Giving Diligence Its Due

The pros give tips on doing your research right, whether you're a business buyer or seller.
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In the world of sales and acquisitions, small business owners shouldn't be like an impressionable child offered candy by a stranger -- they need to avoid the temptation to jump at tempting business confections.

Eugene Ferraro, CEO and founder of

Business Controls Inc., a customized research and due diligence service, relates the story of starry-eyed investors who accepted an unusually large offer for their business without properly looking into the buyer's background.

The acquiring company -- which turned out to be made up of organized criminals -- sold off the inventory on the black market, didn't pay company bills and eventually bankrupted the business.

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Buyers can build great trust and sound like Harvard MBA's," says Ferraro, but that doesn't mean they will be good for the company you may have spent a lifetime building.

Richard Parker, founder of business buyer resource center

Diomo Corporation, and author of seven how-to guides on buying a business, realized how many people don't address this most critical stage of the buying process effectively.

In the small-business world, where many can't afford a due diligence team, advice from the likes of Parker and Ferraro is proving very profitable.

"Due diligence has seeped into the business lexicon," says Ferraro. "It's not like the days of yore when

companies sent in accountants to make sure column 'A' adds up."

The idea is to organize everything you need so you can hit the ground running when the due diligence clock begins, says Parker. Also, be sure to review the documentation first. "Chances are if they don't make sense to you, they won't make sense to your accountant," explains Parker, who has purchased 10 small businesses since 1990.

Sellers and intermediaries will generally push for the shortest due diligence period possible, so as Parker advises, don't be a pushover. Allow an average of 20 days for the whole process.

To truly determine the credibility of a company, take the time to do it thoroughly. "You need to skin the onion and take a closer look," says Ferraro.

Don't Get Emotional

More often than a larger company, when a small business sees the proverbial carrot dangling, it tends to forgo the essential details in its eagerness to take a nibble.

The seller can be enamored by large business and enormous growth, says Ferraro, but there may in fact be no contracts behind all the hype.

"Don't get passionate about the business

during the due diligence process," says Parker. "You must gear your passion toward discovering everything that you can about the business and nothing else."

Then there's ego to contend with: "You're talking about a big boys and girls club," says Ferraro. "Everyone at the table is supposed to know better."

Due diligence often seems like a sign of weakness to buyers, who want to convey the image that they can run a better business than the current owner, but avoid getting a big head and you'll be the one looking smarter.

Fine-Tooth Financials

Unfortunately, there are many creative ways for companies to hide liabilities and inflate revenue, so never take financial figures at face value.

"Numbers don't lie; people do," Parker points out. Financials should be examined through an investigation of the entire business and must include the assets, systems, employees, competitions, contracts (legal and corporate), sales and marketing strategy and the industry as a whole.

Parker goes by the mantra "don't treat any incidents as catastrophes, nor treat any catastrophes as incidents." No business is perfect, so compile the issues that you will no doubt find and compartmentalize accordingly.

One red flag that should not be ignored is unreported income, says Parker.

"Don't be fooled. There's no guarantee that this

income even exists," says Parker. "If the seller says 'There's much more coming in then what's on the books (wink wink)' well good for them, not for you."

Beyond the Buck

Due diligence is a combination of looking at problems and verifying what the other company relays to you.

For small businesses, one of the typical areas that buyers overlook is employment law and action, says Ferraro -- research terminations that didn't go well and may have precipitated litigation. These cases can be detrimental if they bubble to the surface post-acquisition.

More importantly, the quality and order of human resources forms say volumes about the sophistication or sloppiness of a company, says Ferraro. Ask if the personnel forms are in the proper order and in the proper place (I9 forms are not supposed to be in personnel folders). Is its employment application professional and efficient?

"I have dealt with otherwise sophisticated companies that don't have an application process," says Ferraro.

Parker recalls speaking to a potential buyer of a gas station who came to him within days of completing what he saw as thorough due diligence.

After Parker advised him to check with city hall about any possible road construction being scheduled, the buyer found out that a massive installation of underground pipes being considered would lead to a two-year road closure.

"Those who shun helpful guides and resources usually wind up making horrible decisions," Parker cautions.

A Few Good Professionals

It's also important for both seller and buyer to put together a strong team, which includes transaction attorneys to do the deal properly, tax specialists, investment bankers representing the seller and a due diligence team, whether that be a hired group or a bunch of your buddies and co-workers.

When possible, engage people who are familiar with the industry and business size.

Lastly, keep your team informed. "Don't wait until the last minute to tell your accountant about the start date of the due diligence," says Parker.

Attorneys and accountants can't do all the work, but "with experienced professionals and our checklists and guides, you can do a flawless job," Parker says.

Finally, Parker advises sellers to avoid hiding anything, and to be sure to assemble all the documentation and information they feel the buyer would want to know.

"Small-business deals rarely happen when there's a lack of trust between the parties," says Parker. "You can ruin that bond very quickly." The seller should do proper background checks on buyers as well, especially if they are financing any part of the sale.

Ferraro warns both buyer and seller against complacency at any point of the due diligence processes.

"If your life savings are tied up in a $10 million sale of your business, the cost to do it properly is pretty inexpensive insurance."