We often come across the term ‘due diligence’ in the context of buying, selling or investing in a business. Simply put, it is the investigation or in-depth analysis of a business in order to ascertain its true worth. We can compare it to the process of buying a property (e.g. a house) for ourselves. Before we buy a house, we check the location, try to determine whether the house is in good condition, check if there is any legal issue involved which may land us in trouble, and so on. Similarly, before you buy a business, conducting due diligence on that business is a must.
Now, let us try to understand due diligence better by considering the various important aspects of it.
What Are the Different Types of Due Diligence?
Business: Begin by evaluating the type and size of business and its nature of ownership. Evaluate the position of the business and its products and services with respect to the market, the profile of the seller, relationships with suppliers and other channel members, quality of the existing staff, status of existing leases (if any), and so on.
Financial: It is best to seek assistance of your accountant to evaluate the financial health of the business. Request audited financial statements of the business for at least the last three years and provisional financial statements for the ongoing year, if applicable. Assess the profitability, net worth, cost structure, debt equity allocation, asset utilization, current ratio and any major outstanding liabilities. Also, request financial projections for the next 3 5 years and ascertain the future potential of the business in an objective manner.
Technical: What are the core technology elements in the business? What is the efficiency of technology used in the business? Is it state-of-the-art and cost effective? Can it be easily extended to match with future technology? Are the licenses and patents in place for any technological innovation carried out by the business? Is there adequate infrastructure to support the current and future technology?
Legal: Look for any legal matters of concern, such as if the business has been served any legal notices and the present status of such notices, status of tax compliance of the business, any disputes on ownership of the business, any ongoing or past litigations, safety aspects of plant and factory, if any, and so on. You can further deepen your analysis specific to a particular business and get professional opinion from your legal advisor.
When Should You Conduct Due Diligence?
As a prospective buyer of business, you will come across a number of attractive business opportunities. The best time to conduct due diligence is after you have shortlisted your prospects to a maximum of 2 businesses, which match your criteria to the maximum possible extent. Once you are certain that the business seller is genuine and has a clear reason for selling the business, that there are no obvious red flags in the business as per your initial analysis, and that you are satisfied with the overall initial assessment of the business and its reputation, it is the perfect time to take the deal forward and conduct due diligence to investigate the business in depth.
Why Should You Conduct Due Diligence?
Due diligence on a prospective business is a must for buyers because –
- It helps them find out any issues or concerns with the business that can affect their purchase decision
- It helps them gather the inputs required to carry out an objective valuation of the business
- It is critical to manage future transition in a better and smoother way
How Should You Conduct Due Diligence?
The best way to conduct due diligence is to first have in place a cross-functional team consisting of an accountant, a lawyer, a tax advisor and a business analyst. Create a checklist of documents to be requested from the business owner and keep on tracking the receipt of such documents on a regular basis. As your team proceeds with the due diligence process, request them to keep a list of all the questions for which they need clarification, and share these with the seller periodically. Don’t leave anything for the last minute, keep addressing issues in a timely manner.
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