The Due Diligence Process: NEVER SKIP Due Diligence

I’ve been fortunate to have had a great career both supporting clients to buy businesses and also starting/buying businesses for myself. Over time, you develop some pretty good mental shortcuts but no matter what you’ve experienced in the past, NEVER SKIP Due Diligence when buying, creating a business partnership or even starting a business. It may be tedious at times and the seller may even get frustrated at some of the requests but it is critical to clearly understand what you are walking into to protect your capital.

In this article, I will focus primarily on the due diligence steps in a purchase scenario but you can apply many of these to other business scenarios such as partnerships and start ups.

Here’s a breakdown of what the due diligence process entails and how you can navigate it effectively.

 

Understand the Purpose of Due Diligence

Firstly, the aim of due diligence (DD) is to verify what you are being told by a seller or a broker and uncover any hidden risks or liabilities associated with a business. There are 2 types of DD:

2.   The Initial DD where we identify enough information to be comfortable to make an offer. This may include talking to the owner and getting a verbal understanding of the business, staffing structures, clients, etc; reviewing recent financials; reviewing websites and reviews; speaking with key staff members such as a General Manager critical to business operations, etc.
3.     Once you’ve made and had your offer accepted, it is time for Deep DD. This involves a deep dive into the businesses financials, accounts payable/receivables ledgers, customer databases and contracts, supplier agreements, lease agreements, staff contracts and structures, reviewing internal documents such as operations and compliance manuals, obtaining evidence of licenses or other critical factors to ensure operations can easily continue.

The purpose is to verify the information provided by the business owner, assess its legal and financial standing, and evaluate potential risks that may affect your investment. It helps ensure that you are making an informed decision, avoiding potential pitfalls and ensuring the business aligns with your goals.

 

The Categories of Due Diligence

Due diligence can be divided into several key categories:

• Financial Due Diligence: This involves analysing the financials of the business. You will assess the profit & loss statements, balance sheets, tax returns, profit margins, cash flow, aged payables/receivables reports, work in progress reports (WIP), financial forecasts including the assumptions made and debt obligations. You do not simply assess the current financials – we recommend reviewing at least 3 years, where available, to get a clear understanding of historical fluctuations which will help you craft the next round of questions for the owner. It also helps you see whether a business is trending upwards or downwards overall.
• Legal Due Diligence: During legal due diligence, you will examine all the legal aspects of the business. This includes checking for any ongoing or potential lawsuits, intellectual property/patents, employment contracts, supplier agreements, lease agreements and compliance with relevant laws and regulations. We highly recommend you outsource this to your legal professional as they will have a broad understanding of potential risks and can spot them quickly.
• Operational Due Diligence: This involves reviewing the operational processes and systems of the business to check if there any inefficiencies or gaps that could affect profitability or scalability. Here we advise to assess the company supply chain, customer base including client retention & return rates, product or service quality, management team and also how well all processes are documented and automated. If an owner cannot quickly supply you with an overview of their processes and key systems, it’s an indicator that they may not have strong ones in place or a good records system. Furthermore, imagine the handover post settlement where your first job will be to extract how to run a business from the previous owners head while they’re already planning their vacation. Systems and processes + a good business = highly saleable and easy to hand over.
• Market and Competitive Due Diligence: This focuses on understanding the business’s position in the market. Who are the competitors? What market share do they have vs the business in question? What do they do better or worse? What are the trends in the industry? Is the business likely to grow or face significant challenges? If you are unfamiliar with the industry you are buying in, call in a mentor, industry expert or one of your professional advisors to give you guidance on the risks. What may look like a great opportunity could be a looming disaster if you don’t ask the right questions. We believe that all businesses can be successful but you need to understand what you’re dealing with first.
• Cultural Due Diligence: This often overlooked but it is critically important to understand the company culture, values and employee satisfaction. You should assess whether the employees are motivated and aligned with the companies goals and if you feel they will align with your vision. This is also a must as you do not want to settle on a business, only to lose half your key employees.

 

Identifying Risks and Opportunities

Due diligence is about uncovering both risks and opportunities. While uncovering potential risks (such as pending legal disputes or questionable financial practices) is crucial to protect your investment, due diligence should also reveal opportunities that can be leveraged for growth. Look for things like gaps in the market, customer pain points, process inefficiencies, opportunities to improve team morale and innovations to change your competitiveness.

 

Involve Your Professional Advisors IMMEDIATELY

While conducting your own due diligence is important, it is critical to consult your professionals who have done this for a broad range of clients across different industries. They have likely seen things go very wrong and very right – enjoy the benefits of their experience. Legal professionals, accountants, financial professionals, mentors and industry specialists can provide insights that you may not have access to otherwise. Their experience can help you identify critical issues and interpret complex data. Many first time business buyers make the mistake of avoiding professionals because they want to save costs but spending a few thousand dollars on the right advice vs losing your life savings and risking legal action is much more advisable. Even billionaires and experienced business operators have a team of advisors that understand their objectives and have a clear process to verify a business aligns with what they want to achieve.

 

Negotiating or Re-Negotiating the Terms – The Final Decisions

Once the due diligence process is complete, you may decide to proceed with the deal but with certain conditions or adjustments to the original high level agreement. This is where negotiation comes in. DO NOT be afraid to put forward what is reasonable to you. A critical mistake people make is not knowing how to tackle the conversation so they avoid it completely which ends up costing them more post settlement. You can use your findings to negotiate terms that protect you, such as adjusting the purchase price, renegotiating contracts such as key employees, suppliers and customers, applying KPI’s to the sale such as part settlement upfront and the remainder after 12 months providing the business continues to perform. You may also negotiate in an unpaid handover period with the existing owner or a condition may even be that the key general manager gets a small shareholding and agrees to stay on for 5+ years. When it comes to business, most things are negotiable and custom. Again, rely on your advisors to help you structure terms that are reasonable. If all is agreeable, your lawyers will prepare the final legal agreements and settlement planning can begin.

If you can’t reach agreement or are uncomfortable with what DD revealed, never forget that it is ok to walk away. There are plenty of deals to be done.

 

Conclusion

The due diligence process is essential to making an informed decision when it comes to settling on a business. By carefully investigating financials, legal standing, operations, market position and cultural fit, you can mitigate risks and ensure you set yourself up for success. If you aren’t satisfied, walk away. If you are, get ready for a rewarding journey and an exciting addition to your wealth journey.