Due Diligence Is an Absolute Necessity When You Buy a Business

You have decided to purchase a business. Congratulations. It takes a lot of courage to arrive at such a major life decision.

More than likely your business lawyer, assuming you’ve made the wise decision to hire one to help guide you through the process, has possibly advised you to make an asset purchase as opposed to a stock purchase. Hopefully he or she has also explained to you the potential benefits of such a choice, including extinguishing any prior liabilities of the prior company. There are also potential tax benefits to an asset purchase deal. You may be able to reset the tax basis in the company’s assets, and furthermore may be able to depreciate those assets 100% going forward.

These decisions will hopefully be made in conjunction with your CPA or other qualified tax advisor. Hopefully you’ve also decided to obtain a valuation of the business from an objective professional, such as a certified valuation analyst, prior to incorporating a price term when you submitted your letter of intent or original purchase contract. After all, most businesses on the market are over-priced!

By this point in time, the parties, you and the seller, and each of their respective counsels have passed around term sheets or letters of intent. These are generally non-binding documents, that may contain binding confidentiality or standstill provisions, which reduce the deal to essential terms so that the parties can have a meeting of the minds. While a term sheet is not an obligatory part of a transaction, it helps to focus the parties on the transaction, saving time and money.

Diving into the Dirty Laundry

As part of the term sheet, your lawyer should have included and have allocated a period of time for due diligence, which serves to help confirm that all material facts represented and/or warranted by the seller as part of the transaction are true.

The importance of due diligence cannot be overstated. You, the buyer of the business, should be as informed as possible. When you buy a house, a car, or a condo, it is customary to have an inspection performed. A business is no different in this sense from any other asset.

Imagine you are paying sixty dollars for something that is worth one hundred dollars and likely to grow in the future. You, as the purchaser of that note would likely be enthused by such an opportunity. The only problem is that in this scenario, you the buyer failed to realize that the individual who tendered to you the hundred dollar bill is a master counterfeiter, who has been using one dollar bills and imprinting Benjamin Franklin’s face on each bill tendered to purchasers. The words of Warren Buffett seem appropriate in such context: “If you’ve been playing poker for half an hour and you still don’t know who the patsy is, you’re the patsy.”

In this widely-acclaimed quote, Mr. Buffett was speaking of an investor who buys a fractional interest through the stock of a publicly-traded company, fails to understand the underlying fundamentals, and hopes to make money in the stock market from the eponymous Mr. Market. In the private markets, a buyer has less of an excuse to be the so-called patsy at the poker table because he can look to his advisors to help make an informed decision. Imagine if a purchaser of the stock of Enron or MCI WorldCom had had a forensic accountant pour through its books, attempting to uncover earnings manipulation and understand the quality of those earnings, all while calculating the free cash flow available to the owners, the companies’ shareholders (which in the case of those aforementioned firms was negative).

A purchaser in the private markets, who reserves a period of time to perform due diligence from a sideline view, has a clear advantage over a securities analyst, who analyzes the fundamentals of a public company from the nosebleed section of the stadium. The key thing to remember here is the following: Earnings can be manipulated, cash available to owners cannot. This is one of the many reasons due diligence is particularly critical.

Your business lawyer, when making the due diligence request memorandum, should cast a fairly wide net when requesting documents on your behalf. These items could possibly include the following, which serve to get an inventory of what the business has and where it is currently:

1. Documents, including bank and tax statements;
2. Contracts and other agreements;
3. A list of vendors and agents;
4. A review of payables and receivables; and
5. Off balance sheet items that merit review.

The last item can be particularly critical as it may materially impact the value of your intended acquisition, from both the standpoint of marketability and risk management. In the event something adverse is uncovered, the purchase price can be readjusted, the whole deal can be renegotiated, or in the most egregious cases, the entire transaction can be canceled. Sometimes this can be the most favorable result for a buyer, often resulting in short-term pain as opposed to a lifetime of full-blown heartache. Like a home buyer who can lead himself to financial ruin in pursuit of his “dream home,” a buyer of a business can leave himself worse off than when he began his search.

Much like asset protection is never an impenetrable fortress, due diligence can never completely eliminate risk. However, like a seasoned poker player, a buyer of a business should know to play his hand only when the odds are in his favor. Some seasoned buyers, like their poker playing counterparts, have become a living almanac of odds and risks. As such, they have little need for due diligence. Berkshire Hathaway’s duo in Buffett and Munger are two such individuals (although stacking the deck in the form of having buyers call you, possessing a war chest of capital, and only purchasing from people you like certainly can’t hurt).

A friend of the firm has relayed to me he can compute the sales of a restaurant by sitting through a week of table service, without the need for tax statements. The rest of us, however, can tremendously benefit from due diligence. If nothing else, it helps to tip the odds of winning away from the house and in your favor.