Whether you are buying a business for the first time or you have purchased and sold number of businesses you cannot underestimate the importance of due diligence before signing on that dotted line. The mistake made at this stage can not only be costly in terms of financial losses; but it will get you stuck with bad business for a long time.
So what is due diligence? Due diligence is the process of looking at the business you are planning to purchase from multiple angles to verify that the financials match with what the seller promised earlier. Presumably, you have already done your homework in terms of market analysis, competition, and future potential before putting an offer with the seller. The due diligence comes into picture after the seller has agreed to your offer. It is usually one of the last steps in the buying process before you start preparing the closing documents.
To perform proper due diligence you should get as many financial documents as you can from the seller. Typically, the documents you should ask for are – tax statements, monthly breakdown of sales and expenses, profit-loss statements, balance sheets, cash flow statements, employee records and lease agreements. You should get at least last 3 years of financial statements from the seller. In some cases the seller may not have all these documents; however the more you can get the better job you can do in due diligence process.
There are several ways you can analyze the documents in due diligence with the goal of verifying seller’s statements about past and future profit and ensuring that there are no hidden problems that will hurt you after you have bought the business. Here is what you should look for in the documents:
- Sales and Expense Trends – Is the sales going up or down in the last 3 years? How about expenses? You want to look for positive trends in terms of increasing sales and decreasing expenses.
- Red Flags – Are there any inconsistencies between various documents you have collected. For example, if the labor cost is going down (thus showing higher profits); while at the same time number of employees is going up you know that something is wrong and you need to ask the seller for explanation.
- Monthly breakdowns – How are the sales trending throughout the year? Do certain months of the year produce higher sales than others? Are there large fluctuations in the sales and profit through the year? This helps you understand how you should manage your cash flow.
- Improvement opportunities – How do important metrics compare to industry benchmarks. For example, in food industry labor cost is typically 30% of sales. If the seller is running at 35%; you know that the seller is not managing well and you can improve your profit by managing labor cost better.
The key to success in performing due diligence is to look at the numbers without being emotional about the business. Just remember, you can always find better opportunity somewhere even if you “miss the train” on this one. It is also important to work with outside consultant; who can bring in neutral perspective and uncover issues you may have overlooked yourself. After all, buying a business is one of the most important decisions you will make in your life!!
We at Angel Business Advisors have helped number of buyers with due diligence. You can find sample due diligence report and additional details on our methodology here.