Due Diligence in Buying a Business (part one)

We have successfully negotiated agreement upon an offer to buy a business based on the information our business broker and the seller have provided. This offer included many conditions that we must be satisfied with prior to closing or the offer becomes null and void and our deposit, refunded.

We must now plan and execute a reasonably thorough analysis of the business and the information provided.

Our goal is to identify any fatal flaws, verify that the information is reasonably accurate and confirm that this business will really work for us. Professional advisers can assist us with this process, called due diligence.

Our business broker will help us develop a diligence plan and coordinate its execution, but he or she will not do our diligence, which is our responsibility as the purchaser to carry out to our satisfaction. Keep in mind that we will have to work from whatever the current owner has as records.

We may want to have an accountant help us verify cash flow, assets, liabilities, financial history and projections and review tax filings, associated risk, corporate structure and potential tax issues resulting from our purchase. If we want them to, they can also review financial control systems and make recommendations we can employ when we take control of the business.

Involving them in the preparation of our business plan and financial projections may help in securing financing.

We will need legal advice. An experienced tax and transaction lawyer will give us their findings and advise us on the risks and the structuring of the transaction and the business after our acquisition. They will also review the ownership and transferability of the intellectual property. Keep in mind that there will always be some risks and that we are the buyer(s) – not our accountant or lawyer. Listen to their advice and that of your business broker but the decision to proceed or not must be yours. I have rarely heard an accountant or a lawyer recommend that a buyer proceed with an acquisition. Their job is to keep you from making a mistake or taking undue risk. The only way to avoid risk is to do nothing. You must decide if the risks are acceptable.

Most purchasers buy a business with the intention of growing revenues and increasing profits and cash flow. During their first year of ownership, most new business owners see revenue increase some 15% to 30%—a result of new energy, different skills and the assistance and support of the previous owner.

We need to focus on long-term growth. Typically, increasing profits requires increasing sales leads, improving the conversion rate and increasing the number of transactions per customer, the average sale value and the margin on each sale. Can we do better in one or more of these areas? To determine this, we need to assess many aspects of the business beyond the financials and legal diligence.

Will the business meet your needs?

We must confirm that the business can generate sufficient cash flow to 1) support us, 2) do the debt servicing to pay for the business over a reasonable period of time and 3) provide a return on our invested capital. If it is falling short, we must have a vision of the changes we can make to ensure it meets these needs in the future.

Assess the market—its size, desires and how it is being approached. The level to which the business’s product or service is currently accepted may not be indicative of the future. We recommend surveying present satisfaction and future purchasing intentions of existing clients. Sellers who haven’t tested sometimes misjudge and misrepresent.

Is there a future for the product or service? Changes in population, lifestyle and trends, legislation, interest rates and economic fluctuations and so on have to be considered. Can we improve leads, conversions and volume of sales? Do we have the right salespeople and processes, marketing and sales tools, testing and measuring systems? Can pricing be increased? Can costs be reduced? Do the changes require additional capital investment? If so, do we have sufficient capital or credit for these changes?

The first six months

For the first six months of ownership, we usually recommend that new owners operate the business the same as the previous owner ran it. Retaining current clients, skilled staff, existing supplier relationships and the confidence of the marketplace is important. Your experience over the first six months will give you a better understanding of the systems and processes already in place and form a basis for benchmarking changes you may then wish to make.

Systems, combined with the competence and attitude of the employees who operate those systems, are at the core of most good businesses. You will be able to review both during due diligence. While the need for confidentiality makes it hard to assess employees before closing the purchase, you can learn much about them from the current owner, from seeing how they are currently performing and from your customer survey. You should review the files the business has on each employee as well as HR systems and policies.

You also need to assess their technology. Is it adequate? What can be improved? Review the existing facilities and related agreements including leases, maintenance, warranties, current suitability, expansion potential and future options. Are licenses and permits current and transferable? Are furniture, fixtures and equipment serviceable? Can they support the business in the future? With equipment, technical and economic obsolescence is an issue—sometimes a perfectly good piece of equipment should be replaced by a newer version with lower operating costs or more desirable features. You may need the help of a knowledgeable technician to make such an assessment.

The original version of this text was published online in our At the Broker’s Table series and included in my book Insider Tips on Buying a Business in Canada. Stop by one of our offices across Canada for your free print copy. Or you can download a pdf copy here.

Default image
Gregory Kells
Articles: 89