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Buying a Business: Due Diligence Checklist

Due diligence checklist

Fortune favors the bold, something true in the business world. Deciding to purchase an existing business is a big step, indeed. Regardless of whether the deal is structured as an asset transaction, a stock transaction, or a merger, make sure you know what you are getting into. As a potential new business owner, you should understand that in order to fully understand the finances and legal issues, you need to do your due diligence.

This article helps you understand the due diligence process by providing a due diligence checklist. This is a list of detailed information or documents you should review from the small business seller. From small business operations to finances, use this checklist to leave your risks at a minimum.

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Organization and Good Standing

These documents should give you an initial overview of the company:

  • Articles of incorporation and all amendments
  • Company's bylaws and all amendments
  • Minute book, including all minutes and resolutions of shareholders and directors, executive committees, and other governing groups
  • Organizational chart
  • Shareholders list and the number of shares held by each
  • Copies of agreements relating to options, voting trusts, warrants, puts, calls, subscriptions, and convertible securities
  • Certificate of good standing from the secretary of state of the state where the company is incorporated
  • Active status reports in the state of incorporation for the last three years
  • List of all states where the company does business and annual reports for the last three years
  • List of all states, provinces, or countries where the company owns or leases property
  • List of all states, provinces, or countries where the company has employees or conducts business
  • List of all assumed names and doing business as (DBA) names and copies of registrations of each

These initial documents are important. If the company was not active with the secretary of state when it signed a contract, then that contract could be void. You should make sure you know these things before buying a small business.

Financial Information

Before you dive into reviewing financial documents, make sure you understand the basic terms used. These include:

  • Audited financial statements for three years, together with auditor's reports
  • Most recent unaudited statements, with comparable statements to the prior year
  • Auditor's letters and replies for the past five years
  • Business credit report, if available
  • Any projections, capital budgets, and strategic plans
  • Analyst reports, if available
  • Schedule of all debt and contingent liabilities
  • Inventory schedule
  • Accounts receivable list
  • Accounts payable list
  • A description of depreciation and amortization methods and changes in accounting methods over the past five years
  • Any analysis of fixed and variable expenses
  • Any analysis of gross margins
  • General ledger
  • A description of the company's internal control procedures

You can review more business finance topics if anything stands out to you in your review. Requesting the help of a certified public accountant or a business broker is also helpful.

Physical Assets

Not all businesses will have physical assets, but most will. Even online companies may have equipment like computers or inventory. Among them are:

  • Schedule and locations of fixed assets
  • All Uniform Commerical Code (UCC) filings
  • All equipment leases
  • Schedule of sales and purchases of major capital equipment during the last three years

Understanding the depreciation value of these physical assets is also important when you determine the valuation of the business you want to buy.

Real Estate

Evaluate physical property, like land and buildings, during this process. Included are:

  • Schedule of the company's business locations
  • Copies of all real estate leases
  • Copies of deeds
  • Copies of mortgages
  • Any title policies
  • Land or building surveys
  • Zoning approvals, variances, or use permits

If purchasing the real estate with the business, make sure the business has a clear title of the property and actually owns it.

Intellectual Property

Intellectual property is valuable to a small business owner. When buying another business be sure to look for these:

  • List of all past and current patent applications
  • Schedule of domestic and foreign patents
  • List of all past and current trademarks and trade name applications
  • Schedule of trademark and trade names
  • Schedule of copyrights
  • A description of important technical know-how
  • A description of methods used to protect trade secrets and know-how
  • Any work-for-hire agreements
  • Copies of all consulting agreements, agreements regarding inventions, and licenses or assignments of intellectual property to or from the Company.
  • Any patent clearance documents
  • Schedule and summary of any claims or threatened claims by or against the company regarding intellectual property. This includes cease and desist letters.

Make sure to talk to an intellectual property attorney if there are pending claims against the business you want to buy.

Employees and Employee Benefits

Employee benefits are a large expense for any company, so you should review documents such as the following:

  • List of employees, including positions, current salaries, salaries, and bonuses paid during the last three years, and years of service
  • All employment, consulting, nondisclosure, nonsolicitation, or noncompetition agreements between the company and any employee
  • Resumés of key employees
  • Personnel handbook and a schedule of all employee benefits and holiday, vacation, and sick leave policies
  • Summary plan descriptions of qualified and non-qualified retirement plans
  • Copies of collective bargaining agreements, if any
  • A description of all employee disputes within the last three years, including alleged wrongful termination, harassment, and discrimination
  • A description of any labor disputes, requests for arbitration, or grievance procedures currently pending or settled within the last three years
  • A list and description of benefits of all employee health and welfare insurance policies or self-funded arrangements
  • A description of the worker's compensation claim history
  • A description of unemployment insurance claims history
  • Copies of all stock option and stock purchase plans
  • Schedule of grants of stock options and stock purchase plans

Knowing the existing team of employees before purchasing a business can help you understand your new team and begin on good terms.

