The Importance of Due Diligence in Business Sales

by Richard Jacobs 28th of November, 2024

The Importance of Due Diligence in Business Sales

As a business broker, I typically perform my own due diligence on a business before agreeing to represent it for sale.

This process ensures that I am presenting the business to the market with complete honesty and transparency. There is nothing worse than attempting to sell a business only to uncover hidden problems that the owner ‘forgot’ to mention. These “skeletons in the cupboard” can derail deals, damage reputations, and lead to costly complications.

For businesses sold as a going concern—where the buyer is purchasing tangible assets, fixed assets, stock, and intangible assets—due diligence must be focused on those areas while the vendor retains responsibility for other liabilities.

It’s important for both sellers and buyers to be aware that when appropriate due diligence is performed, any discrepancies that occur, is likely to result in a lower offer or worst still complete withdrawal by the buyer. So, it is in everyone’s best interest that the business is prepared appropriately for sale and the purchaser is not given good reason to revise their offers.

Here are the key areas I examine when selling a business as a going concern, and they should serve as a guide for both the seller when preparing the business for sale and any potential purchaser considering buying it.

1. Financial Statements: Accuracy and Profitability

When purchasing a business as a going concern, the financial statements provide a picture of its overall health. Buyers should review at least three years of financials, including balance sheets and profit and loss statements. It is essential to understand profitability trends, revenue stability, and key expense areas. Although the buyer will not assume all liabilities, misrepresented profitability could signal operational inefficiencies.

In one case, I was working with a retail business where the financials looked sound. However, a closer review revealed that personal expenses were being recorded as business expenses, affecting the profit margin. Once alerted to this the Vendor had the discrepancies corrected, ensuring potential buyers had a much clearer view of the true financial health of the business.

3. Outstanding Debtors: Risk to Cash Flow

In a going concern sale, long-aged debtors can have a direct impact on the business’s cash flow. If customers owe significant amounts for extended periods, the buyer may face cash flow shortages early in their ownership.

One such example involved a wholesale business where one large customer had overdue payments. This backlog of debt could have affected the new owner’s ability to maintain liquidity. The seller worked with the client to change the payment terms and his own systems to ensure collection was done on a timely basis thus improving the business’s cash flow and made the transaction more attractive to a potential buyer.

4. Aged Payables: Supplier Relationships

While payables remain the responsibility of the vendor, long-standing overdue payables can strain relationships with suppliers. Buyers should review the age of outstanding payables to assess whether suppliers might be hesitant to work with the business post-sale.

5. Inventory Valuation: Stock Quality and Turnover

For businesses with significant stock, understanding the value and condition of inventory is crucial. Buyers need to verify that inventory is not obsolete, overstocked, or nearing expiration. Proper inventory valuation affects the working capital the buyer will need.

In one such business I worked with, much of the stock was seasonal and approaching its sell-by date. I advised the seller to discount or sell off outdated inventory before the sale to ensure a more accurate inventory valuation, and an easier sale.

6. Fixed Assets: Condition and Value

The condition and value of the fixed assets—such as equipment, vehicles, or machinery—are critical in a going concern sale. Buyers should assess the age and functionality of these assets to avoid inheriting equipment that may need expensive repairs or replacement soon after the purchase.

One example I had involved a manufacturing business where several key pieces of machinery was nearing the end of their useful life and significant future capital investment. The seller agreed to discount the sale price, accounting for the necessary equipment upgrades, ensuring a fair deal for the buyer.

7. Lease Agreements: Favourable Terms and Transferability

For businesses that operate from leased premises, the lease terms are vital. Buyers need to ensure that the lease can be transferred and that the terms are favourable for long-term operations. Hidden clauses, such as future rent increases, can dramatically impact the profitability of the business.

I was once involved in the sale of a business with a favourable lease. However, upon reviewing the lease terms, I discovered a clause allowing the landlord to increase the rent by 25% upon renewal. On another occasion it was discovered the business being location dependent, was owned by the vendor whose intention was not to renew the lease as he wanted the premises for other purposes.

8. Supplier and Vendor Agreements: Stability and Transferability

Long-term supplier and vendor agreements are important for maintaining operational estability. Buyers should verify that these agreements can be transferred and that they provide the business with favourable pricing or terms. Losing a key supplier could result in higher costs or supply disruptions.

In many cases I have found that the supplier agreements were informal and not legally binding. This created a risk for the buyer, as key suppliers could easily change terms post- sale.

9. Customer Contracts: Key Accounts and Concentration

A strong and diverse customer base is a key asset in any going concern sale. Buyers should investigate whether a few key customers account for most sales, as this concentration poses a risk if those customers leave after the transaction.

For instance, a services business I handled had 70% of its revenue coming from just one client. I advised the seller to either diversify the client base before putting the business on the market or appreciate that lack of diversity of clients was a substantial risk and a potential
the buyer is likely to want to discount the price offered to mitigate the risk to themselves.

