Common Pitfalls in Buying a Business – Inadequate Due Diligence ©

Note: The following article is not legal advice. Competent legal, tax, and financial counsel should be obtained before doing a deal.

Common Pitfalls in Buying a Business – Inadequate Due Diligence ©

By: Dennis J. Gerschick, Attorney, CPA, CFA

This is the fourth in a series of articles that will address the mistakes that are commonly made by purchasers of a business. The term “due diligence” refers to the buyer’s evaluation of the targeted business. It involves a consideration of operational, personnel, financial, marketing, legal, and tax issues. In short, the buyer is studying various aspects of the business. They do this by asking many questions, inspecting what they are buying, and reading numerous documents.

By performing due diligence, the buyer is trying to determine exactly what they are actually buying and what the value of it is. The quality of due diligence varies considerably because some people see what they want to see and hear what they want to hear. Due diligence is not exciting work. In fact, it is often boring. Consequently, many buyers either skip it, shorten it, and/or don’t focus on it and then mistakes are made. In contrast, smart buyers focus on due diligence because this is where they determine whether they should proceed with the deal or just walk away. Many buyers refuse to walk away no matter what they learn from their due diligence.

A very important point is this: the buyer’s due diligence should be tailored to the deal. The due diligence that is done should vary depending upon whether the buyer is purchasing from the seller select assets, a division, a subsidiary, or a stand alone entity. Does the target business consist of one location or many? What exactly is the buyer purchasing?

An important question a potential buyer should ask is, “What do I need to be successful in this type of business?” The answer will vary depending upon the type of business involved. When a buyer is considering purchasing a business, it should step back and consider the “big picture.” What makes the target business attractive? What does it have that the buyer wants or needs? Is it technology, real estate at a good location, established market position, talented personnel, brand name, etc.?

Once the buyer identifies what it wants, the buyer should then consider many other issues such as:

1. Does the seller have good clear title to the desired assets?

2. Are the desired assets encumbered by liens or security interests?

3. What action must be taken to transfer title to the buyer?

4. Are any approvals for the sale necessary from government officials or third parties?

Whatever the purchaser will buy from the seller, the purchaser should inspect it thoroughly. Is the asset in good condition? What is its value? Does the seller actually own the desired asset, simply lease it, or license it?

Consider who is qualified to do the due diligence. For example, if the buyer is purchasing large pieces of machinery, does the buyer have the knowledge to determine if the machinery has been well maintained? How much longer can the machinery be used for? What is the machinery currently worth? Another buyer is considering buying a jewelry store. He is mesmerized by the sparkling inventory. Are they really diamonds or just cubic zirconium? How would the buyer know? The buyer could hire a gemologist to evaluate the inventory. Consider a seller who has patents the buyer wants. How does the buyer determine whether the patents are any good? The key point is that the due diligence will vary depending upon what is involved. Specialists are often needed to do the due diligence properly. A buyer would be well advised to admit what they don’t know and get some help.

Adequate due diligence often takes time and some expense is required. Another important question is: how much time and money should a buyer spend on their due diligence? To put it another way, how much time and money is the buyer willing to spend on a potential deal and then walk away if it does not see what it wants? My experience is that as the buyer’s investment of time and money increases, the harder it becomes for the buyer to walk away. As their investment increases, their commitment to the deal increases and sellers often take advantage of this to extract concessions from the buyer during contract negotiations.

In conclusion, buyers should keep in mind that the purpose of their due diligence is to provide them with a basis for deciding whether they should close the deal, or not. Also, if they elect to go forward, the due diligence should help the buyer determine a fair price to pay.

© 2007 Dennis J. Gerschick All Rights Reserved

Author:.

Dennis J. Gerschick, Attorney, CPA, CFA 2691 Blairsden Place Kennesaw, Georgia 30144 dennis@gerschick.com www.Gerschick.com Dennis Gerschick is a CPA, Attorney,Chartered Financial Analyst, and Venture Capitalist. He started a venture capital fund in 1999 and continues to manage it. As an attorney, he represents both purchasers and sellers of businsesses. He also represents companies seeking capital and investors making a capital infusion either as a loan or the purchase of an equity pos...

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