“Due Diligence” in a Business Purchase: What Does It Really Mean?

We’ve all heard the term “due diligence” and understand that it generally means to do your homework and research. What exactly the term really means depends on any number of factors, including the type of transaction, the business area and the industry involved, and the relationship between the parties in the transaction. At its heart, however, due diligence is about risk: investigation, identification, assessment and allocation of risk between the parties in a given transaction.

In the context of the purchase of an existing business, there is certainly plenty of risk involved. Any business that has been operating for an appreciable period could have looming and lurking liabilities, unknown or undisclosed but waiting to jump out and say “hello” to an unsuspecting purchaser. Due diligence in a business purchase transaction involves peering behind the curtain of the seller, looking beyond the sale price and other obvious items to determine what level of risk is involved in the transaction and whether the deal should move forward.

As this concept suggests, proper due diligence takes time. And because time is always of the essence in a business purchase transaction, there is often the pressure or temptation to skimp or skip a few steps, sign a contract and get the deal done. Sometimes it’s the seller or the seller’s agent pushing for a speedy closing, characterizing the transaction as standard or run of the mill with no need for a lengthy period between introduction between the parties and the deal closing. Sometimes it’s a high-pressure sales tactic that prompts haste, with a potential buyer being warned that there are other buyers out there and any delay could kill the deal. Or, there can be any number of other factors urging haste.

The purchase of a business, however, is a life-changing event, whether you’re a first-time buyer or an experienced and serial entrepreneur, investor or venture capitalist, involving a substantial amount of money. And risk, of course. Plenty of risk. It is paramount, therefore, to conduct a purchase transaction in an orderly and structured fashion that pays appropriate time and attention to due diligence. As noted above, what exactly that means depends on various factors, but there are, at a minimum, certain due diligence tasks that should be conducted to minimize the potential for nasty post-closing surprises.

• Entity Review. The buyer should conduct a review of the selling entity’s organizational structure and history, including reviewing foundational documents like Articles of Organization or Incorporation, the minute books and resolutions records, assumed name filings, ownership records and the like. It is also typical to seek a certificate of good standing from the Secretary of State.
• Financial Review. A purchase price is often one of the earliest terms agreed upon between the parties, but the buyer does not always have the necessary documentation to review the justification of that price when it is agreed upon. The financial review is done, at least partially, to verify the purchase price as a reasonable valuation of the business. If the financial records of the seller don’t match up with that initially agreed upon price, or otherwise suggestion an adjustment or varied payment structure is appropriate, then the buyer should not complete the deal until the terms are updated accordingly. Financial statements, profits and loss reports, projections and professionally prepared reports, schedules of indebtedness, liabilities, inventory, accounts receivable and payable, tax returns, credit history and such other financial info as the buyer may deem relevant. Carefully analyze the cash flow of the seller, particularly in light of purchase loans and pending debt servicing.
• Physical Asset Review. Some businesses and industries have minimal fixed assets, with all or most of the value being the goodwill of the seller. But a proper review of the physical assets is important to determine if the buyer will be able to continue business post-closing as it was run before closing and to get a proper outlook of needed investments and expenses after closing. Make physical inspections of all major equipment and assets. Obtain schedules of all fixed assets, owned and leased. Review the pertinent UCC filings.
• Real Estate. Both owned and leased, should also be inspected for condition, issues and red flags. Appropriate tests and analyses should be conducted. Leases should be reviewed. Rightful possession and use of the property verified.
• Intellectual Property. Obtaining detailed lists of all patents, copyrights, trademarks, trade secrets and other claimed IP is a must. Are any third-party rights involved? Any potential infringements?
• Employee Matters. This includes reviewing lists of employees and contractors, positions and salaries, benefit programs, non-compete and non-solicit agreements, employee manuals, stock options and grants, and any issues with or claims by or against employees.
• Contracts, Licenses and Permits. Obtain a list of all material contracts and all licenses and permits needed to operate the business. Review of the actual contracts is typically appropriate, including to determine whether key agreements can be transferred to the buyer. History or instances of breach of any material agreement should also be disclosed and reviewed.
• Legal Compliance. This includes environmental issues and filed, pending or threatened litigation, asset liens and tax liens. Is there any pending litigation? Any filed judgments? A public records search is one of the most important aspects of the due diligence process to determine outstanding issues that must be resolved before closing. Unless specifically negotiated by the seller, assets should be sold free and clear of all liens and liabilities. Remember also that if the deal involves a stock transfer, rather than asset transfer, then the assumption of liabilities outlook changes accordingly.
• Review of the Product or Service Lines. The buyer should obtain as much information as possible about the core of the business being purchased. Analyzing and understanding the products and/or services of the seller is a must. Have there been any regulatory approvals or disapprovals? Any warranty claims made? Is the seller working on new product or service lines? Any discontinued lines? Is the purchaser able to continue operating those lines in the same manner as the seller? E.g., is special training or licensing required that the buyer lacks (if, for example, 10% of the seller’s AR comes from a particular service, and the buyer is not qualified to perform that service, then the purchase price may not be justified to the buyer)? Are the clients, customers or patients happy or satisfied with services of the seller? Has the client base increased or decreased in recent years? Are there any professionally prepared reports or analyses? Is there any information or analyses available on the market or competition? Etc.
• Insurance Information. What policies are in place? What policies are required to operate the business? Any issues or claims made?
• Public Records Review. The public records should be careful reviewed to determine, among other things, that the assets may be transferred free and clear of any liens and encumbrances, including UCCs, pending litigation, and active judgments.

This is by no means an exhaustive list. Your due diligence may have many more aspects and facets. Depending on the deal, the due diligence checklist may be substantially more detailed. Ultimately, however, you and your team of advisors must determine what due diligence is required to cross the comfort threshold and have determined to move forward with the transaction. In this process, the seller should be an open book. If the seller is reluctant, or even refuses, to comply with due diligence requests, that can be a red flag and a frank discussion should promptly ensue. There may be a good reason why some information can be held back, but remember that the buyer really has very little information going into a deal. Open access to information is the only way to properly assess risk and make a final determination on the deal. The deal isn’t done until it’s done. Minimize risk and avoid buyer’s remorse. Do your due diligence.

LEGAL DISCLAIMER

The information herein is not legal advice and does not create an attorney/client relationship. The information is in the form of legal education and is intended to provide general information about the matter.  The above is not, nor is it intended to be, legal advice.  Consult your attorney with questions.