When a deal is reached to buy a business, one of the contingencies is due diligence. This is when the buyer examines the books and records of the business being sold to verify the information that was presented and to look for any other problems that might cause the buyer to terminate the deal or seek to revise the price or terms. The typical period for due diligence in the sale of a small business is two to four weeks. It is important that the buyer use this time wisely.
Sometimes a buyer sends a laundry list of information that they want in the belief that if they ask for lots of information, they are more likely to find any problems. The problem with this approach is that because the buyer receives so much information, they may miss what is important. It can also take a while for the seller to put together the information and for the buyer to review it, using up more of the due diligence time.
Here are a few thoughts on how to approach due diligence more effectively. Keep in mind these are the author’s thoughts. You should get the advice of your lawyer, accountant, and other advisors on how to handle due diligence.
Separate the due diligence into three broad areas – verifying the financial information, checking for other deal-breakers, and crossing the t’s and dotting the i’s. The first priority is confirming that the financial information is accurate. If it isn’t, you may terminate the deal or seek to revise the price or terms. If this is verified, the next step would be to check on other issues that could be deal-breakers. This could be undisclosed liens, contingent liabilities, or other problems. The final group, “crossing the t’s and dotting the i’s” may be items needed by the attorneys to close the transaction, but are not typically problem areas.
One way to reduce the time it takes to review the material is to use sampling. Let’s say you would like to look at all the invoices and expenses for the past three years. But, you don’t have the time to do so. You could ask the seller for monthly income statements for the past three years and look at all the information for a few months. If the transactions in the chosen months are confirmed, you may decide that it is likely that the rest of the information doesn’t need as much review. You may look at less data to confirm the rest of the information.
Here are some other tips. You can verify the seller’s tax returns by getting copies directly from the IRS. The seller needs to fill out a 4506 form authorizing you to receive the copies. Speaking of the IRS, you may want to check out their “Audit Technique Guides”. These manuals are guides for auditors on how to examine particular businesses. There is one that covers retail businesses. These can be found on the IRS website.