Buying a business: due diligence checklist
Buying a business is a big deal (literally). The investor needs to research the company extensively, so their knowledge of all aspects of the business and its financials is as complete as possible. This due diligence work is essential to an accurate valuation and to not getting any nasty surprises down the track.
So, what does due diligence involve? Here’s an overview of the process and a handy checklist to get you started:
Pros and cons of buying a business
Buying a business can help you bypass some of the difficulties involved with building a business from scratch, but purchasing an existing business does come with some downsides and considerations to keep in mind.
When buying a business, you avoid one of the biggest traps of starting a new business: determining viability. New companies often go through a long period where the owners need to focus on making sure that the product, business model, or both are viable. When you buy an established business, you can generally skip this phase entirely — someone else has already done it.
Lower initial operating costs
Purchasing an existing business means you don’t need to worry about the initial startup expenses involved with securing a location, gathering supplies and finding your first employees. This frees up cashflow to focus on aligning the business with your vision and building on existing momentum.
An established business is almost always seen as a lower risk to financiers and potential investors. The reason is simple: it has a proven, real-world track record that can offer some indicator of future performance. This generally makes it a safer bet for lenders.
Intellectual property value
When you purchase a business, you often acquire that business' intellectual property as part of the deal. This has the potential to be much more valuable than the business itself. Many tech companies, for example, are explicitly acquired for their intellectual property, which can be incorporated into the acquirer’s software or become an addition to their software suite.
Higher upfront purchasing costs
While buying an existing business might mean lower operating costs, you do have to consider the purchasing costs involved. When you buy an existing entity, you’re also paying for the existing customer base, branding, equipment, and intellectual property, along with all the time, energy and money poured into building the business and ensuring viability.
What this means in practice is that purchasing a business can sometimes be more expensive than starting a new business of the same type. This is especially true for companies that are well-established and profitable. Of course, the upside is that you get to bypass a lot of the uncertainty of the early stages.
Lack of company knowledge
When you build a business from the ground up, you become intimately familiar with its inner workings, as well as the industry. When you purchase an existing business, you have to learn about it after the fact. Not having this context can add pressure to day-to-day operations.
Although the due diligence process is extremely thorough in most acquisitions and business purchases, no process is perfect. There’s always the risk of buying into a problem that remained hidden before the purchase, whether intentionally or not. This could be as simple as equipment that needs replacing, or it could be more complex, like a poor brand perception. Once the purchase is finalised, that problem now also belongs to you.
One issue that perhaps isn’t acknowledged enough is resentment and negative feelings among employees of the business being purchased. Many organisations begin to feel a bit like family to the employees, and the processes and methods of the organisation can become deeply ingrained. As a result, staff may not appreciate new leadership or changes to the procedures they’re used to. This is a reality that needs to be carefully acknowledged and managed by the new owners of the business.
Buying a small business: Due diligence checklist
One of the most important steps in buying an existing business is conducting due diligence. This is where you do your background research and confirm the business is a smart investment. Here’s a small business due diligence checklist to help you get started:
Conduct due diligence
The first step in the purchasing process is to thoroughly research the business you’re looking to purchase. Known as due diligence, this is an in-depth research project that makes sure all aspects of the business are explored and analysed. This helps with accurate valuation and minimises the risk of surprises.
Research your industry
Your goal here is to learn as much as possible about the market of your potential business purchase. Some questions to ask when buying a business include:
Who are the target customers?
Do the target customers and the business' current demographic match?
Who are the primary competitorsanalysis and how are they performing?
Answering these questions will help you understand what opportunities there are to grow your customer base and increase revenue.
Assess finances and assets
After you conduct market research, you’ll want to look into the business' financials. This research serves a dual purpose: it helps back up the business' valuation, so you can confirm you’re paying a fair price and it provides useful insight into the business' performance.
Financial statements: Review financial statements for the past several years.
Physical assets: Determine the value of tangible assets like machinery, buildings, property and inventory.
Other assets: Determine the value of intangible assets like intellectual property, copyrights and patents.
Review legal information
Here, you’re looking for potential compliance issues, since these will all become yours after the sale is finalised.
Documentation: Make sure leases, insurance policies and any other binding legal documents are valid and up-to-date.
Any other compliance papers that might be relevant should also be in place before purchase.
Evaluate the business profile
Here, you want to look over high-level items like business plans and forecasts to make sure the business has been managed well and is in good shape. Look into:
Market conditions: Evaluate competitor and overall market performance.
Sales information: Look at sales reports, forecasts and whether the business tends to hit its targets.
Business history: Start date and changes in location or ownership can provide valuable background information.
