Due Diligence Steps in Purchasing a Business
Businesses are bought and sold quite frequently. However, such events are just as frequently very unusual to the particular people involved - a person might go through only one such transaction in their entire life.
Therefore, the procedures to be followed in assessing and controlling a purchase transaction are often unfamiliar to the participants. And that is why purchasers usually request the assistance of their own independent team of accountants and lawyers. The purpose: to identify exactly what is being purchased, and to ensure that all the facts relevant to the value and viability of the business are identified, and dealt with.
What follows is a list of items usually reviewed during the course of “due diligence”, which occurs at a stage of the process usually after the initial expressions of interest are made, and may even occur after a deposit has been paid and various written assurances are given to protect confidentiality. Simply put, the due diligence stage of the process is performed to determine whether the transaction should proceed any further.
Due Diligence Step | Purpose of performing this step |
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| Financial Considerations |
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| Chart of accounts | This gives the purchaser an overview of the extent of detail contained in the general ledger, often indicating the extent of care and attention the vendor has paid to the information generated by the accounting system. |
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| Trial balance | This are the building blocks of the financial statements, which can be invaluable in assessing various financial statement items, which are usually groupings of several, or perhaps several dozen, individual ledger accounts. |
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| Year to date financial statements | If reliable and up to date, this tells the reader how the business has been performing up to the present time. |
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| Financial statements for last 5 years from outside acct | 5 years of financial history is a reasonable span of time to assess the profit trends of the business - external accountants will have exercised at least some measure of independent review and reflection on the reasonableness of the figures presented (of the various types of accountant's report that would be appended to the statements, the best is "Audit", second best is "Review", with the lowest level of assurance (practically, none) being "Notice to Reader" statements). |
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| Obtain pro-forma financial statements for the next 3 years | External accts will be reluctant to provide these, due to liability concerns, but a business is only worth what is can earn in the future, not the past, so projections and estimates of future results are a necessary part of managing any business - the existing management will undoubtedly have at least some form of budget information. |
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| Cash receipts journals - 3 years | These will reveal the source of a company's revenue - a few key customers, or many? |
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| Cash disbursement journals - 3 years | This will indicate the established pattern of payments - who are the principal suppliers? Has the company been fairly consistent in making payments for supplies, payroll, and various taxes? |
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| Evidence of unrecorded revenues | Often, a key consideration where some measure of dishonesty is suspected in the vendor - possible indicators would be many credits to the shareholder loan accounts and poor margins on sales. |
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| Discretionary expense details and evidence | Vendor may be adding back to earnings forecasts a figure for "unreasonable" expenses which he will have deducted regardless - must be assessed to determine if indeed they are unreasonably high in an arm's length context |
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| Details of owner benefits | If the vendor has owned the business for a long time, certain habits may have crept in, involving asset investments or expenses or transactions that would not have happened in an arm's length context - these should be identified and added back to the future profit projection. |
| Details of capital expense requirements in next 3 years | Businesses can be made to appear more profitable than they really are, if important plant and equipment is not renewed, replaced or maintained, but rather allowed to run down. A considerable obligation for replacement of plant and equipment would seriously affect the value of the business to the buyer. |
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| Building/premises lease | How is the business housed - are the facilities adequate, too small, or overly lavish? Rental terms reasonable to market rates, or out of line? Will landlord renew the lease or otherwise allow subleasing? How much remains in the term? Will new lease imply much higher rents? |
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| Inventory |
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| Sales by item, for last 12 months | Indicates what products are selling well, which ones not (and are the latter overrepresented in the inventory listing)? |
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| List of supplies and inventory - current and obsolete | Properly run businesses should possess accurate and reliable inventory lists. Inventory management and cost minimization is key to keeping financing requirements under control |
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| Sales |
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| Sales policies | What are the internal controls the business places over the soliciting, making and fulfillment of sales? Is credit granted, and if so, on what basis are customers evaluated? If lax, accounts receivable may contain uncollectable amounts. |
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| Discount/pricing structure | Is the business generally able to sell their product at full list price, or is it always necessary to discount - which customers get the discounts? |
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| Sales report by salesperson/channel | Want to identify the biggest producers of sales for the company - and can they be counted on to remain with the firm after the sale? |
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| Sales-by-customer report for last 2 years | This identifies whether the business is dependent on one, or a small number of key customers |
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| Summary of current quoting process | How precise is the company in pricing and competitive bidding? Is there room for improvement? |
