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7 Key Areas of Due Diligence when Buying a Business

Buying a business is an exciting time. You’ve found an enterprise that suits you, costs the right amount, and you’ve signed up a contract to buy or a terms sheet.

At this point, you’re feeling committed to the process. You’re crunching numbers for future profits, jotting down ideas for how you’re going to improve things, and generally looking forward to how you’re going to build that business once the purchase completes.

But it’s important not to get too far into the future because there’s a big job still to be done – your due diligence checks.

As a standard part of buying a business, your lawyers and accountants will perform several due diligence checks that you’ll need to pay attention to. But what should you do when presented with the results?

Well, here are our top 7 areas that you don’t want to ignore when it comes to due diligence if you’re buying a business.

Court Actions

A business being involved in litigation is not, by itself, an item of particular concern.

What matters is:

  1. The number of court actions; and
  2. What the court actions are about.

So, for example, if the business you are buying is involved in a lot of litigation, then you need to be asking why. Is it a high-risk business, and this is expected? Is the current owner particularly fond of suing people? Is there a common theme among the court actions that can be identified?

Similarly, you need to find out if any of the court actions relate to critical aspects of the business. So, for example, if the business depends entirely on a monopoly to produce item X, and there is a significant dispute about whether the business owns the rights to produce item X, then that is an obvious red flag.

Outstanding Tax Returns or Payments

If there are unlodged tax returns (income tax or BAS) or lodged but unpaid returns, these should be something to pay attention to.

Depending on how you are buying the business, you can sometimes become personally liable for some of these debts.

Next, unlodged or unpaid tax returns are a sign of a poorly run business. This will have a significant effect on the financial figures you have otherwise been provided.  If the business hasn’t paid its tax, then that will inflate the income/profit figures artificially.

Unpaid Employees and Superannuation

Do the wages reconcile, and is the superannuation payable being cleared out at the correct intervals?

These questions are for essentially the same reason as unpaid tax returns. If there are unpaid employees that you were planning on taking on, you can become liable to the employees for those previously unpaid amounts.

Even if your structure or contract doesn’t mean that you do become liable, you again have the problem that the business simply isn’t going as well as you previously thought. There are also some unhappy employees to deal with right out of the gate.

Significantly Different Financials

Business brokers and agents are prone to making many representations as they seek to sell a business.

Some of those will be in the form of various financial statements, which have been put together based on the information provided by the business owner.

But what happens if your due diligence shows significantly different financials than what was disclosed?

Well, again, the question you need to be asking is why? Was there simply an end of year adjustment between the figures, or is there something more concerning behind the change?

What counts as “significant” will depend on the size of the business you are buying. If in doubt, always ask for both the reason for the change and evidence to support that reason.

Long Aged Creditor Lists

Cash flow is the lifeblood of any business.

So if you’re looking at buying a business, you need to see that it actually gets paid for its goods or services reliably.

That’s especially the case if you are “buying” the debts that the business has owing to it at the time you take it over.

But if you’re looking at aged creditor reports showing large numbers of long outstanding creditors, then three things should be considered:

  1. Again, why are these creditors outstanding? Are these potential disputes in the making?
  2. What’s the average collection time for regular debts owing to the business? Have you factored this into your own financial projections?
  3. Do these old outstanding debts really have any value? If not, has the purchase price been adjusted accordingly so that these can be written off if not collected without damaging your hip pocket?

Big Deviations in Revenue

Sale price is often based on an appropriate multiple of EBITDA (earnings before interest, tax, depreciation and amortisation) or some variation of that method.

However, this is regularly an area where people try to maximise their sale price by selling just after a large influx of revenue.

So, for example, if the business secured a particularly large job in the past financial year that could have improved revenue.

But is that normal? What were the previous years like, and how has that affected the numbers on which the valuation was based?

So look for significant peaks or troughs in revenue, and satisfy yourself (in discussion with your advisors) about whether that has been appropriately factored into the numbers.

Unprotected Intellectual Property

If a business relies heavily on its brand, a process, or a particular product in order to generate revenue, then what has it done to protect those things?

Does it have registered trademarks, designs, patents or the like? Has it taken steps to protect its revenue?

If not – what are the risks that might exist as a result? Does the failure to protect those assets impact the value that has been ascribed to them in the balance sheet? Could there be litigation looming on this topic or a dispute in the pipeline that you’re not aware of?

Need Help with your Due Diligence?

Buying a business is a complicated affair, and working through the outcomes of due diligence searches and investigations can be a bit of a headache.

Give us a call, and we’ll help you at every stage of the business buying process.