Due Diligence: What to Investigate Before You Buy a Business

Before you buy a business, do some due diligence.

Some call it "due diligence." We call it "common sense." It's 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.

Tip Be ready to sign a confidentiality agreement. This assures the owner that you'll use the information only to check out the business. Just make sure the agreement lets you share the information with your lawyer and accountant.

Learn About the Business Finances

Step one in your due diligence is learning all you can about the financial condition of the business. Check out documents like the current balance sheet, profit and loss statements (past 5 years'), tax returns (for income, unemployment, and sales tax, for the past 5 years), audited financial statements, accounts payable and receivable, and more.

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. If you find that banks, suppliers, or other creditors filed what's called a UCC-1 form when they extended credit to the business, realize that if their debts weren't paid, they can seize and sell the secured assets, even if you're now the owner.

Inspect the Physical Assets

Your purchase may include physical assets such as equipment and inventory. Make sure the equipment is in good working order. Consider hiring an expert to check it for you. If some equipment is being leased, look at the terms of the lease and make sure you have the right to take it over.

As for inventory, see that it's up to date and marketable. You don't want to pay good money for obsolete goods.

Read the Lease

Most businesses occupy leased space. You need to get a copy of the lease and review it carefully. How long will the lease last? Will you have an option to renew? Are the terms and restrictions acceptable?

Make sure it's okay for the business to continue to occupy the space under the same lease if you're the owners. The lease may require the landlord's consent for this. Or, you may 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.

Check the Business's Legal Status

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 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 also any related documents such as bylaws, resolutions, and operating agreements.

Confirm that the business is in good standing with the state and that the owner has legal authority to sell it.

Finally, ask the owner of the business (no matter its legal structure) to tell you of any pending or threatened lawsuits or governmental proceedings.

Get the Owner's Guarantee

Even after you've carefully investigated the business, other surprises may be lurking. Have the current owner personally guarantee that the information you have is complete and accurate. You can put this in the purchase agreement under the heading, "Representations and Warranties."

Hold Back Some of the Purchase Price

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 (a debt, for example, or a tax liability), you can deduct the money from what you owe.

When you're ready to record all the terms of the purchase in a written contract, Nolo provides all the appropriate documents in: The Complete Guide to Buying a Business , by Fred Steingold, and Quicken Legal Business Pro software. Or if you'd prefer to hire a lawyer for help with any part of this process, Nolo's Lawyer Directory will provide you with detailed personal profiles of lawyers in your area -- all of whom have taken a pledge to treat their clients with respect.

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