Due Diligence when Purchasing a Company

When investing in an existing company, make sure your accountant gives the books a thorough going-over. March 18, 2006

What is a reasonable level of due diligence when purchasing shares of a company? A comparison of the general ledger to the financial statements does not seem excessive to me, so what would cause this to be deemed excessive by the owners? A Letter of Intent has been signed; thousands of dollars spent, and lawyers and accountants have been involved.

Forum Responses
(Business and Management Forum)
From contributor A:
This is a no-brainer. If they won't show you what you are buying into, obviously they are hiding something. I once tried to buy a company I worked for, over 25 years ago. I knew the company had some problems but I knew what they were and could fix them. After my accountant got done going over all of the books and doing the comparisons, it turned out that the stock of the company actually had a negative value. His suggestion was to forget it and start my own company, which I did.

Sure, the place made money. It supported seven workers and the owner, but the owner always ran the business in the red or at break even, deliberately. He and his bookkeeper did not like the fact that my accountant found that out, and I backed out. Not buying into that company was the best thing that ever happened to me. They closed a few years later and the place is now a parking lot for a hospital.

From contributor B:
I don't see how you can buy a business without seeing the books. If the financial statements are audited by a CPA then you can rely on them.You could counter with a contingency, to the effect that in the event that detail requested at time of sale is not accurately represented, the seller agrees to reduce payments by x (based on a multiplier of net or gross and the reduction) or guarantee that you will net at least as much as he does for 3 years.

From contributor C:
How did it come to be that you were afforded this opportunity? Were these circumstances that were discussed for a period of time during your employment, or did you approach management to bring about this offer, or were you spontaneously approached by management? Is it possible that the owners are in need of cash, and have exhausted other channels of acquiring funding? Perhaps your investment will be viewed as an interest-free loan (interest free in the sense that you may not receive dividends if there is no disbursement) that does not need to be paid back until you sell your shares or leave the company.

When you are offered the opportunity to buy in but are not able to see the books, I would question what it is that they do not want you to see. I agree with the above posts, and would add that I have seen a situation where employees were asked if they wanted to buy into the company. The owner used the money for his personal benefit, and the company later went Chapter 11. It took a long time for the investors to be reimbursed. Be careful.

From the original questioner:
This situation involves purchasing all shares. We have a small shareholder group that is counting on me to do this correctly. They have their own accountant who requires full disclosure before their funds are available to allow purchase. Statements have been reviewed but not audited. Comparison to the daily ledger should be just a formality, but one that is mandatory. The company is good and makes profit but the owner has always worked in the grey when it relates to bylaws, taxes, etc. Purchase of shares makes me responsible for his sidestepping.

From contributor D:
I have been involved in closely and family held businesses, directly and as a consultant, for 25 years. And I've seen any number of ways that small business owners can doctor their books. That can include phony inventory, kiting invoices back and forth with a relative who owns another business, cutting checks that aren't mailed but are on the books to mask a negative cash position, etc. In one case, I saw a business whose books were so untrustworthy that they showed a net worth of well over 2 million when reality (after the scrub up) was upside down over $800,000. Trust your gut. Walk away.

In a purchase, due diligence goes as far as necessary to protect the buyer. And let the buyer beware. Someone talking to you about trust during due diligence should be sounding sirens not just warning bells. Like good fences making good neighbors, intense due diligence makes for happy buyers and sellers after the deal is done. My very best advice is walk away. If you are still intent on buying this business (probably because you have more of an emotional investment than the current owner) then smile, tell him that you're getting all sorts of good advice on how to make sure you remain friends after the deal is done, and keep pressing. Next step: your own independent audit of the books including a valuation of the assets and a 100% physical inventory.

From contributor E:
Get a lawyer involved, and get an accountant involved. Get five years of income tax returns. Form a new company. If you buy the shares, you also buy the liabilities past, present and future. For example, what if there is an IRS audit scheduled? Buy the assets into the new company. Buy the name of the old company if it is good and well known, and use it as your trade name; i.e, new company d/b/a old company name. They can change the name of the old company and close it when they are ready. Don't forget a non-compete clause. The first two points are the most important.