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Ask About Due Diligence

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By | May 25, 2012

Dear Toolkit,

Can you explain what "due diligence" means? It sounds like the name of a rock band to me.

Curious in California

Dear Curious in California,

You're right—Due Diligence would be a great name for a rock band! But in the business world, it's just a fancy phrase for doing your homework.

Probably the most common situation where the need for due diligence arises is when a business is being sold. After a buyer signs a letter of intent to purchase a business and the seller accepts the letter, the buyer will be granted a specified period of time in which to conduct a "due diligence investigation" of the seller and the company being purchased. During this period, the buyer should have access to the seller's financial and other records, as well as to the seller's facilities, employees, etc., in order to examine them before finalizing the deal.

Ideally, the seller will have collected and examined most of the information the buyer wants, as he or she prepared the company for sale. The vast majority of it is in paper form. The buyer who is exercising due diligence will want to see copies of all leases, contracts and loan agreements, in addition to copious financial records and statements. He or she will want to see any management reports, such as sales reports, inventory records, detailed lists of assets, facility maintenance records, aged receivables and payables reports, employee organization charts, payroll and benefits records, customer records, and marketing materials.

The buyer will want to know about any pending litigation, tax audits, or insurance disputes. Depending on the nature of the business, the seller might want to consider getting an environmental audit and an insurance checkup before offering the business for sale in order to be informed about any unforeseen problem that might emerge as a result of a potential buyer's due diligence.

If financial statements are unaudited, and especially if they were prepared in-house, the buyer may want the seller to pay for updated statements by an accountant of his or her choosing, as a condition of closing the sale. The buyer will then perform an independent financial analysis of the company, where, for example, the buyer may look at key financial ratios and examine the trends over time, compare them to industry averages, create projected statements for the business using his or her own assumptions, etc.

A wise buyer will also want to take a look at the facilities and spend some time "in the trenches" with management and/or employees as they go about normal business. This request should be accommodated, even if it will cause some disruption of normal operations.

Buyers tend to be more concerned about what they don't know than they are about minor or even major problems that might turn up in an investigation. If problems exist, a seller is much better off disclosing them and talking about possible solutions, rather than shoving them under the rug.

A duly diligent buyer will also look at the environment the business operates in, including the size and makeup of its market, the principal suppliers and customers, the competition, and the overall industry.

The seller needs to do his or her own due diligence. He'll want to find out the buyer's credit record, management experience, reputation, and the plans he or she has for the company's future operation. This is particularly true if there is a plan to continue an employment or consulting arrangement with the buyer after the sale, or if some part of the purchase price will be paid into the future though a financing arrangement, or an earn-out.

Even if a seller plans to collect all cash at the closing, walk away and never look back, the seller should satisfy himself or herself that there's at least a reasonable likelihood that the buyer will be able to operate the business successfully. If the buyer fails miserably, there's a strong likelihood that the seller may be sued for fraudulently misrepresenting the condition of the business as it was offered for sale.

A second situation where due diligence arises is in certain public investments. If you buy into a mutual fund, the fund is required to send you a written prospectus, and you must sign to the effect that you've read and understood it before they will take your check. You are signing to acknowledge, in effect, that they have tendered all relevant information to you and that you've done your due diligence investigation and accept their offer in full knowledge of the facts.

In this caveat emptor world, due diligence is a buyer's first line of defense.

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