Due Diligence

 The Due Diligence List for a Business Appraisal

Due diligence is a further matter that needs to be considered when dealing with business appraisals, and this involves delving into the background of the business, identifying any issues that could affect the business in the future, and other related matters. It is more like performing a Forensic Business Valuation.

There are certain tasks which should be included on any due diligence list, before applying the business valuation approaches and methods, as follows: 

1. Determine seller’s motives. The business owner’s decision to sell may be motivated by any number of factors including, but not limited to, retirement, illness or death, internal disputes, inadequate capital and poor market prospects. By identifying the seller’s motives, the buyer obtains valuable information necessary for assessing the risks involved in the transaction, as well as for determining an appropriate valuation for the company. 

2. Review all financial records. Review of the target companies’ financial records is always a key component of any due diligence investigation because it provides the principle basis for the business valuation. The financial review should include, but is not necessarily limited to, a review of the following: 

(a) The (a) The target companies’ income tax returns for at least five (5) years (if available); 

(b) Balance sheet, income and expense statements, profit and loss statements for at least 5 years; 

(c) Current operating budgets and any forecasts of future company operations; 

(d)  The most recent Schedule (ageing analysis) of accounts receivable and payable together with comparable data from previous years; 

(e) A schedule of all contingent liabilities such as guaranties and product or service warranties.

Often, the financial records of many small companies are extremely limited. In such a situation, the due diligence investigation should be expanded in an effort to obtain the financial information necessary for a reasonable valuation. Limited financial data may also impact the terms of the purchase. For example, in a business that has a large number of accounts receivable, without reliable financial statements, the buyer may want to place a substantial discount on the value of these accounts, or even require the seller to guarantee that all or some of the receivables will be collected. At a minimum, the buyer will want to conduct a more thorough investigation regarding the nature of the receivables and the customers owing the debt.

3. Review of all third party contracts. The contractual obligations and rights of the target entity must be identified for a proper valuation. Therefore, the due diligence effort at a minimum should include a review of the following:

(a) Franchise and licensing agreements;

(b) Sales contracts or other contacts the company is a party;

(c) Insurance policies;

(d) Agency, distributor and advertising contracts;

(e) Supply contracts;

(f) Government contracts and;

(g) All other material agreements to which the target company is a party.

4. Review employment contracts. In many companies, the real value lies not in the assets, the product or customer list, but rather in the employees of the company. Therefore, the terms of all employment contracts for key employees, company retirement and benefit plans, as well as employee manuals and union contracts, to name a few, are all crucial to the success of any business venture and should be reviewed as part of the due diligence effort.

5. Inspect all inventory. An inspection of company inventory is obviously central to business valuation. Such inspection should also include an inspection of all fixed assets, motor vehicles and other assets needing a recorded conveyance or change of registration.

6. Review all leases, deeds, mortgages and loan agreements. Included here, the buyer should review the following:

(a) Documents and agreements evidencing borrowings by the target company, including loan and credit agreements and other evidences of indebtedness;

(b) Documents evidencing mortgages, security interests or loans on assets of the business;

(c) Guaranties, agreements to maintain net worth and similar agreements;

(d) Agreements confirming lines of credit;

(e) Leases of real or personal property to which the company is a party, either as lessor or lessee; and

(f) Documents and agreements evidencing other material financing arrangements including, without limitation, letters of credit and installment purchases.

7. Review all litigation files. Information regarding pending or threatened lawsuits involving the target company must be carefully examined. Included here, the buyer should also review any administrative proceedings, governmental investigations or inquiries.

8. Review all required government filings. Various government permits and licenses are often required before a company may lawfully conduct business such as a sales or tax permit. The buyer should insure that all required permits and licenses have been appropriately maintained.

9. Review all documents establishing the legal entity for the business. The buyer should review any assumed name certificate, partnership agreement, shareholder agreement, bylaws, articles of incorporation and any other document establishing the legal structure for the target entity.

10. Evaluate all intellectual property. Lastly, the buyer should never forget to evaluate all intellectual property, including any patents, copyrights, trademarks, trade secrets and goodwill.

The Business Valuation due diligence process can be extremely complex and often requires the involvement of several legal, financial and business professionals. That’s we I often use the term Forensic Business Valuation when dealing with a Business Appraisal. Those interested in purchasing or selling an existing business should take the prudent step of engaging appropriate professionals. There are many risks associated with the purchase/sale of an existing business, even a small one; however, with proper due diligence and financial forensic examination, these risks can be effectively minimized.