Due diligence is the thorough investigation of the company or business that you wish to buy to make sure that the information and assumptions that you are basing your decision on are valid. It is the business equivalent of taking a used car to a mechanic and having it thoroughly checked out, then taking it for a test drive under different road conditions, and then making absolutely sure that the seller owns the car outright and has the ability to sell it.

Your due diligence review of the selling company should include both financial and legal due diligence. At the beginning of the process, you should deliver a Due Diligence Request List to the seller that asks for copies of all the material you and your advisors wish to review, including the seller’s financial books and records, incorporation documents, minute books and share registers, title to assets, material contracts, and litigation documents. The investigation will also consist of interviews with the seller’s senior management personnel and professional advisors, which often turn up important issues that the document review does not, as well as site visits to verify ongoing business operations and assess potential environmental liability and other concerns.

Even if you are experienced in business, your due diligence investigation should be performed, or at least assisted, by experienced financial and legal professionals who know what they are looking for. If you buy a company with an unknown liability or one which did not have the legal ability to transfer all of its assets and operations to you, it could have drastic ramifications on your own business, not to mention your personal financial well-being. Another reason to have professionals conduct these investigations is it provides a buffer between the two management teams, which helps maintain the good relations necessary to operate the combined businesses in the future.

Financial due diligence will seek to ensure that the selling company’s balance sheet and results of operations are accurate and contain all material information about the financial health of the company. It will also make sure that the assumptions underlying any financial projections the seller has provided, as well as the assumptions underlying your own financial analysis of the company in valuing the business, are valid. Finally, it will review the selling company’s financial and accounting systems and policies to assess how difficult it will be to combine the operations of the two companies.

Even though the material reviewed during the financial due diligence process is mainly historical, the investigation should always be forward looking. For example, with respect to the seller’s income statements, the financial due diligence investigation should focus not only on whether the historical earnings are correctly stated, but also whether those earnings are sustainable in the future. The persons performing financial due diligence should therefore analyse such things as whether the business relies on a few key customers and how stable those customers are, as well as whether non-recurring sales and other events drove up past profits.

With respect to the assets reflected on the selling company’s balance sheet, financial due diligence will look to whether the value of key assets is accurately stated and whether those assets will be available for future use. A review of the liabilities will also assess whether they have been valued properly, as well as whether all contingent liabilities such as ongoing lawsuits have been disclosed and adequately reserved for. It is also extremely important to investigate potential tax liabilities, as well as unfunded employee benefit and pension liabilities.

In addition, the financial investigation will study the company’s historical cash flow statements and current cash flow situation to assess its ability to generate cash in the future, as well as what additional financing requirements the business will have following the acquisition. In this regard, both the financial and legal due diligence team will review whether the seller’s outstanding bank loans, lines of credit, etc. can or should be kept in place. Finally, the financial due diligence investigation will review the selling company’s accounting systems and policies to assess whether the financial statements can have confidently relied on, the compatibility of the buyer’s and seller’s systems, and future changes and consolidations that will need to be made.

Your legal due diligence advisors will look to whether the selling company actually owns the assets it purports to own, whether the contracts and licenses it operates under are valid and transferable, whether its contracts with customers and suppliers are on terms that are acceptable and sustainable, whether it is in compliance with applicable regulatory requirements, and the risks involved in ongoing or potential claims or litigation.

For example, the legal due diligence team will take a close look at the intellectual property used by the seller to make sure it is the true owner of its trademarks and technology, or at least has a valid and assignable license that will be available for use in the future. They will also review the company’s leases and loan agreements to determine whether the terms are acceptable and whether the sale of the company will result in either being terminated.

Another key area included in the legal due diligence review is the selling company’s corporate books and records. The buyer’s legal due diligence team will look closely at the selling company’s Memorandum and Articles of Association, filings with the CRO, annual returns, share registers and minute books to make sure that the company has been properly incorporated, shares have been validly issued, and all matters that required board and shareholder resolutions were approved. They will also review all agreements regarding shareholders, directors and management personnel, including voting, employment and non-competition agreements. You don’t want to find out after the deal closes that the sales executive you intended to let go has a golden parachute agreement that will cost you a year’s profits.

Throughout the due diligence process you should take the attitude of “Buyer Beware” and should not only rely on the representations, warranties and indemnities included in the purchase agreement. It is always better to know about problems before the deal closes, because attempting to collect indemnification afterward is always uncertain and requires a considerable amount of time and expense. Running a business is hard enough as it is, you don’t want unpleasant surprises from a business you purchase, and that is why due diligence is so important.

The due diligence investigation, however, is only one of the steps required at beginning of the process of buying a company or business. Another is to decide whether to buy shares or assets. Next we will discuss the purchase of all or a majority of the selling company’s shares, either directly or by merger.