Types Of Due Diligence and why do it

Types Of Due Diligence + Why You Must Do Due Diligence When Buying a Business

By Russell Bowyer

One of the most important elements in the process of buying a business, is the due diligence you do on that business.

The types of due diligence to do before buying a business include legal, commercial and financial due diligence. It’s important to do due diligence before buying a business, as it helps you assess whether to buy the company and reduces the risk of you incurring costs once you’ve bought the company.

Due diligence is the checks you make, before you buy the business, and these are checks you can ask professional advisors to do on your behalf, or, you can do them yourself…if you know what you are doing, of course.

Due diligence is like test-driving a car, before you decide to buy it.

And…Just as you would want to check if the car runs well; you check if it has all the features you need; you check it doesn’t have outstanding finance on the car, and; check it’s in good condition, etc., business due diligence involves thoroughly examining the company, to ensure it meets your criteria, that the business is as it’s described, it’s making the profits disclosed on the accounts, taxes have been paid, and so on, before, you commit to buying it.

In the words of President Ronald Reagan; “trust, but verify!

It’s very important not to skip this step when you buy a business, as you never can trust whether or not an owner has lied, or, if they’ve lied by omission, and they’ve not told you something about the business, that could impact the company significantly, under your ownership.

Due diligence, is normally one of the last things you’ll do, before you buy a business, and whilst you can never remove all risks, no matter how much checking you do, and, you can never be 100% certain to uncover everything during the due diligence process, the due diligence process is designed to protect you as far as is possible, from making costly mistakes, when you buy a business.

But on the other hand, because you can never be 100% certain to uncover everything during the due diligence process, this is why you must always have backup warranties and indemnities in the sale and purchase agreement as well…or certainly you should do!

What can go wrong even if you do due diligence?

When I bought my business, probably about 6-12 months into my ownership, I discovered a problem that hadn’t been disclosed to me by the seller, and that wasn’t pickup by me in the due diligence process.

I’m sure he was probably aware of the problem, at the time he sold the business to me, but his withholding of information, I accept falls into the category of “lying by omission”.

To put this in context, the business I bought was a fitted furniture business. And as part of nearly every set of furniture the business installed, in customer’s homes or businesses, the furniture had doors fitted to it.

A large percentage of the doors we fitted, were what’s known as vinyl wrapped doors. What this means is they were made from MDF, and the MDF was covered in a vinyl material (or wrapped in vinyl).

The vinyl was glued to the MDF in a process to make the doors, and the problem that came to light, was where the covering was coming away from the MDF, because of a faulty batch of glue.

This became known as door delimitation.

As it happened, these doors were outside of the warranty the customers had on those doors, and the supplier’s warranty too, which meant it also fell outside the warranties given to me, by the seller of the business in the first place.

But I decided in this case to be pragmatic, and to maintain the very good goodwill the business had, I did a deal with the supplier to buy replacement doors at a lower than normal price, and I offered to replace these doors free of charge in any event.

As this was a large business making profits in excess of £100k, so a few thousand pounds or dollars to fix the problem, wasn’t a huge loss to the business, but was a big gain in terms of keeping the goodwill in place.

The lesson here in buying a business, was also my lack of industry knowledge, but as with anything, there are always disadvantages, as there are advantages of buying a business in an industry you know nothing about.

But also, in my opinion, the test that all good businesses should do, is to ask themselves this question, but from the customer’s perspective; “do you consider the item you’ve sold, should last longer than the period within which it failed?”

To give you an analogy using the car purchase again, if you purchased a new car, and let’s say the gearbox failed within the first 5 years of ownership, is that reasonable, assuming you’ve not done excessive miles at this point?

Would you expect this to happen to a relatively new vehicle? I suggest not. 

Which means that subject to the warranty period on the vehicle concerned, and, assuming the warranty period has expired, for this example to make sense, I suggest the manufacturer should replace the gearbox, as the original one wasn’t “fit for purpose” in the first place.

So, back to due diligence…

By highlighting what can go wrong, when you buy a business, and what can come to light, once you are the new owner, is also another very good reason why you should never pay the owner all the sale proceeds upfront.

It’s far easier to withhold money than it is to get it back! Especially if the owner has moved overseas!

Now that you understand the due diligence process, and why it’s important to do, let me cover the types of due diligence, that are relevant to buying a business.

There are three types of due diligence, which include:

  • First is legal due diligence – which I suggest you ask your solicitors to do, especially if there’s a property purchase involved with the transaction.
  • Second is commercial due diligence – this will include, doing your research on the industry (or sector) the business trades in, be it a growing market, a normal or stable market, or a declining market, researching the company on Google reviews and other review sites specific to the company or business sector, perhaps carrying out a mystery shop, getting an understanding of how the business gets its customers in the market…and so on.
  • Thirdly is financial due diligence – this is normally carried out by accountants, but if you know what to look for, and you know what to do, there’s no reason why you can’t do this yourself. Doing your own financial due diligence will save money on the transaction, and should the deal fall through, this will minimise any aborted costs, should your checks reveal any deal-breakers that render the deal, not worth pursuing. This happened to me on a few occasions at the due diligence stage of buying a business, and meant I saved thousands of pounds or dollars, because I’d done the work myself.

One of the benefits of doing due diligence, other than to give you peace of mind that the business is sound, and to reduce the risks involved in buying a business, is that it can also lead to a renegotiation of the deal, because of what is found.

In the end, you want to feel you have done all the checks necessary, to give you the peace of mind, that the price you pay for the business is fair, and that there are no significant costly skeletons in the closet that could appear after you’ve bought the business.

If you have any other questions on this topic about buying a business, or on any other aspect about the process involved in buying a business, please drop a comment below.

And always remember that no question is a stupid question, if you don’t know it, you don’t know it, and by having the answer to a question you have, might be all it takes to move to the very next step in your journey to buy a business.