10. Intellectual Property (IP): Ownership and Protection

For businesses with valuable IP—such as trademarks, patents, or proprietary processes—it It is important that these assets are properly registered and protected. Buyers should ensure they are acquiring legal rights to any IP that is part of the sale, particularly where such IP can easily copied.

11. Employee Contracts: Retention of Key Staff

While it is impossible to 100% ensure retention of key staff when a business is being sold Retaining key employees can be essential to the success of the business post-sale. Buyers should review employment contracts and verify whether there are incentives or retention agreements in place to encourage key staff to remain after the transition.

I recall on one occasion a business owner, had a member of his team that was critical to the business, and upon further investigation the reason for the owner wanting to sell was because the critical person had already informally advised the owner he wished to retire.

12. Health and Safety Compliance

Health and safety compliance and other compliances are in many industries, where non-compliance can lead to fines or shutdowns. Buyers should confirm that the business complies with all regulations to avoid any potential liabilities post-sale.

I handled the sale of a manufacturing business where the seller assured me that everything was compliant. During due diligence, however, it was discovered safety reports were outdated and there were potential violations that could have resulted in significant aggravation and cost to a new owner.

13. Licenses and Permits: Validity and Transferability

Certain businesses require licenses or permits to operate, and it is crucial that these are valid and transferable. Buyers should confirm that the business holds all necessary licenses and that they will be transferred as part of the sale.

I once dealt with a business that relied on several key permits to operate. However, I discovered that one of the most important permits had expired and could not be renewed.

This posed a huge risk for a buyer.

14. Customer Satisfaction: Reputation and Reviews

The reputation of the business is a key intangible asset. Buyers should research customer satisfaction and reviews to understand the business’s standing in the market. Negative reviews or a poor reputation can significantly impact sales and growth potential.

15. Marketing Strategy: Strength and Effectiveness

A strong marketing strategy is essential for continued business success. Buyers should assess the current marketing efforts and determine if they are effective in attracting new customers and retaining existing ones.

Opportunities can be created through online presence, often business have limited or outdated website presence or social media strategy. These can not only improve the business’s visibility but also attracted buyers interested in growing the business through modern marketing techniques.

16. Trademarks and Branding

Strong branding can be one of the most valuable assets in a business sale. Buyers should ensure that any trademarks or brand assets are legally protected and that they will be transferred as part of the sale. Strong branding can provide a competitive edge, and it is important that buyers are acquiring the full rights to use the brand.

17. Technology and Systems: Suitability and Scalability

For modern businesses, the technology and systems in place can significantly impact operational efficiency. Buyers should assess whether the current technology is suitable and scalable to support future growth. Outdated systems may require costly upgrades soon after the sale.

In a manufacturing business I worked with, the seller touted their use of production technology as a competitive advantage. However, during due diligence, it was discovered their software was outdated and no longer supported by the provider, posing a risk of operational disruption.

18. Insurance Coverage: Adequacy and Risk Management

Adequate insurance coverage is essential for mitigating risks associated with running the business. Buyers should review the existing insurance policies to ensure they cover the most important risks, including general liability, property insurance, and coverage for any business-specific risks like product liability or machinery breakdowns.

In one case, I worked with a manufacturing company that had appropriate general liability and property insurance but lacked coverage for machinery breakdowns, which could cause major production disruptions, the reason for this was the additional cost would have been
significant but this considerable and understating critical insurance has a huge negative impact on profit margins.

19. Owner Transition Plan: Smooth Handover

When a business is sold as a going concern, the transition of ownership is critical to ensuring the continuity of operations. Buyers should discuss and agree on a transition plan with the seller, particularly if the seller’s involvement has been central to the business’s success.

In one instance, I was handling the sale of a family-owned business where the owner was integral to daily operations and client relationships., it became clear that a formal transition plan was needed The seller agreed from the outset to stay on as a consultant for six months post-sale, ensuring a smooth handover and reassuring a buyer that the business would continue to thrive under new ownership. But be warned, different personality types may find it difficult to work together, and previous owners may find it difficult if a new owner launches into change, whether the changes are sound or not.

20. Goodwill and Customer Relationships: Intangible Value

Goodwill, which includes a business’s reputation and customer relationships, is often one of the most valuable assets in a sale. Buyers should assess the strength of the customer base and the business’s reputation to understand the value of goodwill.

In one retail business I represented, the seller had a loyal customer base but lacked a formal system for tracking customer relationships. This made it difficult to quantify the value of repeat business and customer loyalty. Implementing a simple CRM system can be worth Gold.

Conclusion

When selling or buying a business as a going concern, thorough due diligence is essential to ensure a smooth transaction and protect both parties from unforeseen risks. By carefully examining the financials, assets, contracts, and key operational elements, buyers can mitigate risks and make informed decisions. Likewise, sellers can present their business with full transparency, ensuring a fair and successful transaction. Whether it is understanding the value of inventory, securing key customer relationships, or assessing the condition of fixed assets, leaving no stone unturned during the due diligence process is critical to achieving a favourable outcome for both buyers and sellers.

Tags: selling exit strategy tips small business