Due diligence for ordinary folk

If you've heard of due diligence before it probably conjures up images of horrendous legal and accounting bills, months of arduous research and haggling and multi-million (or billion) dollar mergers. Forget all that. Think of due diligence as someone looking over your shoulder to help you evaluate a potential deal. That's it. But the key word is "potential." Due diligence done after the fact isn't due diligence, it's damage control (or more appropriately "loss control").

Most times due diligence is done to help a buyer evaluate the profit potential and any hidden issues in a business purchase. But it can also be used to help entrepreneurs decide whether or not to start a new business from scratch, or to evaluate rental properties to see if they will turn a profit. Banks are also big due diligence clients when it comes to making loans (if they do it in house instead of hiring a CPA or attorney they call it underwriting).

So why don't people perform more due diligence. The simple answer is money. It's not cheap to pay someone to slog through business records, invoices, insurance policies and financial statements. But consider this. You are thinking of buying a retail establishment. The current owners claim average sales of $50,000 per month with gross margins of 30%. You pay a CPA $5,000 to evaluate the seller's books and verify their claims of profitability. Among other things the CPA finds out margins are 28% instead of 30% meaning the bottom line profit is $12,000 per year less than the sellers claim. If the asking price is based on a 3 year earnings multiple the price just dropped $36,000. Not a bad return for your $5,000 investment in due diligence.

But due diligence should also ask some pragmatic questions that help protect you from surprises after sale. For instance, will suppliers give you the same terms and prices as the previous owner or will they require you to go COD with fewer price breaks and comps? Was the previous owner's insurance adequate or were they cutting costs with a greater risk tolerance than you are comfortable with? Was the previous owner's debt or corporate structure such that they were able to avoid costs that you cannot, costs that could make the difference between a profit or a loss?

The point of my little sermon here is that if you are thinking about spending money to buy a business, to purchase a rental property or to start a new venture it really is smart to have someone in your corner asking tough questions and approaching the subject with dispassionate objectivity.

One final note...if a business broker tells you there's no need for due diligence run, don't walk, to your CPA's office. They might be nice, they might be 'good people' but business brokers get paid to sell businesses. Enough said, I'm off the soap box now.

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