Procedure documentation: Does the business have sufficient documentation for processes, procedures and workflows?
Business plan: Does the company have a documented business plan?
Verify the seller and their claims
An important part of due diligence is finding the evidence to verify the seller’s claims. Be prepared to go digging for information and not just accept what the seller says at face value.
Consider the seller’s liabilities
Any money owed by a business can decrease its value. Additionally, some liabilities, such as employee entitlements, are transferred to the new owners, so be sure to enquire about these.
Evaluate potential business profits
A business is an investment, and it’s important to make sure it’s a good one. As such, evaluate the commercial life of the business and consider the opportunity costs — are you passing up other investments that might be better than this one?
Review current customers and suppliers
You should carefully consider the status of customer and vendor relationships. A business is in a strong position if it has a large customer base and a few preferred suppliers.
Determine the value of the business
After investigating a business, the next step is to determine its valuation. The seller likely has a number in mind, but it may not align with the company’s real-world value.
Choose a valuation method
There are several ways to assign value to a business. You’ll likely want to use a combination of methods to arrive at an accurate and fair number.
Current market values: You can consider the current state of the business' industry and the value of comparable companies.
Return on investment (ROI): Here, you’ll want to look at the business' forecasts and past performance. Consider how likely it is to meet these expectations and how this stacks up against the asking price.
Business asset value: Another way to calculate value is based on assets, either tangible or intangible. Some examples of tangible assets include equipment and property, while intangible assets include intellectual property, brands and reputation.
Cost of starting a business from scratch: An excellent guideline for business valuation is how much it'd cost to start that same business from scratch, both in terms of time and money.
Future profits: Finally, you’ll want to consider the future potential of the business. A business that has a track record of bringing in large profits is generally worth more today than one that lacks that record or has slimmer margins.
Get an independent valuation
It’s never a bad idea to bring in a third party to evaluate a business. An accountant, business advisor or broker can conduct an independent valuation and let you know if everything aligns with the asking price. They should review the following:
Assets: All the business' assets, including buildings, land, equipment, inventory and any cash in the bank.
Liabilities: These include debts and employee entitlements.
Goodwill value: The value of a firm’s reputation. If the business is viewed positively by the public and customers, it can increase the value significantly compared to one that has a negative reputation.
Commercial lifespan: If things continue as they are, how long can the business be expected to remain operational?
Work in progress: The active, outstanding contracts and projects the new owner will inherit.
Check the contract
You should have the contract evaluated by a lawyer before signing to make sure there are no surprises or misunderstandings. More specifically, have them look for or ask for the following inclusions:
A performance clause that clearly states the minimum takings of the business in the period leading up to the sale and settlement.
A condition that guarantees all representations made by the seller are accurate, written or otherwise, as well as one that ensures important contracts are transferred to you after purchase.
A restraint of trade clause that prevents the seller from opening a similar business in the same market for a certain number of years.
A material adverse change (MAC) clause that enables you to terminate or renegotiate the transaction if circumstances negatively impact the business before the sale.
Verify right to the business name
This one’s important, but easy to overlook — make sure that the business' name is free to use and that there are no potential issues with other entities having copyrights or intellectual property related to it. The seller should have:
Clear ownership of the business, with no restrictions or limitations.
The right to transfer ownership of the business to you with no issues.
Structure the payment of the sale in stages
When setting up a payment plan for the business, work out terms that allow you to pay in stages. This is so the business transfer can occur at a pace you’re comfortable with. It also allows you to retain part of the purchase price for a longer period.
Finalising the sale and next steps
Now that you’ve worked through your due diligence checklist, it’s time to finalise the sale and start running your new business. Let’s walk through some steps and explore what to ask for when buying a business.
1. Make an offer
With due diligence done, it’s time to make the big decision — whether to buy. If you decide to go through with the purchase, you’ll need to make an offer and begin negotiations. Once you’ve agreed a price with the seller, make sure you have a contract drawn up to formalise it.
2. When you sign the contract
Make sure both you and the seller have a copy of the signed contract (and any other signed documents). After signing, you’ll need to pay your initial deposit. Again, make sure you get receipts from the seller.
3. After signing the contract
Immediately after signing the contract, you’ll want to submit applications for the transfer of the business name to you. You’ll also want to ask that all licences, permits, certificates and other registrations be transferred.
4. Create and measure business goals
Once the sale is finalised and you own your new business, it’s time to start looking to the future. Lay out your goals for the business, and make them clear and specific. Then, start working towards them and track your progress.
Manage your new business, not just your books
Buying a business might seem daunting, but it doesn't have to be. With this checklist for buying a business, you now have what you need to make a smart purchase.