4 Reasons to Do Due Diligence When Purchasing a Business

Nearly every business owner has heard the phrase ‘fail to prepare or prepare to fail’. Business is all about ensuring sensible decision-making and not rushing into rash decisions. Due diligence plays a crucial role in doing so when an individual makes inquiries into a business purchase. This article will explore why an effective due diligence process is necessary when purchasing a UK business. This will ensure you enter any UK company purchase with full knowledge of the target business’s strengths and weaknesses.

What is Due Diligence?

Due diligence involves a potential buyer thoroughly reviewing a business’s financial, commercial and legal documents.  Doing so provides a prospective purchaser with sufficient knowledge of the legal and financial standing of the company so it can adequately value the purchase price. The scale of due diligence depends on the size of the company you are purchasing. Some prospective buyers will review the documents themselves if the relevant business is small. However, larger companies’ potential purchasers usually seek advice from legal and financial advisers. This is because the due diligence process involves the request and review of complex documentation and follow-up queries. For larger companies, this process can take weeks or even months.

Why is Due Diligence Useful?

Practically every financial adviser and corporate lawyer will advise prospective purchasers to carry out reasonable due diligence.

What is ‘reasonable’ will depend on the size and nature of the business. The buyer for a large chain of department stores will require more information than purchasing a single cafe. 

Realistically, a lawyer or financial expert will want to request and obtain sufficient information to ensure you enter any business sale with full knowledge of its strengths and weaknesses.

We will now consider four critical reasons to conduct effective due diligence when purchasing a UK business.

Ensures Full Knowledge of Business Finances

Naturally, if you wish to purchase a business (rather than a charity), your starter questions will likely include ‘does it make money?’ and ‘will it make money in the future?’

Simply asking the company seller is unlikely to provide you with much assurance as, frankly, it is akin to asking a homeowner whether their neighbours are nice. Their neighbours could be difficult and have house parties at 11 pm every night, but they will likely gloss over this to achieve a sale.

Because of this, you should take all comments about income and profitability with a pinch of salt until you have fully reviewed their incomings and outgoings over a relevant period.

Enables Relevant Questioning of Sellers

Most due diligence processes involve sending supplementary questions to the company sales.

So, for example, if there is an unexplained debt of £50,000 within the financial accounts, you (or your lawyer) are likely to query the reason for the debt and the debtor’s identity. It would also be helpful for you to obtain a copy of the relevant paperwork regarding the debt.

This is akin to purchasing a second-hand car. You want to turn up and inspect the vehicle in and out and, if you notice any imperfections, question the buyer at the time. Naturally, finding out that the company is less profitable than otherwise alluded to may allow further negotiation of the sale price.

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Allows Discovery of Deal-Breakers

Every prospective company buyer has red flags regarding potential new business ventures.

You may only wish to invest in companies that clearly have enough assets and current income to meet their outgoings for the next 12 months (sometimes known as a ‘going concern’). Alternatively, you may want to avoid purchasing any business with poor or irregular financial accounting.

Whilst every prospective business purchaser will have different deal-breakers, the most common examples include the following:

1. significant financial risks to the company (such as the company facing a winding-up petition);
2. unrealistic projections of future profit without sufficient evidence between those calculations;
3. overvaluation of physical and non-physical assets (which may artificially inflate the value of the business); and
4. incomplete or missing financial documentation.

The above examples lead to questions concerning business operations and the company’s strength.

Protects Your Significant Financial Investment

It goes without saying that purchasing a business is never a small investment. Even within the odd situation where an individual buys a football club for £1, they immediately inherit a hefty wage bill and weekly outgoings.

In this way, you must focus on more than the purchase price but also the ongoing costs and risks from that point onwards.

Ignoring due diligence and going on gut feeling alone can have high costs to your finances, health and time.

Key Takeaways

The importance of due diligence is a well-known fact akin to individuals knowing they should wear a seat belt in a car.  Whilst it may not be the most glamorous of tasks, it can help protect you from danger down the line.  Given the importance of due diligence and the hefty financial risks involved in a foolhardy business purchase, most individuals obtain professional advice.

If you need assistance carrying out an excellent due diligence process, our experienced business sale lawyers can assist as part of our LegalVision membership. For a low monthly fee, you will have unlimited access to lawyers to answer your questions and draft and review your documents. Call us today on 0808 196 8584 or visit our membership page. 

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