How to Conduct a Due Diligence Review When Purchasing a Business
Today we start a 3-article series on how to conduct a due diligence review when you are considering buying an existing business. Part 1 of the series covers the financial, corporate and historical data you should look at with your accountants and your lawyer.
If you're thinking about purchasing a business, there are many issues you need to consider and many documents you need to review with your legal and financial advisers before you close the deal. It's not only important to know the current status of the business, but also its past history, its long-term viability, future market opportunities, and potential for growth.
You will need to perform an in-depth due diligence review of all aspects of the business. What you uncover in that review will help you determine whether the business is a sound and worthy investment. Today's post is the first of three blog posts that look at all the materials you should investigate during the course of your due diligence review.
I. Why is the owner selling?
This should be the first question you ask, because the answer you get (or don't get) will determine whether you go any further. Have the seller back up his/her answer with some documentation or other evidence, unless it's obvious. For instance, if the owner is in his 70s and says he wants to retire and spend his time fishing, you can probably assume that's true.
II. Review all the financial information for the past 5 years.
Have your accountant review all the books and accounts, tax records, and financial statements of the business for the past five years (or since its inception, if the company has not been in existence that long). Get answers to the following questions:
- How much revenue did the business generate in the past 5 years? If the business recorded losses, how deep were they? Can the business be made profitable, and if yes, how? And how long will it take and how much will it cost to get there?
- How much debt is the business carrying? What is the outstanding amount of each debt, and what are the payments? Are they all up to date? If not, how much is overdue (including interest and extra charges)?
- What is the current status of the accounts payables? What is the payment arrangement for each payable?
- How much is the business carrying in accounts receivable? What percentage is over 60 days? Over 90 days? Older than 90 days?
- How much has the business written off in bad debt over each of the past 5 years? What is the percentage of bad debt vs. total amounts billed?
- Are there any prepaid expenses?
- Have all tax returns been filed in every applicable jurisdiction (state/provincial, federal, foreign)? If there are any unfilled tax returns, whose responsibility is it to file them?
III. Review the corporate records and the history of the company.
Are you buying the company as well as the assets of the business? If so, you'll need to review the corporate minute book, articles of incorporation, share structure, shareholder records, capitalization, and any shareholder agreements and stock option plans.
- Is the company validly registered in each jurisdiction in which it conducts business? Are all of its corporate filings up to date?
- Is the company's minute book complete and up to date?
- Are all minutes and resolutions properly passed and signed?
- Have all annual meetings been held (or resolutions passed in lieu of meetings) in each year of its existence?
- What classes of shares have been authorized? Have all issued and outstanding shares been validly issued?
- What are the restrictions on transfers of shares? Have all share transfers been properly conducted and documented?
- Are there taxes owing on any share transfers?
- Are the company's by-laws in compliance with its charter and with the applicable statutes?
- What are the qualifications for corporate officers? What powers do the corporate officers have?
- Are there provisions for delegation of the board's authority to a committee? Are there any committees currently sitting? What is the structure of the committee, and what responsibilities does it have?
- What are the provisions for appointing/electing and removing officers and directors?
- Who are the current directors and officers? Will they all be resigning when the business changes hands? If so, what impact will that have on the business?
- Have any employee stock options or other rights to acquire shares been granted? How many of these are still outstanding?
- Are there any bonus, retirement, profit sharing or other incentive / benefit plans in effect?
- Are there any written or oral agreements with employees, directors, officers, stockholders, or related parties? What are the company's obligations under each? When do each of them expire? Do any of these contracts have automatic renewal dates? Will (or should) any of them be terminated on the sale of the business?
- Are there any shareholder loans still outstanding? Are they to be paid out at the time of purchase? If not, what are the repayment terms? What type of security has the company granted to the shareholder?
- Has the corporation leased any property from board members or stockholders?
- Are there any licensing, royalty or franchise agreements in effect?
- Has the corporation prepared and delivered all required annual reports to shareholders? Have all reports been filed with state/provincial and federal authorities (if required)?
- What are the corporation's long-term or material commitments?