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Due Diligence

Due Diligence is a systemic process of investigations conducted by the buyer and buyer’s representatives for the intended purchase of a business. Both buyer and buyer’s representative want to make sure that all the facts regarding the business are available and have been independently verified.

Due Diligence is divided into the following methods:

1. Investigation Conducted by Buyer

This is the first step in the process of a business investigation. The buyer personally sits with the seller and reviews all financials (such as profit and loss statements, balance sheets, taxes, etc.), lease, license and permit status, reports (such as invoices, shift sales reports, daily/monthly/yearly sales reports, m bank statements). The buyer will go through all of these documents and the seller will address all of the buyer’s questions and concerns. Both buyer and seller will walk through the premises and do a visual inspection. It is always a good idea to have a meeting between the buyer and seller in the presence of their authorized agents.

With mutual consent and approval of the buyer and seller, the buyer will come to the business premises for a designated period of time (timing based on the seller and buyer’s understanding) and work like an employee to verify the sales, nature of the business, type of customers, and other vital business information.

There is no law to say what the buyer can do on the business premises while working as part of due diligence. This is purely an understating between the buyer and seller and such an understanding is for their mutual benefit.

2. Investigation Conducted by CPA

This is one of the key investigations in the process of due diligence. A CPA or tax consultants will conduct a financial audit including profit and loss statements, balance sheets, and taxes.

  • Read and review the last three years federal taxes, state taxes
  • Read and review the sales taxes, UST taxes, city and local Taxes and verify this with bank accounts or confirm with canceled checks
  • Read and verify all invoices, pay in and pay outs of the business for the last three years
  • Read all sales reports generated from the POS and verify with tax reports, bank statements for the depository slips, etc.
  • Read and review the balance sheet and profit and loss statement of the business for last three years
  • Review the current year profit and loss statements
  • Analyze the cash flow of the business
  • Review the current assets, liabilities, and the value of the business
  • Compile all the records and give a summary of the cash flow and comments on the business financial audit report with all necessary recommendations

3. Investigation Conducted by Appraiser

This is the third part of due diligence. Appraisers are licensed professionals specialized in the valuation of businesses. They use various industry approved methods and tools to get the value and worth of the business. In order to get the value they commonly use the following methods.

  • Review and count the tangible assets such as furniture, fixtures, and equipment etc.
  • Find out the cash flow of the business based on the seller’s business financials
  • Net Operating income, Debt service, and Discreet profit or loss
  • Factors affecting the current earning and future earnings
  • Reviewing the lease copies and all other supplemental or associated agreements impacting the business
  • Current zoning, neighborhood, new developments and future impacts of those changes
  • Employee role and owner impact on the business
  • Types of operations, facilities of operation, business hours of operation
  • Condition and viability of the business
  • CC&R and status of licenses, violations, restrictions in the past, current and future impacts, etc.

The Appraiser uses the following methods to get the valuation of a business:

  • Asset Approach: This is the fair market value of assets of the business. In this the appraiser will use either going concern asset based method i.e. lists the businesses net balance sheet value of its assets and subtracts the value of its liabilities, or liquidation asset-based method to determine the net cash that would be received if all assets was sold to pay off the liabilities.
  • Income Approach: The appraiser uses the current business cash flow and calculates the debit service coverage, rate of return, rate on returns, cap rate, and future earnings of the business, etc.
  • Market Approach: The appraiser uses this method to compare how many similar businesses were sold and in what price range they were sold, how long they were on the market, type of sale, etc. Generally, this will give valuations and sales trends in a given geographical area.

With this, you know what you are buying, the value and worth of the business, and also the nature, risk, and viability of the business.

4. Investigation Conducted by Attorney

This is one of the paramount investigations done by an attorney. The attorney will read the current lease, options, your duty as lessor, lessor control on the premises, type of operation, hours of operation, future additions or deletions to business model, expansions, current agreements with the business (such as equipment lease agreements, oil supply agreements, indemnity agreements, franchise agreements, vendor and supplier agreements), current seller notes, business title reports, merchantability of titles, transferability of license and permits, work agreements, insurance over ages, seller carry note terms and conditions and preparation of notes, lender notes, and will look for any successor liability issues, etc.

5. Investigation Conducted by Other Professionals

Other professionals associated with the business on and off, such as general contractors, may check to see whether the fixtures are up to code, if the business equipment is up to code, and also check the condition of the equipment. An insurance broker may see if there are any claims in the last three years, either by the seller or a third party, what kind of insurance is currently held, and what is needed for future coverage, etc.

Check List for Due Diligence:

  • Business ownership documents
  • Financial information for last three years with current statements
  • Physical assets of the business
  • Intellectual property if business has any
  • Employees and employee benefits
  • Licenses and permits, including any canceled in last three years
  • Material contracts such as leases, equipment lease contracts, indemnity supplying contracts, franchise agreements, etc.
  • Businesses products and services list, including operational methods
  • Customer information such as deposits, accounts, etc.
  • Litigation of the business such as judgments, violations, etc.
  • Insurance coverage, current coverage and any previous claims
  • Contact information of all concerned departments

This is a general list only and not a total list. Each business has its own requirements. You can talk with your broker/agent or representative to find out what exactly you need for your due diligence.

Note: A successful due diligence is the key to an eventual investment. This process is much more serious and important than the preparation of a business plan.

If you want to know more about due diligence or have further questions about due diligence before you buy a business, please contact us at help@bizworldusa.com or 415-234-8833 and one of our approved third-party due diligence professionals will contact you.