Once the indicative offer has been placed and the letter of intent has been signed, the next step is to validate that everything that has been said is true and that there are no hidden liabilities. Surprises are not appreciated in business, and especially in M&A when they can cost business owners millions of dollars. So to prevent these surprises from arising, due diligence has to be conducted before buying a business.
What is the due diligence in the buying process of a business?
As stated above, due diligence is an analysis that the buyer does to verify that what we have said is true. The buyer´s objective is to verify that what they are buying is what they are receiving. This is simply because after acquiring the company, both its advantages and problems will become those of the buyer.
Many inexperienced entrepreneurs tend to easily accept the first option they find and will look for a shortcut with the due diligence phase because they want to close the deal as fast as possible. This may happen because they have been looking for a company for a long time and are weary of negotiating: and above all, they would not want to start the whole process all over again. However, the due diligence analysis requires calm and objective actions, conducted through a thorough and rigorous revision. It usually takes between four to eight weeks.
In other cases, the seller will hold back from sharing all the information with the owner, or the owner may also be afraid to ask for it. Given the complexity and the resources needed on these corporate transactions, it is important to explain all the negative aspects of the business at the starting point as well. By not wishing to harm the relationship with the potential seller, the buyer could leave important matters uninspected. The consequences could be detrimental. If after due diligence the buyer discovers that the reality is different to what was negotiated, it is possible that he won’t even make another offer. He will simply stop the process leaving a bitter taste in everyone’s mouth due to the time and effort wasted.
The results of the due diligence can be an important tool for verifying if the offered price is adequate and the buyer often uses the results as a negotiating tool for price and contract terms. Sometimes, the seller isn’t aware of his own problems until the buyer discovers them in the due diligence.
Main aspects to analyze in the due diligence
In due diligence, there are three areas that must be analyzed: the business, its finances and its contracts.
The following aspects, within these three areas, should be evaluated: the history of the company, its transactions, products and services, the market and competitive position, its clients, the quality of both directors and employees, the established compensation system, competitors, facilities and machinery, stocks, financial statements, the production, planning and control systems, marketing, internal reporting, technology, environmental issues, its legal situation, social security, future prospects, business model, insurance, patents, brands, and debt.
The buyer must prioritize the information that is most relevant for him since the seller usually provides limited information in the due diligence process. Besides, his energy and documentation delivery will slow down as the process develops.
Due diligence provides four types of information:
- Key facts needed to decide whether to buy a company or not
- The price range
- Terms and conditions of the sale agreement
- Opportunities to improve the company
There are certain findings that can cause a rupture between the buyer and seller. Some outcomes create an insurmountable difference between the expectations of the buyer and the seller. Other results reveal very high risks for the buyer.
Thus, the operation is usually broken when (1) the financial picture after the due diligence is very different from what the seller said, (2) it is discovered that the perspectives of the companies are bad, (3) there are high contingencies, (4) the company depends too much on the seller, or (5) the company requires strong investments to be able to stay or go back.
Lastly, it is advisable to interview former employees before buying the company, as they may reveal other issues which have not yet been exposed.
Buying a business is a long and arduous process, accompanied by intense emotions. The advisors that have participated in numerous M&A transactions know it is a matter of perseverance and patience. Finding creative formulas also accelerates the process until the objective is fulfilled. If you are looking for a business to reinforce yours, do not hesitate to contact our team of experienced advisors.