Due diligence is a similar process for everyone, but it’s not the same process. The depth of your analysis will depend on your appetite for risk, the particular business you are looking at and your specific requirements for a business.
It involves assessing your expectations of a business proposition against the target acquisition to determine if it measures up and where there might be gaps, risks and issues in a transition to ownership.
The following 5 high-level areas of focus will usually be considered to some degree in every due diligence process.
Think about a business’ customers as being a portfolio of earnings potential.
Ask yourself:
The operating environment involves considering the trends and issues faced by the business in the market and how they might materially impact the business you’re looking to purchase.
Often people look at a business’ product or service range but don’t necessarily look at the corresponding inventory levels.
Imagine the business you’re looking to purchase is selling air conditioner model XYZ. XYZ is one of the business’ top five sellers and for the past two years the business has averaged 55 sales per year of this model. The current inventory level of XYZ is 78 units, with each having a wholesale value of $5000.
You now need to consider what impact this inventory level will have on your working capital position. Your due diligence may have confirmed that you have a strong chance of selling 55 units per year. Do you want to buy 78 air conditioners on day one, when you will likely only sell 55 per year? You will be holding a surplus of 23 units – that is $115,000 of extra working capital you will be outlaying on day one.
We talked about inventory management in detail in our eBook Managing Cash Flow and Working Capital and one of the topics discussed was obsolete and slow-moving stock.
When assessing inventory levels in due diligence it’s important to recognise the difference between overstocked items – like air conditioner XYZ – and obsolete and old stock items.
Be careful not to wind up paying face value for stock you may have difficulty moving.
Due diligence in this area also requires pressure testing the value of relationships with key suppliers.
It’s just like customers: think of the suppliers as a portfolio of relationships that have elements of value to bring to the table i.e. products. They may each be operating under different terms, which you will need to understand.
They will also have their own views on the business you’re buying, so engage them in early discussions to understand their perspective on the business:
The final piece of this section, if inventory is part of the sale process, involves doing a stocktake. This usually comes after all of your other due diligence and just prior to completion.
Stocktake is an important part of the due diligence process because any ‘red flag’ issues you identify regarding inventory levels may necessitate a price renegotiation or discussions on other remedies.
What you’re trying to do in this stage of due diligence is understand the quality of the team you have available upon transfer:
This issue is very important for a successful transfer and you will want the following information:
Once you have an understanding of the processes you need to consider to what extent those processes have potential areas of failure that could impact the financial position of the business.
For example, how do those processes mitigate the risk of poor or inconsistent pricing in quotes, or even the risk of fraud?
Legal due diligence is a very important component of due diligence and is covered in more detail in Chapter 3 of our eBook, How to conduct due diligence on a business purchase.
One important part of this process is looking for formal or informal agreements or understandings between the business owner and key people or organisations. These people may be customers, suppliers or collaborators.
The agreements could be anything from the actual premises lease documents and what’s required in terms of lease obligations, assignment and transfer, to a verbal agreement with a sub-contractor to provide product installation services on an hourly rate basis, with no documentation at all.
When buying a business as a going concern, the legal contract will help protect you from some obligations, but you will still find yourself approached by people with views on your commitments to them, and you’re going to need to know what they are and whether they’re appropriate.
When thinking of due diligence most people think of numbers.
This area of due diligence may be very extensive, or less so, depending on your risk appetite and also on the work you’ve already done in getting to the stage of due diligence. It’s also about comparing financial performance to the physical and non-financial aspects and trends impacting the business to identify trends or breaks.
Typically there are a few things we like to look at here, including:
From the JPAbusiness archives
Refreshed and checked for accuracy April 2017
Buying a business will be one of the more significant investments you make in your lifetime. To ensure you are fully aware of the risks, issues and opportunities your target acquisition presents, consider engaging an experienced business advisor to assist you in conducting due diligence.
Call the JPAbusiness team on 02 6360 0360 for an obligation-free, initial discussion.