Due Diligence Tips for Buying a Business – Part 1

Demystifying Valuation, Economic Damages + Forensic Accounting

Leonard and Sylvia Buy a Business

Leonard and Sylvia sold their sheet metal manufacturing plant in Pittsburgh and decided to move to sunny Phoenix, Ariz.  They wanted to buy another business and, through a business broker, found a high-tech electronics manufacturing company that was for sale.  Leonard and Sylvia thought “manufacturing is manufacturing,” whether it was of the sheet metal or high-tech kind, and that if the price was right, they could easily handle this particular business.

Leonard was a competent manager of his last business, even though he had little training or experience in accounting.  He had always used qualified accounting personnel to work in his business back in Pittsburgh and relied on them to aptly handle all accounting matters for his company.  Sylvia didn’t have much to do with the company in Pittsburgh, even though she had two years of accounting courses taken several years ago at a local community college.

Leonard and Sylvia met with the owners of the high-tech company and started the negotiations for purchase.  Leonard and Sylvia decided they would personally perform the “due diligence” for this potential acquisition, rather than hire an experienced CPA to do the work.  After spending two days at the target company touring the plant, interviewing the sellers and other key operating personnel, and reviewing past financial statements of the business, Leonard and Sylvia made an offer of $4 million.  Leonard and Sylvia liked the sellers, a father and two sons, and considered them to be pretty down-to-earth, charming and forthright.  After some haggling back and forth, the sellers and buyers agreed to a price of $4.3 million.  Leonard and Sylvia wrote a check to the sellers for the entire amount.

Something Fishy

After taking control of the acquired high-tech company, Leonard and Sylvia soon learned that the some of the purchased trade receivables were being disputed by customers.  They also discovered many receivables had been outstanding for a much longer period than reflected on the receivables aging report, and the potential collection of the overall receivables was about 30 percent less than what Leonard and Sylvia originally thought.

Inventory was found to contain old and obsolete items that were worthless.  As a result, almost one-third of the inventory would have to be written down on the books.

Three pieces of purchased manufacturing equipment could not be located.  A lease for another large piece of equipment could not be transferred to Leonard and Sylvia due to restrictions by the lessor.  They would have to purchase the equipment, or find another lessor of the equipment.

Legal Battles

Leonard and Sylvia initiated legal action against the sellers for intentional misrepresentation of the financial information regarding the assets of the business.  The legal battles went on for more than two years.  By the time Leonard and Sylvia had spent more than $100,000 on legal and accounting expert fees, the sellers had spent most of the money they had initially received from the sale of the company.  They had few assets from which Leonard and Sylvia could receive restitution should they be fortunate enough to win their litigation case.  Leonard and Sylvia decided not to pursue the matter any further.  In the end, they had lost several hundreds of thousands of dollars of their original investment the day they took command of their new business.

Summing it Up

The story of Leonard and Sylvia is one that is repeated over and over by buyers of businesses throughout the country.  Too many times, buyers believe they are able to perform all the necessary due diligence steps when buying a business – even if they have possessed little or no experience with the due diligence process.  And, too often, a story similar to that of Leonard and Sylvia occurs.

If you are looking to purchase a business and you believe you are qualified to “kick the tires” of the targeted business, the next post will provide some tips that may save you disappointment after the deal is done.