The Steps in Due Diligence when Buying a Business

One of the first questions I am asked by clients looking to buy a business is, “What do I have to do for due diligence and how much will it cost?” At least, I hope they ask. A concerning number of people looking to buy a business do not do the basics of due diligence. They are so caught up in their plans for success that they simply take the seller’s word about the health of the business. No business is perfect and a certain level of “challenge” is to be expected. But, there is a point where challenges become serious problems that sink a new business venture.

Performing due diligence when buying a manufacturing business is especially important. Unlike other types of businesses, you often have fluctuating inventory and accounts receivable/payable that can put the business in the red or black by hundreds of thousands of dollars over the course of a month. In a manufacturing business you also tend to have multiple, complex relationships with vendors and customers. If there are problems in any of these areas, you want to know about it. That’s what due diligence is for.

Many people buying a business don’t do thorough due diligence because they think they are saving money. While it is not uncommon for due diligence to cost in the millions for a large, complex business sale, due diligence for most small to medium sized business only needs to cost a small fraction of the sale price. After the sale, your only recourse if something is not as represented is to hire a lawyer and sue. When you compare the cost of hiring a lawyer and going through the litigation process, investing in due diligence quickly becomes worth the money.

10 Essential Steps of Due Diligence 

Following, I have mapped out the ten basic steps of due diligence, paying particular attention to manufacturing businesses. While the steps are laid out roughly in order, some of them overlap in content. 

Due Diligence Step #1: Lien Search

One of the first things you want to do during due diligence is figure out if anybody else has a potential claim on the business, its property, or its income. To do this, you need to perform a lien search. The goal is to make sure you can get clear title to all of the assets you’ve purchased. Types of lien searches you might need to do include:

• Checking with the county recorders’ office to see if there are any liens on the real estate involved
• Checking with the secretary of state to see if there are any mechanics or other types of liens on the inventory or machinery 
• Checking with the DMV to make sure the business has clear title to any cars, trucks, etc. 

Lien searches are relatively easy and something you can do yourself. There are companies that do lien searches and cost less than it would to hire an attorney to do it. However, the tricky part is not just knowing what lien searches to perform but where to search. Get the wrong jurisdiction and you can miss something critical. An attorney experienced in due diligence can make sure a lien search company looks for the right things in the right places.

Due Diligence Step #2: Public Records/ Litigation Search

Companies, and people, get sued for a variety of reasons. A public records litigation search will tell you if there are any lawsuits pending against the seller or if the seller is subject to any court judgments. It’s also a good idea to know if the products the company is manufacturing are prone to product liability lawsuits. It could be an industry-wide issue and you need to plan for it. Similar to lien searches, there are companies that will do a litigation search for a reasonable price. They too need to be directed where to look and what for, so it’s best to have an attorney who knows how to direct them.

Due Diligence Step #3: Financial & Accounting Review

When most people think of doing an accounting review as part of due diligence, they think of the overall financial health of the business. Wise business buyers realize they should do their own thorough financial and accounting review rather than simply taking the seller’s word about the financial health of the business. Beyond helping you determine whether or not to buy the business, you need to do a thorough financial and accounting review in order to make an accurate plan for growth. 

This is not the time to hire your tax preparer to look over the books and give you an overall impression of the business. You need to hire an accountant with experience in financial due diligence who knows where potential problem areas might lie and how they might be camouflaged. Fortunately, it’s not expensive to hire someone who knows what they are doing.

Due Diligence Step #4: Contract Review

This step in the due diligence process overlaps with other steps such as financial review and real estate review but reviewing contracts warrants its own step because some contracts don’t fall into the typical categories. Following are some questions to ask in order to figure out if there are other contracts you need to look at:

• Vendor and Customer Agreements - Does the business have long term agreements with vendors and customers? Are they good agreements or a bad ones? 
• Licensing Agreements - Does the business license any software or trademarks?
• Mortgage Paperwork - Is there a bank loan or mortgage on the business? Is there a prepayment penalty?

Due Diligence Step #5: Real Estate Review

As discussed in other steps, you need to review any lease agreement or title documents related to the physical property. It is also important to do a physical inspection of any buildings or other property related to the business. Manufacturing businesses also need to consider an environmental assessment which might turn up issues that could lead to expensive remediation or a lawsuit.

Due Diligence Step #6: Insurance & Liability Review 

Part of the purpose of due diligence is to answer the question, “What might the business be held liable for?” To do that you need to review any business insurance to see if coverage amounts are too low or deductibles are too high. Manufacturing businesses should consider underlying potential product liabilities they might get sued for when evaluating insurance plans and coverage. This is a good time to make adjustments for future insurance needs.

Due Diligence Step #7: Intellectual Property (IP) Review 

In addition to real estate and inventory, a business can lease or own intellectual property. As part of the due diligence process, you should have an experienced attorney clarify what intellectual property the business has rights to and what it doesn’t. Some things related to intellectual property that you should consider include:

• Owned or licensed patents, copyrights, trade names and trademarks
• Website domain name, phone number, business name and logo
• Techniques the business uses that are licensed or a protected process

Due Diligence Step #8: Human Resources (HR) Review

We typically think of lawsuits as originating from outside the company; but many times, lawsuits happen because of actions within the company. Employees can sue a business for a variety of reasons and poor HR practices can leave a business vulnerable. Questions you should answer to assess your liability in this area during the due diligence process include:

• How are employee contracts set up? How much vacation and sick time are employees promised? Does it carry over from year to year?
• What is the status of employee health care plans and other benefits?
• Have employees signed a confidentiality agreement or a non-compete agreement?
• Are employees part of a union? If so, what are relations like?
• Are there any poorly documented relationships with people who might think they are entitled to part of the business?
• Are there any employees who need to be let go? If so, for liability reasons it’s best to have the seller do that. 

Due Diligence Step #9: Supplier and Customer Review 

I once had a client who bought a distribution business without confirming that the primary supplier to the business would continue to make product available on the same terms, conditions and prices as they had been. He also failed to talk with the primary customer to verify that they planned to continue buying the company’s product. So, unlike the seller, he did not know that the supplier was raising prices and the main customer was not planning to buy any more product. My client was not able to replace that customer and lost his investment. 

Sellers typically won’t let buyers talk to vendors and customers until late in the process but you should insist on doing this step in the due diligence process even if it’s uncomfortable. After all, there are reasons why this business is being sold and you want to know if it’s because it’s about to go out of business.

Due Diligence Step #10: Operations Review  

At the time of closing, the buyer should have an inspection of all machinery and equipment done to confirm that it is working properly and the buyer won’t need to make a major capital investment shortly after taking over the business. Included should be an inventory review of raw materials, work in process, and finished product. It also may be appropriate to perform a physical inventory post-closing.

Conclusion: Invest in Due Diligence

I hope what you take away from this article is that proper due diligence can save a new business venture from financial ruin and lawsuits. Working with a lawyer who knows exactly who to hire for each step in the process will get you the information you need while keeping costs down. Call our offices today at (440)796-4592 if you have any questions about how our attorneys can help you be an informed business buyer.