Buying a business is a high stakes matter. What makes the process even more nerve-wracking is that a business is different from just about any other asset one can buy. When someone purchases a piece of real estate, a car, or any other tangible product, a buyer usually knows what they are getting and can inspect the goods and has a chance to find hidden problems (or pay a specialist to find them). A business, on the other hand, is largely intangible. While some of the aspects of the business may be tangible, many are not. The business will likely have receivables, inventory (both completed products and parts), intellectual property, and goodwill and reputation. Many of these assets may not have the value that the seller claims they have and may be difficult to value. The business will also likely have liabilities like hidden debts and potential lawsuits. Discovering the true extent of these liabilities is crucial in making sure the purchase of the business is worth pursuing. Finally, there are many intangible considerations that go beyond just the company’s balance sheet. How does the business operate as a whole? Is its management team effective and will they stay involved after the change in ownership? How are the relations between the business and its customers?
Because there are so many hidden traps in buying a business, purchasers will usually engage in due diligence on their target acquisition. The main purposes behind due diligence are (1) verifying the information provided by the seller and (2) uncovering any material information that the seller hasn’t provided, either intentionally or unintentionally. Unintentional omissions are actually quite frequent. Buyers often discover potential legal liabilities of their target or asset impairments due to previous regulatory violations or poor legal work that the seller may not even be aware of. Not performing proper due diligence can lead to surprises down the road that end up being far more expensive than the cost of doing due diligence upfront.
Due diligence usually begins after the parties execute a Letter of Intent. The letter of intent will contain provisions providing for a due diligence period and will give the potential buyer access to the acquisition target’s records. Due diligence will then usually have two phases: (1) A request is made for certain written documents, which the buyer then reviews and (2) the buyer conducts on-site verification possibly using interviews of company personnel. There are three parts to due diligence: (1) Legal (2) Financial, and (3) Operational. I’ll cover what goes into each of them in future posts.
Therefore, when buying a business, be thorough in your due diligence, or risk unpleasant surprises down the road.
© 2012 Alexander J. Davie — This article is for general information only. The information presented should not be construed to be formal legal advice nor the formation of a lawyer/client relationship.