Protecting Yourself Through Due Diligence

There are many paths to follow to business ownership. You can start a business from scratch through the feasibility study and business planning process. This process requires a higher tolerance for risk. You can become a franchisee as part of a larger business entity. Franchising might typically afford significant advantages such as a proven business model but carries some costs (franchise, advertising, and royalty fees). Franchising also requires some risks in terms of taking the franchisors business model to a new location. A third path to business ownership is the purchase of an existing business.

Purchasing an existing business, like everything else, comes with advantages and disadvantages that cannot be taken lightly. Buying an existing business avoids the whole “start-up” process in some ways. It can simply be a quick and easy path to business ownership without the risk involved in an unproven start-up. An important point that is often forgotten by the eager entrepreneur is that you are purchasing a business model that comes with a history. While you might have great growth plans, do not forget that the business’s history tells a story. A story of the market, the customers, the supply chain, the competitive advantage, and most importantly, the past profitability. Often times the purchase of an existing business is attractive because it is a quick way to jump into business ownership.

Just like jumping into unfamiliar water, it would be foolish to jump into the business without some thought process. Just like mom would tell you…’check the water.’ How deep is it? Are there buried objects? What is the temperature? For all you know, you could be jumping into an aquatic nest of venomous water moccasins. If you aren’t from the Mid-West, you should understand that water moccasins are “unpleasant”, semi-aquatic, very aggressive, and one of the most deadly snakes in North America. Get the picture. Before just jumping in, let’s do some due diligence.

Due diligence can save you substantial problems. The history that comes with an existing business can provide the potential buyer the knowledge it takes to make an informed purchase decision rather than an emotional decision. Emotional decisions can obviously lead to “complications” that could have been avoided. Due diligence can typically be defined as the process of evaluating a business opportunity in a reasonable manner. In order to begin the due diligence it is important to identify who the stakeholders are in the business. The stakeholders can paint a better, more complete picture than the business owner. You want to know what they have to say about the business; its history, its performance, and its potential. Suppliers, customers, bankers, and employees (past and present) can help provide a realistic picture of the internal and external assessments of the business. Thorough due diligence requires both soft and hard data collection. Everything from opinions to financial statements matter. Remember what you have at stake in the purchase. Do not tread lightly. It is appropriate to ask the seller who these stakeholders are, both internal and external, both satisfied and unsatisfied.

A seller who is hesitant to provide necessary information during the due diligence process should cause you some concern. It is important to determine the root cause for the pending sale. While sellers might indicate that pending retirement or relocation might be the cause it is an important question to pursue. Retirement or relocation are easy to roll off the tongue. However, is the reason really unprofitability, weak cash flow, franchisee issues, regulatory changes, extensive competition, or pending legal issues? You just ‘gotta know’!

In order to paint a more complete picture then, what have you got to know? What have you got to ask for?
Steve Mariotti and Caroline Glackin, in their book, “Entrepreneurship & Small Business Management” provide a comprehensive, yet not all inclusive, list of information a buyer should ask for during this process. A list cannot be all-inclusive because when an issue turns up it might lead the buyer down another trail to find additional information. Such a list could start with:

Such a list could start with:

• 3-5 years of tax returns
• 3-5 years of financial statements
• bank statements
• employee records, including turnover history
• ownership/shareholder structure and agreements
• statements concerning capital structure, assets, and nature of ownership
• product or service descriptions, pricing (history), and promotions
• statement of condition of machinery, equipment, and the physical plant (including appraisals)
• inventory records
• contracts, liens, leases and other legal agreements
• patents, trademarks, service marks, and other intellectual property protections
• disclosure of pending litigation
• list of appropriate regulations, ordinances, and local zoning rules (including pending changes) that impact the business
• customer lists and sales records (satisfied and unsatisfied)
• supplier lists and references
• business credit and collections history
• non-compete agreements

While due diligence might seem like an overwhelming proposition, buying a business is complicated. YOU have a LOT at stake. Remember that a key advantage of buying an existing business is that the information you need already exists, unlike a start-up venture. Due diligence provides the information you need in order to make an informed decision. While the process is not easy, information and knowledge are powerful tools to have. This is what separates the successful entrepreneur from “the others”.