAPEX)
• Debt Servicing
• Tax Payments and other timing issues

Managing Cash flow is of paramount importance to operating a business on day to day basis. Accounting rules that govern the creation of financial statements are used to measure profit and loss. Therefore Balance Sheets and Income Statements do not provide an accurate and timely view of a company’s cash position. Not managing cash flow can result in a cash crisis. For example, if cash is blocked in accounts receivables (AR) and investments, a business can find itself in a cash crisis even though the balance sheet is healthy.

Cash flow can be classified as:

• Cash from Operations
• Investment cash flow
• Financing cash flow

A Cash flow statement is a financial statement that shows companies incoming and outgoing cash for a specific duration. When buying a business, studying the businesses cash flow statements (3 to 5 years) plays an important role and must be completed during the due-diligence process.

Marketing Due Diligence

Marketing Due diligence involves the review of the overall marketing strategy and marketing plan of the business being acquired. Typically a summary of the marketing plan is provided in the investment proposal.

During the Due diligence process the investor or the acquirer must review the underlying market research including the size of the market, market segmentation, competitive pressures, threat of new entrants into the market, threat from substitutes and more. It is important to understand the overall size of the market (industry) the business operates in, the size of the market for the business and more. Reports provided by external agencies provide significant credibility to the marketing plan.

• Review marketing plan and marketing strategy documents
• Marketing material for last few years
• Interviews with the marketing manager or the person involved with marketing
• External and internal research data

Legal Due Diligence

Under legal due diligence the business buyer needs to make sure the business does not have legal problems and is being correctly operated. Legal Due diligence requires the business buyer to review all legal contracts and agreements made by the firm. Several legal artifacts must be reviewed including:

• Review all contracts. A company in business can have several contracts in place including contracts with suppliers, customers, employees and others.
• Agreements with employees
• Corporate charter and bylaws
• Non-Disclosure Agreements (NDA) with employees
• Patents, copyrights and other assets in the company
• Minutes and consent from board of directors and shareholders
• Litigation related documentation and summary of current and pending disputes
• Review tax documentation from a legal stand point
• All artifacts related to the issuance of securities

There are several checklists available online to guide you through the process of conducting legal due diligence.

Why list a Business for Sale Online

Business OnlineBusiness for Sale listings used to be posted by business brokers and business owners in print media.  However, listing businesses for sale in print is rapidly declining for several reasons.

To start with space is limited and only a brief summary of business can be listed. If the user wants more information there is no mechanism for him to get it besides calling the business buyer. The print format is just not well suited for business for sale listings, which tends to be more complex and has several attributes attached to it. On BuySellBusinesses.com business sellers can list up 20 images, several videos and any number of documents. Additionally, business sellers can use deal-rooms, which allows business sellers to securely share documents with selected users only.

Print media tends to be expensive, slow with limited reach, so business brokers and business owners have to advertise in a publication for several months to get any attention. In that duration, changing the advertisement can be onerous and time consuming and because there is a physical media involved – expensive.

Online listings are confidential. Business for Sale listing on BuySellBusinesses.com can be set-up with varying levels of disclosure depending on the sellers requirement. The business seller cab decide what to include or exclude from the listing.

Finally, the most important reason print media does not work for business listings is because print readership is declining rapidly and readership not targeted. In the US, only 6% of time is spent on print media. Radio and TV, as an advertising medium, is just not suitable for business for sale listings.

MediaTime

Time Spent on Media

On the flip side, Internet and mobile account for 36% of time spent on Media. The Internet is the first place business buyer’s start the buying process and potential business buyers spend time researching and looking for businesses to buy on multiple sites. On an average, buyers can take between one to two years to complete the buying process and a large portion of the search is conducted online.

Internet traffic on http://www.buysellbusinesses.com/ is highly targeted because Google and Bing match keywords to Websites so that only relevant users are directed to the site. Dynamic nature of the Web allows business sellers to login to a site and de-list their business listing or change the content of their business listing at any time. Additionally, online sites allow business sellers to track and manage leads generated. When a potential business buyer asks for MORE information, the business seller receives the request and the lead instantly.

The ability to syndicate deals online and share business listings on social media is adding fire to the fuel for online business deals. Business deals can be syndicated through a trusted network, through email or through other business-for-sale sites.

Finally, the best part of listing online is the price. Online listings are cheaper than print media and http://www.buysellbusinesses.com/ and makes business listings even more inexpensive. Being mindful of these facts one can safely assume almost 100% business for sale listings will move online in the next few years.

Typical businesses listed online

Almost any business can be listed online, but given the semi-confidential nature of online listings it is best suited for main-street businesses (Businesses valued between $0 and $2 Million). Businesses commonly listed online include E-Commerce businesses, Health and fitness clubs, Websites, Convenience stores, Restaurants, Auto repair, Bars, Fast food franchises, Bakeries, Gas stations, Delis, Printing businesses, Pizza Delivery Businesses and several others.

Non-Financial Due-Diligence (Business Buyer)

The following are a few non-financial due-diligence considerations a business buyer must account for:

Establish Customer Concentration

An important element of business due-diligence is to determine customer concentration. Customer concentration may be defined as the percentage of revenues coming from a single customer. For example, a business may have five large customers responsible for 60% of its revenue.

Customer concentration is directly correlated with the purchase price and the cash at close component of the deal structure. Let’s say there are two similar companies with equal revenues, margins and net income. The business with lower customer concentration will demand higher price and higher cash at close as compared to a business with lower customer concentration. A business buyer should always model the business losing a few customers when ownership changes. If customer concentration is high, losing large customers when the business changes hands can hurt the business significantly.

Non-Compete Agreements

When a business changes hands the former business owner still has a relationship with all customers. This relationship becomes a critical element of the due-diligence process if the customer concentration for the business is high. It is possible that after selling a business the former owner may restart the same business in the same area. The business buyer can protect himself from such behavior through non-compete agreements. If the former business owner could be a competitive threat, the business buyer must work with his lawyer to draft a non-compete agreement and get it signed as a part of the deal.