Due diligence when buying a business

One of the best things about buying a business from a buyer perspective is that generally, the buyer has the option to buy the business or simply walk away.  As a buyer, if it doesn’t feel right whether it is true or not, they can simply say the business is not what they are looking for and they can move on.  Most buyers are very friendly and approachable people during the initial stage of collecting information about the business and deciding if it’s right for them.  However, that generally all changes once the negotiations have been done with the price and terms agreed upon and now the transaction moves into due diligence.

At the moment I am dealing with some buyers that wish to buy a Primary Care and Urgent Care clinic.  Their due diligence list has 182 items on it.  They want to know what they are buying and are leaving no room for error.

So let’s have a look at what buyers can do better during the due diligence phase of buying their business or practice.

Asset sale

Risk and fear are two components that come into play in every transaction.  If the buyer is totally risk averse, the best option when buying a business is to do an asset purchase and not a stock sale.  This leaves the seller to own and manage the liabilities of the business up to the close of escrow and change of possession while the buyer gets to handle all the details going forward from that date.

What is the buyer buying?

This may sound too basic but it surprises me how often I am asked by a buyer to help them buy a business and when I ask the seller for a summary of what’s for sale they will offer to ‘put it together.’  Too many sellers take a business to market without being clear what is or isn’t for sale.  My suspicion is that the seller who doesn’t work with a business broker or third party to help them put the business on the market want to see what the buyer wants and then hope they can convince the buyer it’s not part of the sale.  If it’s not part of the sale AND it’s not currently used in the business then the seller should not have it in the business.  If the buyer can see it or knows it’s in the business then they will almost always want it and then decide later what to do with it.

Representations and warranties

There is a difference between a representation and a warranty and that’s the reason we have attorneys.  Suffice to say that this is an important component in a purchase agreement as it will have a section regarding Representations and Warranties.  As the buyer, be clear on the representations of the sellers and their warranties so you fully understand your risk.  Get advice from an attorney if this area is unclear.

Financial statements

If you buy an ongoing business it will include financial statements.  Some buyers do their own due diligence, some buyers hire a CPA to do it for them. The best solution in my opinion is for the buyer to do the due diligence with the help of an accountant or someone licensed in accounting or tax to assist the buyer.  This approach allows the buyer to understand what set of accounts and record keeping the seller uses so they can decide if they continue with the same system and methods or adopt new ones.  If the buyer is uncomfortable with analyzing the financial statements they must have someone on their team to help them and look after their interests.

Re-hiring employees

If the business has a number of employees and they have worked for the business for a long period of time the buyer would think it’s safe to simply hire them after the close of escrow.   It would also be tempting to keep things simple and ask the seller for a copy of their Employee handbook, change the picture on the cover so it looks new and maintain the status quo with employee hiring and employment practices.

Employment practices constantly change.  With a change of ownership for the business this is the perfect time to get a qualified labor attorney to review what’s currently being done and bring it up to date.  Sure, it’s a cost the buyer doesn’t want to incur just now with everything else happening but the cost is a very small investment in view of the overall picture and potential downside from the distraction of a disgruntled employee.

Other employee items to watch:

Make it crystal clear whether the employees are being terminated by the seller at the close of escrow and hired brand new by the buyer.
This includes whether or not any unpaid holiday pay goes directly to the employee from the seller or from the seller to the buyer who wants to keep that pay and use it as leverage to make sure the employee doesn’t request time off as soon as the buyer takes over the business and makes it harder for the buyer.
If there are any Independent Contractors make sure this is correct, especially for the purposes of Workers Compensation.  If the seller had misclassified a worker as an independent contractor and the Workers Compensation Appeals Board reclassifies them as an employee, the employer is subject to penalty assessments and Stop Orders for failure to secure Workers Compensation coverage.  The Stop Order will include up to 10 days wages for workers losing time while the employer obtains Workers Compensation coverage.  The buyer simply doesn’t need this headache.

Escrow

Putting the business through a third party escrow process is critical for both buyer and seller.  It does add an extra cost but the escrow company’s responsibility is to ensure that the assets of the business move from the seller to the buyer free and clear, all liens are removed and clearances are obtained for government agencies that all taxes and with-holdings are up to date.  I closed a deal some time ago where the seller owed a supplier some money for cabinets installed in the business.  The supplier hadn’t filed a lien and some weeks after escrow found the business had changed hands and came to the buyer looking for the $50,000 he was owed.  Because the buyer had used the escrow service the supplier had no claim against the buyer and the problem was quickly and easily resolved; for the buyer.

Escrow helps both parties so don’t go without it.

If you would like more information about buying a business please visit my webpage Buy a business; or buy a copy of my book Successfully buy your business.  If you would like more immediate help with buying a business you are welcome to send an email to Andrew Rogerson; or give me a call on 916 570-2674.