BizQuest's Business for Sale Blog

Due Diligence - Separating Incidents from Catastrophes

If you're expecting to find a perfect business to buy, you had better adjust your thinking because it doesn't exist. There are always going to be some issues. Of course, the goal is to uncover these before you buy the business, but that's only part of the process. How you deal with them is more important.

Going into the due diligence phase, your strategy should be twofold: First, to validate what has been represented. Second, to identify and address any potential problems that could severely impact the business after you take over.

Throughout the due diligence process, keep an active log of any issues that warrant further discussions with the seller. Don't run to them for every issue. Build your case. Renegotiation may, or may not be necessary. While you should not overlook anything; some points may not warrant a grand discussion relative to the big picture of getting a deal done. Also, keep in mind that you're going to need the seller to train you after closing.

Learn how to separate incidents from catastrophes. If you discover any huge problems then naturally, you may have to confront them immediately. Don't attack the seller accusing them of not disclosing the truth. Attack the problem. However; before you confront the seller, think about all of the possible remedies and what you can possibly negotiate to solve the problem at hand.

Some issues may force you to walk from the deal but often, unless there has been gross misrepresentation, these matters can be resolved.

Just like the buyer, the seller has to properly prepare for due diligence. I was honored to participate in an article written by Annika Mengisen, a journalist with TheStreet.com. She did a splendid job discussing due diligence and some very interesting seller points. You should read the article at: http://www.thestreet.com/newsanalysis/smallbiz/10345511.html

There's a lot to be done during due diligence and a short period to accomplish it. Stay focused. It's a crucial stage in the buying process. Sometimes deals will fall apart at this point and it can be upsetting, but it can be a blessing. Nevertheless, if you keep your cool, compile your arguments, and have solutions at hand, chances are you'll get what you need because the seller doesn't want to see the deal collapse at this point either. However; if things check out to your liking, then get the deal closed and get on with building your new business!

Due Diligence Review - Should buyer use a CPA? How much time should be allotted? What mindset should the buyer have when completing due diligence?

Question:
What are the things I need to be aware of when I get to the due diligence stage of a business? I am very comfortable with financials so do I really need a CPA and what else is involved? Right now the seller and I are far apart on the price; do you have any recommendations? His accountant and mine disagree completely on the valuation. I would appreciate your input.

Answer:
This is an excellent question. The due diligence stage of any business purchase involves far more than the financials including a thorough investigation of the assets, contracts, customers, suppliers, competitors, employees, the systems, sales/marketing plan, and legal issues.

The CPAs Role:
Regarding a CPA my answer is a resounding "yes" to have one involved in the process although they will, for the most part, contribute in the financial review aspect only. One thing that you should do is review the seller documents first, prior to your CPA – if they don't make sense to you, chances are they won't to the CPA either. Also, be sure to engage a CPA who is familiar with the type of business you are reviewing.

What to investigate:
There are typically eleven key areas to review in a due diligence as noted above. Interestingly enough a thorough due diligence review requires you to investigate about 200 individual issues. It's critically important that you organize yourself properly for this stage and getting the seller to comply with your document requests should be your first priority. Compile a list with your CPA of what is needed and my recommendation is that you do not start the clock until you receive all, or substantially all of the documents requested.

The goal during due diligence is to uncover any potential problems before you buy the business. As with any business, you will find some issues and surprises and that's ok. Try to separate incidents and catastrophes.

Additionally, your goal should be to validate everything that the seller has represented about the business. Some buyers go into this phase hoping to find problems so they can renegotiate. While some uncover serious flaws, most don't but in looking to nitpick every minor issue, they end up sabotaging the deal. As such, be thorough; actually, be flawless but don't be taken aback if/when you uncover a problem because you will find them. Keep articulate notes and decide at the end whether or not a renegotiation is necessary.

Bridging the gap on price:
It may make sense for you and the seller to engage a neutral third party to perform an appraisal on the business as well. This may assist both of you to narrow the gap on the price or to at least gain an understanding of what drives the valuation process.

Should you decide to go this route, be certain to use a certified business appraiser and not a CPA. A professional appraiser understands the market for business sales, while a CPA usually attaches a value that may make sense theoretically, but may not reflect market trends, or it can be too much of an asset based valuation whereas small businesses are sold based upon Sellers Cash Flow, and there's a huge difference. The only issue I have with appraisers is when they try to impart big business valuations on small business transactions. In general, my experience with appraisers has been positive and it may be an avenue for you to consider.

