Comprehensive and in-depth due diligence during the process of buying a business is an essential step that will give you the confidence that you are making a sound financial decision with the purchase.
This due diligence involves independently verifying the financial information, among other kinds of important information, that the seller provides about the business. This article will explain what this due diligence consists of, and why it is a good idea to seek professional help and guidance throughout the process.
Types and Importance of Due Diligence
Whenever you make any reasonably substantial purchase or investment, your goal should be to confirm whether you’re making a good investment decision. This is true whether you’re buying a house or a business.
In the context of buying a business, a critical element of due diligence involves confirming whether all the information the seller provides about the business is valid, true, or accurate. Doing so is key to accurately understanding the value of a business or the requested purchase price, and other important information about it.
While there are several types of due diligence that you should pay attention to, depending on the type and nature of the being purchased, this article only focuses on financial due diligence.
Conducting financial due diligence on a business that you are considering buying will provide you with an accurate picture or assessment of the state of the financial health of the business in question, which will be gleaned from its historical and current financial records.
Performing financial due diligence when purchasing a business is important for several reasons. Some of them include:
- It can help you determine if a business is financially healthy enough to thrive going forward when you take it over.
- It can uncover debts or other such financial liabilities that you might be taking on when you purchase the business.
- It can give you more leverage when negotiating the price of the business.
Keep in mind that performing independent due diligence to verify the financial information a seller provides can also help you gauge their overall honesty when they make other claims about the business.
Information Provided by the Seller
The types of financial information a seller may provide include (but aren’t limited to) the following:
- Financial statements that indicate revenue, losses, cashflows, and other such statements.
- Assets and liabilities
- Tax returns
- Information on creditors, debtors, suppliers, vendors, and other such business stakeholders
Importance of Independent Verification of Financial Information
Chances are that you will need the services of one or more types of professionals to help in the verification of the information that the seller provides. For example, you might need to hire a bookkeeper or an accountant to help review all financial information that you are provided with, while you might need the services of a business attorney to verify things like if there is any lien or debt judgment attached to the business or other legal liabilities.
It is essential that you don’t assume the information a seller provides represents an honest and accurate picture of a business’s financial situation. The information may not be perfectly accurate for such reasons like:
- The information may not be thoroughly complete, potentially hiding details that could give you a reason to back out of a purchase.
- The information may not be up-to-date.
- It’s possible the information is simply false or inaccurate.
Also, be wary of a seller who seems excessively eager to sell their business. Although there may be other reasons for this, it could be a sign that they are trying to complete the sale before you discover that they’ve provided you with false financial information.
Recognizing Red Flags and Deal Breakers
It’s not enough to perform due diligence. You must also know how to recognize warning signs indicating that purchasing a specific business would not be a wise financial decision.
Red flags to be on the lookout for may include:
- Any discrepancies in financial statements
- Losses due to a high rate of employee turnover (as the cost of replacing a single full-time employee could be as much as double their annual salary)
- Substantial transactions without clear explanations
- Inconsistent revenue
That said, when you discover any of these red flags, that doesn’t necessarily mean you should immediately back out of a deal. A seller may have a valid explanation for them.
Ask for clarification if you notice any potential warning signs. If a seller appears to have a reasonable explanation for what could otherwise be a deal breaker, you may decide that it’s still safe to move forward with the deal.
Overcoming Challenges in Independent Verification
It is important to be prepared to encounter certain challenges when independently verifying the financial information a seller offers before buying the company. Challenges you might have to anticipate could include:
- Completing the process on time. Again, if you hire a professional to assist you, performing financial due diligence may take less time than it otherwise might.
- Attempting to make sense of a business’s finances if the company has a complex financial structure.
- Trying to learn the financial nuances of an industry with which you might not be thoroughly familiar.
You also have to consider the possibility that the seller might not cooperate with you as you strive to complete your due diligence. However, their lack of cooperation may indicate they have attempted to mislead you when providing financial information.
The purpose of this overview isn’t to make you assume the task of performing financial due diligence when buying a business is naturally an excessively difficult or challenging one to complete. It’s only meant to emphasize the value of this task. Luckily, by coordinating with experts, you may complete this task more efficiently and thoroughly than you otherwise could and be rest assured that you are not making a bad investment decision