What is Due Diligence and How do You Perform it?

by Tim Parker

What does due diligence mean? It's a term that most people use in relation to buying a business. But that's not the only time it's important. Here's what you need to know about doing due diligence.

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Business is filled with terms thrown around as if everybody understands their meaning. Due diligence is one of those terms that you may understand on the surface but don’t know how to put it into practice. Let’s learn about due diligence and how to use it in a real world setting.

What does due diligence mean?

The dictionary definition says that due diligence is, “the care that a reasonable person exercises to avoid harm to other persons or their property.” In plain English, it is simply doing your homework. Before putting your business funds to work on anything, you should make yourself an expert. Often, due diligence is used to describe the investigation done before purchasing another company so let’s start there.

How do I perform due diligence?

Let’s assume that you are planning to buy out one of your competitors who is retiring. The business is attractive to you because it’s perfectly positioned in an area of town that is tough for your business to reach. Before you purchase the business, you (often with the help of professionals) will perform due diligence.

  • Does the business have healthy cash flow?
  • By looking at the books, can you tell where the revenue stream is coming from?
  • If the company has physical assets, are they valued correctly and fairly?
  • Are there any hidden liabilities?
  • How reliable are its financial projections and what multiple is it placing on those earnings?
  • Are the company documents complete? (Articles of incorporation, board meeting minutes, tax registration, etc.)
  • Is the business up to date on its taxes?
  • Does it lease property? If so, when does the lease end?
  • What insurance information is provided and what is covered?
  • Are there complete employee files including salary and benefits?


Of course, this is a very short list of the due diligence that would take place before purchasing another business but maybe you are not in the market to purchase a business. Maybe you’re planning to purchase a new building, add a new vendor or product line. There are plenty of decisions you are likely to make where proper due diligence is key.

Purchasing Commercial Property

  • Environmental Concerns - Does the property contain hazardous materials like asbestos, lead paint, or radon? If it does, have assessments done on the costs to mitigate the hazard. Does the property sit on a flood zone, active fault-line, or protected environment? 
  • Location - What are the mineral, gas, and oil rights to the property? How much traffic will pass by your business each day? Is it easy to enter and exit? Is there enough parking?
  • Building inspection - A qualified building inspector will perform the inspection for you but, in the meantime, are there any liens on the property? Were all contractors who worked on the property paid by the previous owner?
  • Code Compliance - Does the property comply with all building safety, and zoning codes?
  • Performance Data - How did the current owner perform in this space? (obtain business information like profit/loss statements if possible)

Adding a Vendor

  • Is the ordering process easy and straightforward?
  • Do they have multiple warehouses in case a product is out of stock at one site?
  • Is a warehouse close enough that shipping costs will be minimal?
  • From the time of the order, how long until it arrives at your door? 
  • How often do they bill and what are the terms?
  • If the company is manufacturing products for you, are they large enough that you can feel confident that any money paid upfront is safe?
  • Are they willing to put special pricing in writing?

Adding an Employee

  • Ask for three references and personally verify at least two.
  • For professional positions, verify that the person has the credentials they listed on their resume. Ask for copies of degrees, certifications, and experience. When checking references, verify that they worked in the capacity listed on their resume.
  • Test their skills to assure they have core knowledge. Make a test on your own or check with your industry trade group about ready-made assessments.
  • Psychological testing is important for high stress positions. (More information here.)
  • Perform a background check.
  • With the candidate’s permission, perform a credit check if the position involves access to financial accounts or other related position.
  • Conduct an interview and ask another trusted person to conduct another.

The Hard Truth

Due diligence is time consuming, inconvenient, tedious, and sometimes expensive. It goes beyond the basic checks you would normally make and it’s safe to say that if you didn’t find it to be about as fun as going to the dentist, you probably didn’t do it right. You should know just as much about the business or person as you do about your own business.

Bottom Line

Above, we’ve outlined a brief overview of some of the due diligence questions you might answer when performing these common business activities. For other decisions, produce a checklist of your own and make sure to include the needed experts. Even if you’re in a financial field, you aren’t necessarily skilled at evaluating a company’s books, for example. It’s better to spend a little money now to avoid costly mistakes later.

© 2013 Attard Communications, Inc. All Rights Reserved. May not be reproduced, reprinted or redistributed without written permission from Attard Communications, Inc.

 
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