Introduction to Due Diligence: How to Evaluate the True Worth of a Business: Due Diligence 101 or What You Don’t Know Can Kill You!

This article is written as a general discussion on the subject of Due Diligence and how to evaluate a small business for purchase. It is for informational purposes and not intended to be a definitive guideline for your exact situation. You should consult the appropriate professionals with regards to your specific transaction or situation. Further, this article is in no way advocating, suggesting or implying that anyone engages in any type fraudulent activities whatsoever. These are simply things a buyer should be aware of when doing Due Diligence in buying a business.

Is this you? You have just spent months finding the right business. The seller says that you cannot go by what the tax return shows but he insists that the business is making a lot of money, and he can prove it. Your inspection of the profit and loss statement shows that sales have been increasing slightly in the last few years. Most important, and the best news of all is; the price is right! Does it sound too good to be true? I am sorry to tell you this, but it probably is.

I think it was Benjamin Franklin who said, “A fool and his money are soon parted.” Mr. Franklin must have known a lot of business buyers. When you buy an appliance that breaks in a month, it costs you a few dollars. When you go to a swap meet and are cheated because the solid gold watch is really gold plated, it costs you a few hundred bucks.

Different Types of Fraud

When a used car salesman cheats you, by selling you a lemon, where the speedometer has been turned back 100,000 miles, it costs you a few thousand dollars. Getting cheated buying a business can cost you hundreds of thousands of dollars. The only investment or purchase that I know of where you can be cheated out of more money then this is in the area of real estate, because real estate fraud can run into the hundreds of millions of dollars. If we include fraud connected to the US Government it can be billions of dollars.

You would be shocked at all the people between 1875 and 1950 who saw ads for prime real estate in Florida and bought swamp land sight unseen. What about prime Louisiana beach front with alligators living outside your front door? I have written a series of articles on real estate fraud and as I get older the series keeps getting bigger and bigger.

I hope that the point is made. Never buy a business on someone’s word. Actually, you should never buy anything on someone’s word. Confirm everything, believe nothing and understand that regardless of how careful you are, you are still going to find out things, after the close of escrow, which are going to surprise you. A similar example is one known by every employer.

A staff member worked for a company for four months and complained to the personnel officer that the job was just too difficult. He kept complaining that he needed more training and lower quotas. You felt sorry for him. You talk to him and talk to him about it. You listen and believe all the excuses he gives you for his poor production.

Finally he quit, blaming you for something that you did. This is the day before you were going to give up and fire him. Then you started to take over the work of finishing his incomplete projects. You are shocked, as you always are, at what he did wrong and even more surprised at what he had covered up, that he was not doing. This is what happens when you buy a business. You find out all the actions that the seller, not his staff, had stopped doing, from the day that he decided to sell the company.

Introduction to Business Due Diligence

Many of the businesses, for sale, are doing well. Even so, sometimes the owners have personal things going on in their home life that is drastically influencing the business. Sometimes they have medical problems. Over half the time the business is not doing well and the seller is frustrated.

It is very common for a seller to work hard to build his business, but because of many reasons, it doesn’t produce what the seller wants. He gets frustrated and one day he gives up. That is usually the day he calls that business broker he met and asks the big question. How long will it take you to get me out of this place? From that moment forward, in his mind, he is gone. He just counts the days until he physically walks out.

Have I scared you? Good, that is what I am trying to do. Do not despair; there is a plus side. It is worth all the grief that you go through to buy a business when you get in to the drivers seat, put all the marketing actions into high gear and start driving your own business.

In 2000, I had a client buy a car-wash soap manufacturing business for $2 Million dollars. The seller swore it was making $500,000 profit per year. Due Diligence showed it was only making $300,000. When presented with the auditors report, the seller claimed the audit was wrong. The buyer bought the company regardless, knowing he was overpaying for the business. Why? He had done his research on the production department and sales department. He went out on the deliveries with the drivers, and met customers. He determined that he could double the sales and profit within one year. After he bought the business he found two things to be true:

  1. The profit was $300,000, as my audit found.
  2. He could double the sales and profit within twelve months, and did.

The seller tried to screw the buyer, but in the end, justice was served. The seller screwed himself more than he screwed the buyer by not running his business correctly. If he had he could of sold it for a lot more than $2 Million dollars.

Conclusion

It is a hard life when you own your own business; you work long hours. Many people feel that is better than the alternative, which is to work for someone else, pay high taxes, never know if you will be laid off and after years of hard work, never have anything to show for it all.

If you are going to buy a business with your hard earned money, you want to make sure you get what you paid for. Many people believe it is all right to cheat the taxman but otherwise are very honest citizens. Others feel it is all right to cheat any poor sucker that comes along. Don’t be a sucker, do your Due DiligenceDue Diligence and get what you are paying for.

Then build your new business into something you can be proud of and enjoy. While building your new business, I suggest you make it a point to study everything you can about tax planning, tax avoidance and reducing taxes legally.

I started in college learning about the tax codes only to find that there are so many ways to save taxes legally, you would never believe it. You will sleep better at night, I promise you if you run your company “by the book”.  Then ten to twenty years from now when you want to sell your business, you can ask top dollar and get it. This is because a buyer can do a simple business evaluation and clearly see that your business is doing exactly what your books say you are doing.

My advice is to always have someone other than yourself review any business you want to buy, because everyone when buying a business wants it to be the business of his or her dreams and therefore may close one eye to the obvious. So please have Due Diligence completed by a qualified person, making owning your own business a pleasant and rewarding experience!

Due Diligence defined: The phrase is composed of two words. Due, which the dictionary defines as “proper or adequate” and Diligence, which is defined as “Degree of care or caution expected of a person. Especially as a party to an agreement.” Caution: is the watchword in this definition.

Creative Commons Attribution: Permission is granted to repost this article in its entirety with credit to Business Buying Services and a clickable link back to this page.

 

Image credit: tadamichi iStock
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