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| Summary of current invoicing processes | Are sales and shipments promptly billed, and is there adequate follow up for late or slow-paying accounts? |
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| Legal |
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| Asset clearance letter | Important to know that all significant assets of the business have not been encumbered by pledges, mortgages or other claims lodged by lenders or other parties |
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| Insurance |
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| Business | Is there business interrruption insurance in place? |
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| Building/premises | Is coverage here adequate, particularly in view of recent increases in land and construction costs? |
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| Equipment | Is this adequate to replace key equipment? What risk of theft or damage to equipment currently exists? |
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| Vehicles | Adequate? |
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| WCB filings - 12 months | Is the business adequately adhering to its obligations under WCB - uninsured workplace accidents could place an enormous financial burden on the business. |
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| WCB Clearance Letter | This is recommended, as in some industries, WCB exposure is a huge dollar issue. |
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| Furniture, Fixtures & Equipment |
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| Listing of items (mfr., serial number) | Very important to know what is there, and what needs to remain in place - needed for insurance cross-check |
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| Depreciation schedule | Does tax return reconcile to stated assets on hand? |
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| Fair market valuation report | Where equipment is a major element in the business value, a competent appraiser is needed to assess values of equipment on hand |
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| Equipment and vehicle lease agreements | It is necessary to identify which of the assets in the business is leased, what is the status of each lease, the remaining term, and the end-term conditions |
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| Maintenance contracts | Important for many high-value items, to ensure long service life |
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| Systems |
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| Software manuals | Must identify personnel who know how to fix glitches in the company software |
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| Security policy | Again, ties to physical security of company assets and data |
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| Website access, pass codes | Vital for office communication and and important element of data security |
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| Reports currently produced | What sort of management reports are regularly generated by the information system? Does this need to be improved? |
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| Source code documentation | The company's IT group should have this available |
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| Employees & Subcontractors |
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| Organization chart | Vital for determining existing lines of authority and responsibility |
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| Details of employees and subconcontractors | Containing important details, such as compensation levels and history, perks, company car, non financial compensation, expense account privileges, etc. |
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| Employment contracts | Wherever in place and effective |
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| Consulting agreements | Check term and prices |
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| Employee files | Vital for future reference |
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| History of prior labour disputes, work stoppages, union certifications | Vital information for labour negotiations and/or determination of annual salary/wage reviews |
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| Employee benefit program | Medical, retirement - adequate? In need of overhaul? |
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| Company incentive plans | Profit sharing, stock options, etc. (included here may be some "unwritten promises" made to key employees - must be identified |
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| Confidentiality agreements | Vital information must be protected |
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| Marketing |
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| Current marketing plan | Does it appear realistic, and do marketing personnel appear to be working with it? |
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| Company marketing materials | Are they up to date, and in use? |
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| Major competitors | Needed to determine position of this company in the marketplace |
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| Distribution agreements | Are they binding, or (in most cases) cancellable on short notice? |
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| Suppliers |
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| List of vendors | Needed to assess controls over purchases and payables function |
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| List of contracts | Oral agreements are also important. |
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| List of independent contractors | May not be evident at the outset. Canada Revenue Agency may wish to review this list as well for potential "hidden" employees |
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| Permits, Licences, and Regulations |
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| Business licencing regulations | Obviously, vital that the business is in good standing here, and that all necessary permits are transferable to new owners |
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| Other regulatory approvals | The legal review should include an identification of these |
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| Environmental requirements | Can be extremely important and costly if there is a breach - an enviromental standards review might be necessary from outside consultants |
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| Contacts |
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| Accountant | This person would have very large amounts of useful information about the business |
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| Lawyer | As above |
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