In the previous post, What to Think About When Buying a Business, among the topics raised was the importance of doing due diligence. In this post, I drill down on several key areas that should be the focus of the due diligence review: (1) financial, (2) legal, (3) product/services, (4) customers/clients and (5) employees.
1. Financial Review
Obviously, when buying a business you need to review the financial books and records of the company, and you will likely have an accountant to assist you. However, as an entrepreneur, you should understand what are the major financial aspects that need to be examined.
(a) Revenues. Certainly it is important to look at the revenues of the business, but also you need to understand what is the source of those revenues and how stable are those sources. Thus, consider:
(i) Are the revenues primarily from one/only a few customers or accounts?
(ii) Are the revenues growing, stagnant or worse yet, shrinking?
(iii) How are the revenues derived?
(iv) Were there extraordinary events that negatively/positively affected revenues?
(i) Is the overhead high and can anything be done to lower it without negatively affecting business?
(ii) What are the costs of the goods or services sold?
(iii) Is the business burdened by expensive debt service/interest liability?
(iv) What are the sources of the expenses and are they in line with revenues?
(c) Assets. Consider, what does the company really own?
(i) Does the business own any assets, and what are they?
(ii) Asked a different way, are you sure the business owns the key assets and not one of founders or a third party?
(iii) Are the key assets licensed, and if so how long is the license, and how stable is the licensor?
(iv) Who owns the intellectual property?
(v) Who owns the domain names?
(d) Liabilities: What are the long and short term liabilities?
(e) Taxes: What is the structure of the company and is it structured in a tax efficient manner?
2. Legal Due Diligence. Below are just some of the legal issues to consider.
(a) Is the ownership of the assets properly documented?
(b) If there are licenses, are they properly documented?
(c) What type of entity owns the business?
(d) Are the formation/governing documents of the business entity properly drafted and do they include an provisions a buyer should be concerned about; have all minutes/resolutions been reviewed?
(e) Does the company have all the necessary permits and licenses?
(f) Has the company met all compliance obligations, including with respect to corporate matters?
(g) Does the company own the intellectual property it needs to operate the business, and what is the status of any applications or registrations?
(h) Are the assets encumbered in any manner?
(i) Are there any claims, lawsuits, proceedings, defaults pending or judgments/awards outstanding?
(j) What contracts/licenses/undertakings has the company entered into and do you understand them?
(k) Are the important contracts/licenses/customers assignable?
(l) Are there any environmental or other regulatory issues particular to the business?
(m) Did the company grant any rights, options, warrants or the like to third parties?
(n) Has the company made any warranties and what are the obligations thereunder and does it hold any rights under any warranties?
(o) Are the the website policies properly drafted?
3. Products and Services. This may seem a ridiculously obvious point, but before buying a business make sure you understand the products or services being offered by the company. A business may seem attractive from the outside looking in, but drill down and become an expert as to that business before deciding to become financially responsible for it. One way to address any lack of expertise is to requires the prior owners to help your transition the business to the new owners.
(a) Are the customers/clients transferable either by contract or otherwise?
(b) Are there privacy issues that may create issues as to transferring customers/accounts or data about them, including credit card information.
(c) Who has the relationship with the customers? For example, if the old owner(s) leave the business, will the customers stay or leave as well?
(d) Non-compete/Non-solicitation. Try to obtain a non-compete from the sellers of the business.
(a) Review any employment/consulting agreements and understand the obligations thereunder.
(b) Make sure all employees/consultants have signed confidentiality agreements and invention assignment agreements.
(c) Are there collective bargaining agreements or particular issues failing under Labor Laws?
(d) Is there an employee option plan?
(e) Are you sure the key employees will stay with the company if sold?
The above is by no means an exhaustive list of due diligence issues and, without a doubt, there are many others that should be included. However, what the list demonstrates is the importance of conducting proper due diligence when buying a business. The more you understand the business, the better you are able to not only determine if you should proceed with the transaction but address any concerns in negotiating the purchase price as well as draft the purchase agreements.
When you buy a used car, you look under the hood and may even have it inspected by a mechanic. When you buy a house, you walk through it many times and usually get a home inspector to do a thorough inspection. So, if you are considering the purchase of a business, don't overlook the importance of obtaining experienced counsel to assist you with the due diligence because it is not what you know, but what you don't know that can create material business issues down the road.
Disclaimer: Nothing herein constitutes legal advice, and is for discussion purposes only.