Some call it "due diligence." We call it "common sense." Due diligence is the idea that before you buy a business, you need to know what you're getting into.
Buying a business can be a fantastic opportunity—or a disaster waiting to happen. You should investigate a business to detect any hidden problems, by asking for the right information and paperwork. Some information, such as the extent of equipment liens, will be available from public sources. For other information, your main source will be the owner of the business.
The due diligence process can be long (usually lasting months) and tedious, but it's the most important part of the purchase process. It'll determine whether you go through with the purchase, and if you do, for what price.
When you're looking to buy a business, there's a range of information and documents that you'll want to look at. For instance, you'll look at the company's:
But you're investigation shouldn't stop there. You should look at any company records that can give you a full picture of how the business operates and what it's worth. A thorough due diligence investigation will ensure that you won't have buyer's remorse. You should complete the types of due diligence discussed below to have a complete understanding of your potential new business.
(To learn about the due diligence process from the seller's perspective, see our article on the due diligence process when selling a business.)
Step one in your due diligence is learning all you can about the financial condition of the business. You can get a good idea of the business's value and position in the market by reviewing its financial records and inspecting its assets and debts.
You can quickly learn where a business is heading by taking a look at its books. When you buy a business, you should check out documents like:
You also need a list of business debts—and information on whether the creditors have a security interest (lien) on any business assets. You or your lawyer can double-check on liens at the public office where liens are filed. Look to see whether banks, suppliers, or other creditors filed a UCC Financing Statement—also called a "UCC-1 Form"—when they extended credit to the business. If those debts go unpaid, the creditors can seize and sell the secured assets, even if you're now the owner.
Your purchase might include physical assets such as equipment and inventory. Make sure the equipment is in good working order. Consider hiring an expert to give an assessment. You should consider the assets' conditions when settling on a purchase price. If the physical assets aren't as valuable as originally thought or represented, negotiate for a lower price.
If some equipment is being leased, look at the terms of the lease and make sure you have the right to take it over. Some leases don't allow for assets to be transferred; other leases require permission from the lessor.
As for inventory, see that it's up to date and marketable. You don't want to pay good money for obsolete goods.
Find out whether the business owns any real property or whether they lease a shop or office.
Look at any real estate owned by the business. If the business owns land or property, do a search of the land or property records to see whether the deed was recorded and a title report (or "title examination") was completed. A title report certifies that the owner of the business is the true owner and no one else has any interest or claim to the real property.
A title insurance company or an attorney will typically complete a title search of past property records to make sure there are no competing interests or liens on the property. If there aren't any, the title report will certify a "clear title," or a title free of any issues, like liens.
If a report wasn't done, consider asking the seller to supply one or hiring someone to do it yourself. You can negotiate for the title report expense to be deducted from the purchase price. If a problem with the title does come up, make sure the seller resolves it before you purchase the business.
Most businesses occupy leased space. You need to get a copy of the commercial lease and review it carefully. You should ask the following questions when reading the lease:
Make sure it's okay for the business to continue to occupy the space under the same lease if you become the new owner. You might be required by an assignment clause in the lease to get the landlord's consent to take over the lease. Or, you might want to try negotiating a new lease—one with a longer term or lower rent, perhaps.
While you're at it, have the landlord confirm that the current business owner is up to date on rent payments, so you won't be the one facing eviction.
If the business is owned by a corporation or LLC, there are two scenarios. One is that you're buying the assets of the business. The other is that you're buying the business entity itself (which owns the assets). Buying the assets is usually the better option for the buyer. But if you're performing a substantive due diligence investigation, you're likely buying the business itself.
Review corporate documents. If your plan is to buy the business entity—the stock of the corporation or the membership interests of the LLC—then you need to see the documents that created the entity and the ones that govern it. Look at the company's bylaws, resolutions, and operating agreements.
Check the business's legal status. Confirm that the business is in good standing with the state and that the owner has the legal authority to sell it.
Confirm the company doesn't have any legal actions pending. Ask the owner of the business (no matter its legal structure) to tell you of any pending or threatened lawsuits or governmental proceedings. If the company has any upcoming litigation or complaints against it, you might be better off walking away from the transaction.
You can learn a lot about a business's legal, financial, and operational standing by looking at its contracts with suppliers and customers. You can find out the company's legal obligations, income and expenses, and production potential.
These contracts can give you an idea of the money coming in and going out, and how long you can rely on a particular revenue stream. For example, suppose the seller is in the second year of a five-year contract with a customer that guarantees $200,000 per year. You can then feel confident that the company will bring in at least $200,000 for the next three years.
You can also get an idea of how much the company can produce. For instance, a contract with a customer could call for 400 reams of paper every two weeks. Or, the company could have 15 concurrent service contracts, so you know the business has the capacity for multiple large commitments.
The due diligence process is meant to give you a full picture of the company's health before you buy the business. After all, you base your decision to purchase the business (and the purchase price), in large part, on the information the seller gives you. So, it's critical that the information is a total, honest representation.
But you shouldn't rely on the assumption that the information is true and that there are no omissions—whether the omissions are intentional or not. You can take some steps to protect yourself from any future revelations.
Even after you've carefully investigated the business, other surprises could be lurking. Have the current owner personally guarantee that the information you have is complete and accurate. You can put this guarantee in the purchase agreement under the heading, "Representations and Warranties."
Don't pay the full purchase price at closing. Arrange for at least part of it to be paid six months or a year down the road. That way, if you suffer a loss because the owner failed to disclose crucial information (for example, a debt or tax liability), you can deduct that loss from what you owe.
If you have experience with the due diligence process and expertise in the relevant industry, you can probably work through the process on your own. But most business owners can get valuable insight from talking to a business attorney who has experience conducting due diligence. A lawyer can help you create a due diligence checklist while you're buying a business and help you review and interpret contracts and corporate documents. They can also help you negotiate your purchase agreement and draft clauses to protect you from omissions or misrepresentations by the seller.