Conducting proper due diligence is incredibly important before you acquire a business. There are two goals that you want to achieve:
- Verify that the information presented by the seller is accurate
- Make sure that there are no hidden liabilities
It all starts with the letter of intent (LOI) that all involved parties will sign. The LOI should provide for a due diligence period and give you access to the target company’s records. It is a complex undertaking consisting of legal, financial, and operational components. By doing it correctly, you will minimize the risk of wasting your money on an unprofitable business or paying far more than its true value.
3 Major Areas of Due Diligence
Your objective in carrying out legal due diligence is to make sure that the target company is on a sound legal footing. First of all, you want to confirm that the business has been legitimately formed and that it exists. You want to understand the company’s ownership structure, the rights of different owners, and its management. Find out if there are any pending lawsuits, or if litigations could arise in the future. Check to see if the company’s insurance is adequate. Verify that the company is in compliance with all applicable laws and regulations.
Your aim in doing financial due diligence is to verify that the financial information on which your buying decision and purchase price are based is accurate. You should gain a thorough understanding of the company’s finances so that you can include potential contingencies in your projections and financial models. Find out if there are customer collection or cash flow problems. Check to see if there are unfunded liabilities such as pension benefits for current and future retirees and bonuses promised to employees. Depending on the size of the deal and your level of expertise, you may want to engage accountants or financial advisors to help you analyze the financial data.
Your goal in performing operational due diligence is to make sure that the target company will be able to function as you expect after you have purchased it. The business may be profitable now, but it might not be able to generate the same level of earnings after it has been acquired. This can happen for a variety of reasons. Key employees may leave, or key contracts may be terminated or go into default. Leases and loan agreements are often non-transferable, even indirectly through a stock purchase. You should also verify that the company owns its intellectual property and trade names.
Why You Need to Consult an Attorney
Due diligence is a major project that involves scrutinizing an enormous quantity of information. You want to be thorough, organized, and strategic in your approach. Work with your attorney, accountants, and financial advisors to map out a strategy before you begin and get their advice at every step of the process. As you perform due diligence, you may uncover legal or financial liabilities or asset impairments in the target company that suggest it is worth far less than the seller’s asking price or that make you think twice about acquiring the company. The cost of doing due diligence inadequately could far exceed the cost of carrying it out properly.