Buying a business? What is ‘Due Diligence’?

Posted on 15 Aug 2016 by

In the life of most businesses there comes a time where they may want to expand by buying another firm.

When this happens it’s likely that the directors and managers will get involved in a thing called ‘Due Diligence’ (DD) but what exactly is involved?

Put simply Due Diligence is the act of making sure that what you are buying is what you expect it to be and whilst it will be slightly different for every company the main features are very similar.

Due diligence should be seen as an insurance policy and like all insurances you get what you pay for. You may pay for it in your time looking into aspects of a company or you may employ specialists to carry this out for you but the truth is that it is an exercise in risk reduction and the longer you take and the more careful you are the less risk there is.

The starting point for any DD exercise should be the basics. It might seem obvious but checking that the people who want to part you from your cash actually own what it is they are selling is a good starting point. After all we’ve all heard the story of the tourist that bought London Bridge!

Everything that you have heard up to this point should be seen as part of the selling process. The seller will have presented everything in the best possible light and some unscrupulous ones may even have lied to get the sale so all of the sales particulars should be viewed with a pinch of salt.

Checking the major headings of the Profit and Loss and balance sheet are vital.

Are the sales genuine? Do they flow through to cash in the bank? Do the credit card statements match to what has been taken through the tills? Beware the small business owner who tells you that they take sales in cash that they don’t declare because they can’t prove them either.

Think about where sales come from. Are they reliable or do a lot of sales come from one company owned by the brother of the seller?

Again looking at the P&L are the expenses reasonable? Does the rent look right? Some companies may have benefited from an initial rent free period which will overstate profit at the bottom line.

Take a look also across a period of time. This will show you whether sales have increased, remained steady or are in decline. If it’s the latter then what is the cause and if the former then will it continue?

On the balance sheet you need to confirm that the assets shown actually exist and are owned by the company. Make sure that they haven’t given a charge to a bank or finance house too.

Look at the debtors – are they all collectable or are there some really old debts there that will need to be written off?

Similarly check out the creditors. Is that all there is and are any of them threatening legal action?

Bank balances are relatively easy to check but more problematic is physical stock. You may need to employ a specialist company to do a stock take and you should also satisfy yourself that the market value of the stock is a true reflection of what is in the accounts. This is especially important for firms dealing in perishable or short dated stock and goods that go out of fashion quickly.

Although we’ve concentrated on finances it is also important to think about the legal aspects of the purchase.

Get sight of the lease and make sure it’s in force, has a reasonable term and allows it to be assigned to you. Also make sure that it will allow any developments of the business that you may want to make.

Has the company signed up to any contracts? You’ll need to check both contracts with customers and suppliers. The last thing you want is to get saddled with a business that is stuck with a contract that costs it money and it can’t get out of.

Are there any legal issues pending? Is the company being taken to court or are there any employment tribunals. You may want to look at the history to get a sense of whether the company has had issues in the past that it hasn’t learned from because this may cause problems in the future.

Reputation is increasingly easy to check online and it’s worth looking up the firm on things like Tripadvisor or Revoo to see if it has been garnering a poor reputation as this is remarkably hard to get away from.

We mentioned Employment Tribunals earlier but this is not the only aspect of staffing you may need to think about.

Consider who does what in the business. Is the owner the key person and will their departure cause problems? Do the staff have valid contracts of employment and has the company complied with employment requirements?

Alongside employment regulations it is also vital that you ensure that the business has complied with taxation and Companies House rules and regulations. Check that they have filed accounts and annual returns (now called confirmation statements) and they’ve made returns such as VAT, CIS and self-assessment. If you are buying a limited company any fines will attach to the business and not to the previous owner in most cases.

As you can see from this short guide Due Diligence can be as complex or simple as you want it to be. Remember the element of risk; if you skimp on DD then you are increasing the risk you are taking.

This is a simple introduction and each case is different. We’d also strongly suggest that you get advice from specialists in their fields and most certainly ensure you take legal advice before signing on the dotted line.

Buying a company is one of the most exciting times in the life of a business owner and if you follow our tips then you can help minimise the risk of buying badly.

Andrew Charles. Sochall Smith Accountants

 

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