What you need to know about due diligence when buying a business
You’re in the process of acquiring a business. Discussions with the business owner have confirmed your choice and everything is going well. Your letter of intent was accepted and you’re now at the due diligence stage. Find out what’s important to check so you can better prepare your offer.
What is due diligence?
Due diligence is an important step in the buying process, which occurs after the signature of the letter of intent and before the offer to purchase. It lets you verify that what you’ve seen, read and heard corresponds to reality before formally committing and finalizing the terms of the transaction. It also serves to reassure lenders and investors.
Goal: get a complete picture of the business
Checking the business’ track record will help you understand potential risks and make informed decisions. Sifting through all of the seller’s statements will help you identify the strengths and weaknesses of the business and the business model. This step will also help you identify the key benefits and areas that need to be addressed, as well as who you can rely on during and after the transfer.
Build trust and confidence
Step 1: Sign a confidentiality and non-disclosure agreement with the seller.
Promote collaboration based on transparency and build trust to support the sharing of reliable and comprehensive information.
Surround yourself with experienced experts
The analysis is based on human, financial, fiscal, legal and operational aspects. To get a complete picture of the business, surround yourself with the right experts.
1. The financial aspect
An accounting expert will determine the accuracy of the information systems and take several points into account.
Method of recognizing revenue and determining net income
The accounting expert will look at the background trend, standards and accounting methods for recognizing revenue and all costs to determine the strength of the net income. The period observed is generally spread over the last 3 years, with particular attention paid to the last year.
Forecast of results
The accounting expert will determine the current and future situation including sales expectations and forecasts by client. They’ll also review the backlog and associated costs to deliver the product or service.
What is recorded on the books must be consistent with the count and verification of each item. The accounting expert will analyze the working capital in detail to ensure that it’s consistent with what is reported in the financial statements.
Accounts receivable and suppliers
Too much concentration on a seller could give them significant power in the short term.
Similarly, over-reliance on a supplier runs the risk of disrupting supply. It’s also important to verify the financing granted to clients and the historical and current distribution of orders per seller. In order to obtain complete information and verify that the item balance is accurate, your expert may contact some of your potential business partners.
Cash, short-term credit and lenders
Your expert will verify financing agreements and the willingness of creditors to finances the assets. They’ll look at the cash flow, the state of long-term assets required for operations and the related debts (land, buildings, equipment, etc.).
A financially sound business
Be careful of variations between accounting items from one year to the next. If there’s a change in trend, your accounting expert will determine the causes. They’ll analyze the financial and working capital ratios of profitability. Like bankers, they’ll ensure that you can weather a storm during the months following your acquisition.
2. The tax aspect
A tax expert will study the business’ tax history for at least the last 5 years. They’ll verify if the business:
- Is up to date on the payment of taxes (both Canada Revenue Agency and Revenu Québec)
- Has benefited from certain programs in the past and was eligible for certain credits
They’ll also analyze the taxation of the transaction to protect their buyer client.
- Does the seller wish to claim the capital gains exemption?
- Are the conditions met? Are they to the detriment of the buyer? Will transactions be required?
3. The legal aspect
The legal aspect is an important part of due diligence, as it can lead to liability for the business and its officers. In addition to checking whether disputes or proceedings are in progress, a lawyer will examine all active contracts thoroughly (in order to properly grasp the different terms and clauses), such as:
- Legal structure, minutes book, shareholder agreement
- Contracts signed with clients and suppliers, including payment terms and agreements and their renewal or not, once the acquisition has been made
- Insurance and confidentiality contracts, business protection, particularly in terms of data security
- Intellectual property and knowledge protection
- Securities in movable and immovable property, business licences, environmental compliance and employee contracts
4. The operational aspect
In addition to analyzing the business’ positioning, make sure the assets are in good condition to avoid surprises and especially investments once the business has been acquired.
Analyze the production chain from the purchase of goods from the supplier through transportation to the delivery to the client. Break down the organization of the information system, the margin for negotiating prices and updating the technology fleet.
- Visit the site—ideally during working hours—not only to inspect the site and equipment, but also to “get a feel” of the atmosphere. This intangible part doesn’t appear in the written documentation and is probably the most important.
- Meet with staff and review employee files. How long have they been employed and what’s the retention rate? What are the staff’s knowledge and skills?
- Listen to and observe interactions between employees, clients and suppliers. Trust your instinct, listen to your intuition and your feelings. Ask yourself, “Do I feel good in this environment?”
If everything is in order, your negotiating room will be low for the formal offer to purchase. If you’ve identified risks, you have several options:
- Renegotiate the seller’s price or payment terms
- Require an additional balance
- Cover risks that may arise in the future through indemnities provided in representations and warranties
- Create a climate of trust, conducive to information sharing
- Surround yourself with experts before you even start the process: an accountant, a business transfer lawyer, a tax specialist, a human resources firm
- Build a single checklist to share with everyone
- Learn more about the industry
- The process can take several weeks to several months; stay patient
- Always trust your feelings
- Have an execution strategy in mind
- Document your research as it can be useful in the process: write things down as you go, ask questions, check the details
- Make sure you validate everything
- Negotiate the deal properly