Due Diligence: The Top 6 Items to Uncover Before You Buy a Business
When you’re under contract to buy a house, the last thing you’d skip would be the inspection. This is when you hire a professional to find out if the sewer is clogged, if the roof is leaky, if the floors are defective, and whether there’s carbon monoxide, radon, or mold in your hopeful home. It’s when you find out if the foundation is defective. This is the time when you find out whether the house you want not only looks nice, but whether it is actually in good shape.
Yet, when buying a business, many small- to mid-sized businesses think it’s fine to move forward without a formal due diligence process. Except, when buying a business, formal due diligence is more important than an inspection when buying a house. Due diligence is like the inspection, the appraisal, the title check, the loan conditions deadline, all rolled into one.
Due diligence is everything that happens between the signing of a non-binding letter of intent and the signing of binding and definitive purchase agreements – and the wiring of money. And it very much matters.
When buying a business, non-professionals often don’t know what they don’t know. I’ve heard prospective buyers tell me at the beginning of a transaction, “I’ve already done my due diligence.” Almost invariably, those same buyers have done none or almost none of the review that we normally perform as a part of our typical due diligence process. This unknowing overconfidence can have very real consequences for a buyer that does end up proceeding to pay for a business before conducting a proper review of its underlying assets and structure. For those that work with us, we walk them through what should be done. For those that do not, I often wonder what problems they might incur later.
Some of these problems range from a buyer purchasing assets that the seller does not actually own, to not being able to make use of the assets because the seller’s contracts cannot be assigned. Or, at worst, the buyer legally acquiring liabilities that exceed the value of the assets that they have acquired.
In sum, due diligence matters. It should be taken seriously by every company that buys another business, no matter how small the acquisition.
With that in mind, here’s a quick highlight reel of some of:
The Key Items a Business Needs to Learn During the Due Diligence Process and Why They are Important:
1. Understand the Business’s Corporate History
Any well-run company will have a corporate record book that documents its history. For an LLC, this means an operating agreement, employee and contractor assignment agreements, a list of persons who have worked for the business, and annual records with the state. For a corporation, this means bylaws, resolutions of the incorporator, stock purchase agreements, stockholder agreements, stock certificates and history, and annual board and shareholder minutes. For startups, this should include records of restricted stock purchase agreements and 83(b) elections for each stockholder. If a company does not have all or most of these documents, it’s a sign that the company did not keep up on its minimum legal obligations. That’s at least a yellow flag, and sometimes a red flag that should mean stop the deal. Knowing when a business may have been sloppy in the past, and when it has neglected its obligations to the point where the risk is too high to proceed, is essential to know before spending big money buying another business.
2. Get to the Bottom of the Company’s Financial Records
Some buyers will look at one carefully edited excel spreadsheet provided by the seller with a handful of numbers that look favorable, and they’re ready to move forward. When it comes to understanding the real financial history of a business, the critical skill is knowing which questions to ask. It’s easy enough to massage a few numbers and be selective about what looks good. But to really know the history, you need to know the history comprehensively. You need to see tax returns for three to five years if you’re purchasing assets, and seven years if you’re buying a business outright. You need all correspondence with the IRS throughout that time (for some businesses, this can be very telling). You need a list of investments. You need a list of all debt of any kind owed within the last five years. You need credit cards and payroll. You need it all. If you don’t ask for all of it, it is possible that hidden debt or expense could destroy the valuation of the acquisition.
3. Make Sure the Company Has Clear Title to All Assets and Intellectual Property
If you’re buying a startup or a company with a technological component, often times the most valuable asset of the business will be its intellectual property. But the law of intellectual property is nuanced and complex. To be owned by the business, IP must be properly assigned by all persons who have contributed to the intellectual property. This is one of the most misunderstood issues for companies that proceed to run their business without legal counsel or attempt to buy a business without legal counsel. Post-transaction, if you buy the assets of a business and the assets were never owned by the business, you might not actually have the right to use the very thing you think you are buying.
Similarly, there is a very specific process in place for transferring ownership of various types of intellectual property, whether it is for trademarks, patents, or copyrights. If you do not follow the specific steps proscribed by the USPTO in this regard, the asset won’t transfer.
4. Know Not Just the Company Owners’ History, But Its History with Employees and Contractors
If a company has hired an employee or an independent contractor in the past few years, as a buyer of a business, it’s your obligation to know and understand the history of that relationship. Because once you buy the business, that becomes your history, too. Also, if there are current employees or contracts, you need to make sure you understand when the seller will be on the hook to pay salary, payment, benefit, and other obligations and when the buyers will be responsible for those payments.
If you plan to lay off a number of workers in connection with a company acquisition, the laws related to such a transition are both rigorous and demanding. Run afoul of these laws and you almost certainly will be hearing from the relevant legal authorities. When buying a business, a complete understanding of the seller’s employment history is a must.
5. Figure Out if The Seller’s Contracts Can Be Transferred to the Buyer, and Make Sure the Seller Won’t Be Leaving the Buyer with Unexpected Contract Obligations
From the seller’s lease, to its customer contracts, to its supplier contracts, to employer contracts, and beyond, the transferring and assignment of all the relevant business contracts from one business to another can be one of the trickiest parts of a transaction.
If there is one aspect of a business purchase that is much harder than most buyers and sellers expect, it’s this one. A contract is a binding legal agreement between two parties. Every contract needs to have specific language that authorizes it to be assigned in the event of an acquisition of the specific type that is being conducted between the buyer and seller. If it does not, then the parties need to get permission from the counterparty to assign or transfer that contract. If the counterparty is laid-back and amenable, then this might be easy. If the counterparty is disagreeable and difficult, this can take months or even derail the whole deal.
6. Carefully Tease Out All Details on Prospective Business Liabilities
This is partially an issue that needs to be learned in due diligence, and it is partially an issue where the protection of a well-constructed asset purchase agreement is critical. But you need to ask a series of carefully constructed questions of the seller to make sure that all liabilities of the business are fully disclosed and that the buyers know exactly what they might face in terms of health care, legal, accounting, tax, employment, and other areas of liability.
Of course, the above is not an exclusive list. Our due-diligence checklist typically includes 50-100 items that must be answered to our client’s satisfaction before moving forward with any potential deal. But the first step in buying a business is knowing that there is something you need to know. And hopefully this post has been helpful step for some in moving in that direction.
If you have further questions about buying a business, please contact us here.