For anyone making a significant investment in a business, the due diligence process is key. This allows the buyer to thoroughly evaluate the company and make sure that he or she has a clear picture of the business. The goal is to make sure that after the buyer takes ownership he or she is not presented with any surprises that had the buyer known before, would have affected the valuation of the business or even the very decision to purchase it.
Almost always a buyer will find a surprise or some information that he or she was not expecting. This doesn’t necessarily end the transaction. The due diligence process allows the buyer the opportunity to evaluate the problem and work a solution prior to closing. This might include a reduced valuation for the business or the inclusion of specific terms in the transaction to address those concerns.
Now every business is different so it is impossible to identify every area that a buyer should look at for their given situation. Below you will find a discussion of three areas that are commonly evaluated.
Financial Review. The purpose of the financial review is to ensure the buyer has a full understanding of the business’s financial position. Often this review is handled by an accountant working with the attorney. The buyer will want to evaluate the business’s tax returns from previous years, look at its accounts receivable and payable, the company’s payroll, bank account transactions, and any outstanding loans.
The goal of the financial review is to identify any discrepancies or “trigger events.” Some examples of discrepancies might include accounts on the books that don’t really exist, missing money, improper tax payments, etc. I define “trigger events” as anything that might occur abnormally as a result of the transaction. For instance, it is possible that financing the business relies upon may include a due in full clause upon a change in ownership. These are issues a buyer will want to address prior to making a financial commitment in purchasing the business.
Contract Review. The purpose of the contract review is to evaluate the business’s ongoing obligations and benefits as well as any options it or another company may hold in the future. The buyer will want to review supplier contracts, customer contracts, service contracts, leases, etc.
The goal of the contract review is to identify any trigger events or upcoming obligations that might affect a buyer’s evaluation of the business. The buyer will want to evaluate the duration of supplier contracts, pricing under those contracts and any potential changes to the terms, as well as have a full understanding of the company’s obligations pursuant to that contract. The same goes for any other contracts to which the company is a party.
A buyer wouldn’t want to be surprised after the fact to find that the company’s supplier contracts run out 3 months after the close and the cost of goods will double upon renewal. Alternatively, perhaps the company has not developed enough new business recently and its contracts with current customers expire shortly after close. Maybe there are ballooning obligations on the company that aren’t apparent in its current operations. All of these would influence the valuation of the business and a buyer would want to address these issues prior to closing.
Litigation Review. The litigation review is an opportunity to evaluate potential legal liabilities of the company. This includes ongoing litigation as well as potential litigation and regulatory issues.
There are two primary goals during the litigation review. First, a buyer wants to know of any ongoing litigation or regulatory investigations involving the company under consideration. Second, a buyer should take an in depth look at any potential litigation issues that have not already resulted in a law suit or regulatory investigation.
Obviously, the buyer should evaluate any current litigation when determining a proper valuation for the business. A buyer should consider the merits of any claim or defense involved, as well as the costs involved such as court expenses, attorney fees, and any other financial impact those law suits might have when deciding upon a final purchase price.
Perhaps more importantly, a buyer should look at potential exposure to any regulatory investigations or law suits based upon prior activities of the current owner. This not only impacts the costs above but also the overall valuation of the business. The buyer might want to include terms in the transaction such as guarantees, warranties, and/or an indemnity clause to address these issues.
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