What is Due Diligence and How to Do It

Summary

David C. Barnett discusses the critical process of due diligence when buying a business, emphasizing its importance in validating the seller's information. He explains how due diligence involves investigating financials, customer base, suppliers, competitors, and market conditions to uncover any potential risks. He highlights that due diligence can uncover errors and unknowns, but these can be mitigated through proper deal structuring, such as seller financing. Barnett also stresses the need for industry knowledge and suggests that entrepreneurs should take an active role in due diligence to safeguard their investments.

Takeaways

• 😀 Due diligence is an essential process when buying a business, ensuring you verify key business details and uncover any potential risks.
• 😀 It's critical to assess a business’s financial health by verifying sales, deposits, and checking for consistency between records.
• 😀 Customer concentration is a key factor to evaluate—relying too heavily on one or a few clients can be risky if they leave.
• 😀 A comprehensive look at suppliers is necessary. Over-reliance on one supplier can make the business vulnerable if their terms change.
• 😀 You should explore employee stability, particularly the age and turnover rates, as this can affect future operations.
• 😀 Industry knowledge plays a pivotal role in due diligence—understanding market dynamics helps you anticipate challenges and make informed decisions.
• 😀 Financial due diligence requires checking the accuracy of reported profits by verifying revenue claims and reviewing cost structures.
• 😀 Some businesses may have incomplete or messy records, but the key is to adjust expectations and the deal structure accordingly.
• 😀 In the case of undetermined risks or unknowns, you have the option to renegotiate the terms or back out of the deal entirely.
• 😀 Self-conducting due diligence is your responsibility—take control of the process, ask tough questions, and don't rely solely on third-party assessments.
• 😀 Be prepared for unexpected issues that arise in due diligence and be willing to negotiate the purchase terms to protect yourself against these risks.

Q & A

What is due diligence in the context of buying a business?

Due diligence is an investigation or examination process where the buyer verifies the accuracy and truthfulness of the information provided by the seller. It involves checking third-party data, evaluating records, and validating claims made about the business.

Why is due diligence important when buying a business?

Due diligence is important because it helps the buyer verify that the business is as it appears, ensuring that there are no hidden risks or issues. It helps to confirm the financial health, legal standing, and market position of the business, reducing the likelihood of unpleasant surprises after the purchase.

What types of records are typically reviewed during due diligence?

During due diligence, buyers typically review financial records, such as bank statements, QuickBooks files, tax returns, purchase invoices, and customer data. They may also investigate legal documents, contracts, employee details, supplier relationships, and industry-specific concerns.

What are some common issues that arise during due diligence?

Some common issues during due diligence include errors or inconsistencies in financial records, black holes in understanding the business, unclear customer or supplier relationships, and missing or incomplete legal documentation. Additionally, sellers may have weak or inaccurate bookkeeping practices.

How does industry knowledge affect the due diligence process?

Industry knowledge is crucial in due diligence because it helps the buyer understand the nuances of the business, such as customer concentration, supplier dependencies, and market dynamics. Without industry-specific knowledge, the buyer may miss important red flags or fail to identify potential risks.

What role do third-party verifications play in due diligence?

Third-party verifications are used to confirm the accuracy of the information provided by the seller. This can include verifying financial records through bank statements, checking customer relationships with suppliers, and cross-referencing claims about the business's performance or assets with external sources.

Why should a buyer be cautious when looking at QuickBooks files during due diligence?

QuickBooks files can be inaccurate due to human error, lack of expertise, or intentional misreporting. Since QuickBooks entries are manually inputted, it's important for buyers to review these files carefully and cross-check them with other records to identify any potential discrepancies or errors.

What is the 'Quality of Earnings' (QofE) report, and when is it necessary?

A Quality of Earnings (QofE) report is an in-depth analysis of a business's financials, typically done by an external accounting firm. It is used to verify the sustainability of earnings and identify potential financial risks. A QofE report is often necessary for larger transactions, but may not be cost-effective for smaller deals.

How can a buyer deal with financial uncertainties during due diligence?

When facing financial uncertainties, a buyer can ask for more clarification or additional documentation to understand any discrepancies. If the issue cannot be resolved, the buyer can negotiate a lower purchase price or adjust the deal terms to mitigate the financial risk.

What should a buyer do if they can't fully verify all aspects of a business during due diligence?

If a buyer cannot fully verify all aspects of a business, they should evaluate how much risk they are willing to accept. They can adjust the purchase price, negotiate terms such as seller financing, or structure the deal to account for any uncertainties, such as breaking the seller note into multiple payments based on certain conditions being met.