Above all – take your time.

No matter what, take the time you need to do a proper job inspecting the business. Regardless of what pressure you get from the seller, you need ample time. I work as a business broker and I get into many confrontational issues with other brokers when they try to limit the due diligence to five days. The fact is that it's absolutely impossible to complete a thorough due diligence in five days. Please understand that you can easily complete the financial review in five days. In fact, with good books and records, your accountant can complete this even quicker. However, a successful due diligence and inspection period goes way beyond the financials. When a buyer is rushed, it leads to uncertainty which leads to deals falling apart (it's probably why approximately 50% of all deals agreed to between buyer/seller never get to the closing table, according to industry insiders).

The rules to keep in mind for a successful due diligence are:

• Organize and prepare yourself properly
• Engage a competent CPA (an appraiser where necessary)
• Make certain the seller provides the necessary documentation
• Attack this in a methodical manner. Prepare properly.
• Log all of your To Do's.
• Work with a detailed checklist of what needs to be covered
• Negotiate ample time to complete your review
• Follow the quote I once read by McClean: "Don't treat any incidents as catastrophes nor should you treat any catastrophes as incidents."

When you encounter a problem keep a record of it. If you are faced with having to renegotiate, you'll only be successful if you have adequate proof that the business is not worth what you and the seller had previously agreed to.

How Much Should First-Time Buyer Expect to Pay for Financial Due Diligence?

Question:

I am seeking to be a 'first time' buyer of a business. I understand that I need due diligence, and that I need expert help, but what should I expect to pay for this service? How do they arrive at a fair figure to charge?

Answer:

For the financial due diligence of a business you will need to engage an accountant to complete the review. Before we discuss approximate costs, there are several important factors to consider which will have a direct impact on the final costs incurred for their services:

• Hire an accountant who has experience in completing the due diligence review of similar businesses.
  
• Use an accountant that makes sense ¬ñ you don't need a Big Three CPA to review a small business.
  
• Layout very clearly what it is that you want them to do along with what they recommend is required.
  
• Have them provide you with an estimated cost to complete their work.
  
• Don't start the review until you have all (or the vast majority) of documents and files required for them to complete their work.
  
• Get a list to the sellers as soon as possible after you have a signed agreement in place.
  
• As a last point, consider the timing of the due diligence schedule. If it's going to be near the end of a calendar quarter or tax season, you'll want to give them plenty of notice before.

On the first day of the due diligence period, review all of the documents that the seller has provided. Chances are if it doesn't make sense to you, it won't to your accountant. Plus, if a lot of material is missing, you won't be paying the CPA to sit around and do nothing.

Insofar as costs are concerned, I have found that most small businesses being sold for under $500,000 will cost around $2,500 - $5,000 to complete a detailed financial review. Conversely, I have paid as little as $1,500 to have a very competent accountant do the work, but, I made certain that it was flawlessly organized for them beforehand. Most accountants, unlike attorneys, will provide you with a very accurate quote of what they feel the final bill will be. The difference between the two professions is that the financial review steps are fairly standard and so they can closely predict the time that may be involved.

Due Diligence: When to Walk Away From a Deal

Question:
We are currently in due diligence on a wholesale/distribution company and we are finding the operations do not seem to run as smoothly as the seller has indicated. My future partner feels we should try to get a price reduction. I think we should walk away from the deal altogether. Do you have any thoughts on how to handle this situation?

Answer:
Most businesses don't operate as well as the seller represents - remember, they're trying to sell you their business! That being said, I don't agree with you to simply walk away because that will likely lead you on an endless search for the perfect business which doesn't exist.

In nearly every due diligence, you are going to uncover some inconsistencies. The issue is to separate them into incidents and/or catastrophes. You should overlook the incidents and deal with the catastrophes. This could mean renegotiation or it could require you to walk away from the deal.

In this case, it doesn't sound like a catastrophe at all. However, you need to determine what it will take for you as the new owner to get the business running like you want it to and at what cost. This is part of the process of buying and operating the business.

My bigger concern here is the fundamental difference you and your partner have in evaluating this business. It sounds to me like you have very different criteria about what you each want in a business and you both need to have the same philosophy in evaluating businesses even if you have different strengths. This does not mean you must always agree with each other. Constructive debates are a good thing, both now and when you are co-owners. However, the overall vision of what you want in a business, what constitutes a good business, what each of you are looking for, and how you will agree to deal with challenges and set-backs during this process and after you are owners, should be issues that you deal with together right now.

