If you’re new to buying a business, you may be a bit baffled to hear attorneys or business brokers tossing around the phrase “due diligence.” Fortunately, a new report from Yale School of Management on due diligence in business sales outlines the steps needed for a successful process.
Due diligence exists for a simple reason. To paraphrase the report’s authors, Yale lecturer A.J. Wasserstein and Yale MBA case study writer Andrew Seth Jacobs, due diligence is how you make sure the business you think you’re buying really is the business that’s been described to you. You don’t want to take any information in the sale at face value–you need to verify all the facts.
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What is it? A Due Diligence Definition
Before we dive into the details of the due diligence process, let’s simply define what we’re talking about.
Broadly, due diligence means to responsibly investigate and confirm the facts of a situation. For instance, before you buy a house, you get a home inspection to make sure the house isn’t riddled with termites.
In a business sale, due diligence involves verifying the information provided by the seller about their business. Have all income and expense items been correctly noted? Has anything important been omitted that might change the business’s valuation?
Answering these questions is the work of due diligence–and the process begins with the seller.
Seller Due Diligence Prep
If you’re selling your business, your role in the due diligence process is to prepare the information about your business that buyers will review. This is the first step in preparing a business for sale.
Items buyers will request include:
- Articles of incorporation
- Business licenses
- Monthly profit and loss statements
- Sales projections
- Employee contracts
- Customer contracts
- Equipment ownership or lease documents, depreciation schedules, maintenance agreements
- Real estate ownership or lease documents
- Intellectual property documentation
- Court filings for any legal disputes
Due diligence can’t begin until the seller has these documents ready for a buyer to review.
8 Important Types of Due Diligence for Business Buyers
Reviewing a company’s financials is probably the most well-known type of due diligence. But a smart buyer will examine a business from many angles. The complex nature of the process is why professionals will use a due diligence checklist, to track their progress and make sure they don’t overlook any important steps.
There are eight major aspects to a thorough due diligence process, the Yale report notes:
- Financial due diligence–Financial statements are fact-checked and adjustments made if discrepancies are found.
- Legal due diligence–Seller truly owns the business and there are no lawsuits or encumbrances.
- Commercial due diligence–Verify the future viability of the industry this business operates in, and this particular business’s competitive position in it.
- Customer research–Analyze customer information to learn if the company meets their needs and customers are likely to remain post-sale.
- Technology due diligence–Assess the usefulness, reliability, and security of technology employed.
- Human Capital analysis–Examine company culture and identify key employees to retain.
- Operations analysis–Understand the sales process and customer journey.
Other–Engage industry experts to understand any special issues facing this business.
All these aspects need to be considered, to make sure critical flaws in the business model aren’t overlooked. For instance, a company’s finances might look great right now, but industry trends might reveal the sector is on the wane–or a review of employment contracts might uncover that key managers are departing.
Remember, this is likely the biggest payday your seller will ever see, so they have a strong motivation to lie or spin the facts to paint a rosy picture. They may withhold important information that would affect the company’s value to a new owner. By investigating all eight areas of due diligence, you form a more complete, detailed picture of the potential opportunities and challenges ahead for your target business.
The 2 Phases of Due Diligence
The Yale report defines two key parts to the due diligence process: preliminary due diligence and confirmatory due diligence.
Because full due diligence is a complex multi-month process, it’s not practical for business buyers to do the entire process on every business they review. Instead, the buyer’s team quickly reviews existing documents to verify basics, and see if the buyer wants to propose a Letter of Intent (LOI) to buy the business.
If the LOI is signed, an exclusivity period ensues during which the buyer conducts their full due diligence. This is when your team of due diligence service providers will examine all eight aspects of the business outlined above, to confirm the seller’s statements are truthful and complete.
“Much like getting the feel for a shiny new car, diligence is, essentially, taking the business off the lot for a test drive,” the Yale report observes.
How Long Does Due Diligence Take?
While big-money acquisitions can drag on for months or even years, small-business sales tend to have a fairly contained due diligence period. Data from the business-sale marketplace MidStreet showed that due diligence took 45-60 days to complete in under-$25 million business sales.
How Much Does Due Diligence Cost?
Costs for due diligence on small-business sales range all over the map. Seller-side advisors Class VI Partners reported they’ve done deals where due diligence costs ranged from under $100,000 to a $1 million or more. Only the buyer can decide how much to spend investigating a proposed business purchase. The larger and more complex a business is, the more important it is to expend resources for a thorough due diligence process.
3 Major Challenges in Small-Business Due Diligence
When major corporations acquire other well-developed companies, those buyers have the funds to put together a dream team of due diligence professionals to investigate the acquisition before the sale closes.
Smaller business sales? Not so much.
Small-cap deals usually suffer from three major problems, the Yale report found: low diligence budgets, low quality of information, and unsophisticated sellers.
Often, you’ll have a first-time seller, ready to retire after building their one and only business across decades. The seller may be overwhelmed by the amount of time and effort needed to satisfy due diligence requirements, and consider giving up their effort to sell. There may be sketchy, incorrect, or entirely missing information as you review the business.
For their part, buyers of under-$5 million businesses usually operate on a shoestring. That may mean having to choose areas of focus, rather than turning over every possible rock in search of new information.
Build Your Due Diligence Team
As you can see, due diligence is a complex process that requires expertise in many areas. That’s why most buyers assemble a team of due diligence professionals with experience in each area of investigation–an attorney, accountant, industry expert, and so on.
My tip? Get the best experts you can within the budget you’ve got, to create as robust a due diligence process as possible. It’s the only way to make a smart decision on whether or not to buy or invest in a business.
It won’t make sense to do $1 million worth of due diligence to buy a $1 million business. That’s why the expertise of your diligence team is critical, to help you set those priorities.