What is Due Diligence?

Due diligence is an investigative inquiry into a business that is performed by a potential small business buyer in order to ensure that the business being purchased is everything that has been represented by the business owner/seller.

During a due diligence period, the buyer will have an opportunity to verify the accuracy of financial information furnished to him by the seller and other details of the business for sale.

Small business due diligence can take anywhere from 30 to 60 days, depending on the complexity of the business and the number of moving parts.

The due diligence period typically begins after a purchase agreement is signed and the potential buyer signs a  non-disclosure agreement. It is wise to hire a team of experienced professionals to assist with this process, including an attorney and CPA who have experience performing due diligence on small businesses due to the sheer volume of documents and information that must be examined.

Due diligence varies from business to business and industry to industry, making it hard to create a comprehensive checklist. Due diligence can be segmented into 5 major categories: Financial Due Diligence, Legal Due Diligence, Operational Due Diligence, Product or Service Due Diligence, and Human Capital Due Diligence.

To most business buyers, financial due diligence is one of the most important aspects of the examination process, diving into the economic state of the business. Here, a buyer and their team will look for consistency among accounts, assets, and liabilities, and examine the business’s historical trends, projects, and tax risks associated with the business. It is recommended to at least examine the past 3 years of annual and quarterly financial information, included but not limited to income statements, tax returns, balance sheets, and cash flow statements.

Legal due diligence will give buyers the opportunity to explore legal contracts and documents such as leases, purchase agreements, distribution agreements, sales contracts, trademarks, copyrights, employee contracts and more to look for any risks or lawsuits that may be hidden from plain view.

When examining operational due diligence, a buyer will be focusing on the actual operations of the business, such as the business model, the market and industry trends, and the business’s competition. This will allow them to identify customer patterns, performance of products and services, promotions, sales and discounts, and the company’s marketing strategies.

Product, or service due diligence, allows buyers to learn about what their prospective business actually provides their customers with and how they earn their business. As a buyer, you will want to understand the costs associated with producing every product, as well as how profitable each product or service is.

The final type of due diligence that will be discussed is human capital due diligence, which looks at the business’s employees, from management down to the staff. It’ll investigate any required skills and qualifications necessary for each position, as well as identify any gaps where a buyer may want to seek personnel improvements upon acquiring the business.

If you choose to ignore the importance of doing your due diligence and fail to take the time to truly delve into the business you are interested in purchasing, you are risking the future of your new business, as well as your investment.

Additionally, should you move forward and finalize the purchase of your new business without doing your homework, you risk overpaying for your business, not fully understanding its value.

Putting in the extra work in the due diligence process of buying a business is ultimately going to save you time, money, and stress, by guiding you to choose a wise investment and allowing you to grow your new business, rather than depleting your resources while trying to save and overhaul a dying business that was purchased without the aid of due diligence.