Due Diligence of Online Businesses

Question:
Hello Richard. I purchased your course last December and it's been very helpful. In my area (Seattle) the business listings have been terrible for the last six months. To combat that, I've decided to expand my search to relocatable online businesses. My question, how do you perform a proper due diligence with something that's as intangible as online businesses?

Answer:
Great question and you'll be pleased to learn that performing the due diligence for an online business is basically the same as a bricks and mortar one at least from a financial perspective. The numbers are the numbers. The critical components are in the actual operations of the business investigation to be certain that any software being used is licensed, if it's an e-commerce enabled business that you'll be able to secure the same terms from credit card processors, that they have proper ownership of the domain, that you can readily operate the technical side of the business (website maintenance, changes, etc). Also, depending on the nature of the business, is there a programming element that the seller has that you may not be able to work with? Who handles the website? What does the owner do everyday?

The other thing to be careful about is the non-compete. If it's a business with a low barrier to entry, then you will need a mechanism to be sure that the seller does not compete with you. The problem is that an online business can operate discreetly from anywhere and the last thing you want is to chase the former seller for having allegedly breached the agreement.

On the other hand, online businesses can be phenomenal. The best thing we ever did was to convert our business into an online venture. It's the ideal business model: high margins, no inventory, no receivables, few employees and best of all: the world is your market.

If you'd like to speak me with directly, because you are a Diomo client, please email me at the address in your original order receipt or through the contact page on our website and we can set up a phone call together.

Due Diligence - Investigating a Business

Due diligence is probably the most critical stage in the buying process. Many prospective buyers incorrectly identify this period as strictly a financial review. However, an effective due diligence goes far beyond the numbers. Due diligence is the complete investigation and review of a business.

One of the keys to buying a good business comes from your ability to learn the intimate details of it. To identify the strengths, weaknesses, pluses, minuses, growth opportunities and areas of concerns. If you don't do a flawless job of gathering information, you will not be able to pull the trigger and complete the transaction since you'll be uncertain about too many components of the business.

The investigation process must begin the moment a business becomes of interest. Your goal is to be certain that you uncover everything about any business BEFORE you buy it. You don't have to meet the seller or even visit the business for your research to begin. The Internet is an incredible tool that will allow you to investigate the business, the industry, the competition, the marketing, the suppliers, and on and on.

The importance of beginning your investigation early on cannot be emphasized strongly enough. This way, you'll position yourself to ask the seller the right questions. Once you progress to the stage of an accepted offer, you will commence the inspection or financial due diligence. This period usually lasts 10-30 days. This is the time when you'll have access to all of the company's books and records.

Once you being looking at a particular business, you'll find a thousand things crossing your mind regarding the acquisition. Keep a notepad handy at all times and log your to do's. You'll have many thoughts about things "I need to check out". Write these all in one place. Don't trust your memory; these little things are the ones that can and will come back to haunt you down the road. Begin to put together your checklist of what you need to investigate and how you're going to do it along with the materials you require from the seller to accomplish it.

A couple of things to keep in mind:

Prepare properly:
Since you'll have some time restrictions (you'll only have x number of days per the contract), provide the seller with a listing of all of the materials required for you and or your CPA to complete this exercise. No matter what you're told, do not begin the process until they have everything ready for you.

Allow yourself enough time:
Many sellers and some brokers will press for a very short inspection period; sometimes just days. Don't get bullied into this - give yourself ample time to complete this part of the process.

What about surprises:
You'll probably find some surprises, don't panic, it's normal. Work through them. Get clarification. Build your case. Don't run to the seller or broker every time you find an inconsistency between what you've seen versus what you were told. No business is perfect. The rule to follow is do not treat any incidents as catastrophes nor should you treat any catastrophes as incidents. If you find a major problem, get your facts in order and you can then decide the appropriate action to be taken with the seller (i.e. renegotiation, walking from the deal, etc..)

According to industry statistics, nine out of ten people who begin the search to buy a business never complete a transaction. While there are many reasons for this dismal figure, a lot has to do with the inability of people to "pull the trigger". This gun-shy reaction is due to uncertainty: if you have not gathered the right information or failed to investigate the business thoroughly you will not be 100% certain of what to do. And so, you'll drop the project. Conversely, if you do a flawless job of investigating the business, and everything else adds up right, then making the final decision is simply one more step in the process!