Buying a Business and Due Diligence
By Alan M. Briskin, J.D.
One way to start a business is to buy it. In such a situation, the seller has already taken the risk of investing in her idea and has made it work. The company has already established a customer base, trained a staff, purchased the inventory, leased or purchased space in which to work, and developed a system of doing business. For the right price, this may be a wonderful opportunity; however, failure to conduct proper “due diligence” could cause the prospective buyer to purchase the business for an inappropriate price.
“Due diligence” simply refers to the process of carefully investigating the deal before entering into it. In other words, it means “doing your homework.” Due diligence is the careful and methodical analysis of the business, together with an evaluation of the industry of which the business is a part.
Before starting this process, it is critical that the buyer apply mental discipline. Be detached, critical, and patient. Making an impulsive or instinctive decision to buy can lead to disaster. Do not hesitate to seek assistance from various professionals, including accountants and attorneys, as they have substantial experience in advising and assisting prospective buyers through this process.
Now, let’s examine the process. Let’s suppose you have found a business that you would be interested in running. It suits your skills, your aptitude, and your interests. The business is a distributor of hardware that had gross revenue of $2,000,000 in the most recent year. The business has inventory worth $800,000 at wholesale. It has twenty-five employees, an office, and a warehouse. The owner is asking $1,200,000. The business did not have much profit last year, but the owner of the business made $110,000 in salary and bonuses, and the business paid for her car lease.
This seems to be a reasonable deal. Upon casually looking through the business’ records, all the information seems to be correct and substantiated. This, however, is not the end of due diligence. It is merely the beginning.
First, review the records of prior years. Determine whether there has been any change, either negative or positive, in the business’ sales. Carefully review the company’s debt history. Has the owner been using the credit line to keep up her personal income level? This may indicate the company’s revenues or profits have been declining.
How frequently does the business sell or “turn” its inventory? Inventory that sits in the warehouse can be costly, either in interest charges if you borrow to purchase it or by tying up capital. Moreover, to the extent the price includes the value of the inventory, it is extremely important carefully to inspect the inventory. Some of it may be obsolete or defective. Rather than rely upon the owner’s representations, a prospective purchaser should conduct a physical inspection and count of the inventory. The purchase agreement should provide for price reduction for discrepancies or for obsolete or defective items.
Look carefully at the money due the company, also known as the “accounts receivable” or “A/R.” Demand from the owner an “aging” – a breakdown of the accounts receivable by how they have remained unpaid. A number of customers may be very slow payers or even bad credit risks.
Are the number of customers declining or increasing? Is the company dependent upon a few customers for most of its sales? Are there customer complaints on file with the Better Business Bureau or with state or local agencies? Do the records show frequent product returns from dissatisfied customers? Is there a history of claims for defective products or injuries that came from using the products? Have any recalls been issued for products sold by the company?
Do you want some or all of the employees to remain with the company after you purchase it? If one or more are crucial to the continued operation of the business, will he or she remain? Do the employees have any complaints about their compensation or working conditions? Are they members of a union? What benefits are provided to the employees? How long have they been provided? If there is a pension plan or 401(k) plan, has it been properly funded and maintained?
Consider whether the company is current in payment of its bills. Late payments could indicate poor cash flow. Does the company have a good relationship with its suppliers? Are there alternative sources of supply, or is the company dependent upon the pricing policies of a single supplier? If there is a contract with a supplier, is the contract about to expire, and can it be renewed upon reasonable terms?
Is the company current in the payment of its income, sales, and payroll taxes? Your attorney will help structure the transaction in a manner that will assist you in avoiding liability for the previous owner’s unpaid taxes, but there is always a risk that the taxing authority will claim you have what is known as “successor liability.” With your accountant’s help, review tax returns for several years to determine if there are shortages in tax payments and if the most recent tax payments appear to be appropriate for the current sales, income, and payroll. Additionally, if a purchase of the property on which the business is located is involved in the sale, it is important to order a title search to determine (1) whether the seller actually owns the property and (2) whether any taxing authority has imposed a lien on the property for unpaid property taxes. Next, consider whether there are any licenses or permits required to operate the business. With a hardware distributor this is unlikely, however, business such as travel agencies, real estate brokerages, guard services, restaurants do require licenses in one form or another.
Consider whether there relationships with customers or suppliers that will be lost with the departure of the seller. It may be advisable that the purchase agreement require the seller to stay with the business for several months to assist in the transition and in maintaining these relationships. Additionally, determine whether you will need the agreement of a landlord to transfer the leases or of the manufacturer of the products you sell for you to be an authorized distributor.
Once due diligence has been completed, the parties then should negotiate and develop a written purchase agreement for the purchase of the business. Prior to preparing the written agreement, the parties often prepare a letter of intent which outlines the basic terms of the agreement. Note that in almost all situations, it is possible to structure the purchase of a business either as an asset purchase or as a stock purchase. Determining the appropriate type of transaction requires both legal and accounting advise, as the decision is influenced greatly by liability and tax considerations. For more information regarding this decision, please consult an attorney or a CPA experienced in these transactions, or review other articles available on this website.
This list may seem somewhat overwhelming, and, in fact, it is by no means comprehensive, as each business requires evaluation of factors too numerous to include in this short discussion. Fortunately, if approached methodically and with the assistance of professionals who have worked through the process before, this can be accomplished successfully. Without appropriate due diligence, the buyer cannot possibly know whether she is entering into a profitable deal. With thorough due diligence, however, the buyer can sleep more soundly at night knowing that reasonable contingencies and risks have been addressed.
The information you obtain at this site is not, nor is it intended to be, legal advice. You should consult an attorney for individual advice regarding your own situation.