Licenses and Permits

Some businesses, like the cannabis industry, require federal permits. These should be available:

  • Copies of any governmental licenses, permits, or consents
  • Any correspondence or documents relating to any proceedings of any regulatory agency

You want to purchase a business that is current on its licensing and permits.

Environmental Issues

A potential buyer should carefully review environmental documents concerning the company they want to purchase. These should include:

  • Environmental audits, if any, for each property leased by the company
  • A listing of hazardous substances used in operations
  • Description of the company's disposal methods
  • List of environmental permits and licenses
  • Copies of all correspondence, notices, and files related to the Environmental Protection Agency (EPA), state, or local regulatory agencies
  • A list identifying and describing any environmental litigation or investigations
  • A list identifying and describing any known superfund exposure
  • A list identifying and describing any contingent environmental liabilities or continuing indemnification obligations

Enlist an environmental lawyer and compliance officer to help you review these documents.

Taxes

Knowing existing and future tax liabilities helps you assess if this purchase is a good investment. The following are crucial:

  • Federal, state, local, and foreign income business tax returns for the last three years
  • State sales tax returns for the last three years
  • Any audit and revenue agency reports
  • Any tax settlement documents for the last three years
  • Employment tax filings for three years
  • Excise tax filings for three years
  • Any tax liens

Using an accountant or tax lawyer to review these documents for you would be ideal.

Material Contracts

These are contracts or agreements that are essential to the business operations and the purchase of the business and include the following:

  • A schedule of all subsidiary, partnership, or joint venture relationships and obligations, with copies of all related agreements
  • Copies of all contracts between the company and any officers, directors, 5% shareholders, or affiliates.
  • All loan agreements, bank financing arrangements, lines of credit, or promissory notes the company is a party in
  • All security agreements, mortgages, indentures, collateral pledges, and similar agreements
  • All guarantees to which the company is a party
  • Any installment sale agreements
  • Any distribution agreements, sales representative agreements, marketing agreements, and supply agreements.
  • Any letters of intent (LOI), contracts, and closing transcripts from any mergers, acquisitions, or divestitures within the last five years
  • Any options and stock purchase agreements involving interests in other companies
  • Company's standard quote, purchase order, invoice, and warranty forms
  • All nondisclosure or noncompetition agreements to which the company is a party
  • All other material contracts

Failure to produce or disclose these documents could result in voiding your agreement to purchase.

Product or Service Lines

If you are buying a business, then the products or services of that business interest you. Find out about:

  • A list of all existing products or services and products or services under development
  • Copies of all correspondence and reports related to any regulatory approvals or disapprovals of any company's products or services
  • A summary of all complaints or warranty claims
  • A summary of the results of all tests, evaluations, studies, surveys, and other data regarding existing products or services and products or services under development

Make sure you look for any product liability concerns too.

Customer Information

When buying a business, you want to ensure the client and customer list is not padded or embellished. A review should provide:

  • A schedule of the company's twelve largest customers in terms of sales as well as a description of sales in the last two years
  • Any supply or service agreements
  • A description or copy of the company's purchasing policies.
  • A description or copy of the company's credit policy
  • A schedule of unfilled orders
  • A list and explanation for any major customers lost over the last two years
  • All surveys and market research reports relevant to the company or its products or services
  • The company's current advertising programs, marketing plans and budgets, and printed marketing materials
  • A description of the company's major competitors

Too many returns on products or cancellations on service contracts could show a devaluation in the company and lower the purchase price.

Litigation

Nothing can stop a purchase faster than undisclosed lawsuits. Be on the lookout for:

  • A schedule of all pending litigation
  • A description of any threatened litigation
  • Copies of insurance policies possibly providing coverage as to pending or threatened litigation
  • Documents relating to any injunctions, consent decrees, or settlements to which the company is a party
  • A list of unsatisfied judgments against the company or in its favor

Do not skip over this step. You can always have a business attorney review these documents and complaints for you.

Insurance Coverage

Owning a business comes with business liabilityBusiness insurance policies help offset the monetary damage to the company. Look for:

  • A schedule and copies of the company's general liability, personal and real property, product liability, errors and omissions, key-man, directors and officers, worker's compensation, and other insurance policies
  • A schedule of the company's insurance claims history for the past three years

Ensure you can handle the insurance premiums in your operating budget before agreeing to purchase the company.

Professionals

Knowing the team behind the existing business helps you understand if there are any conflicts of interest before purchase. Get a schedule of all law firms, accounting firms, consulting firms, and similar professionals engaged by the company during the past five years. This helps you find a point person if you have any questions.

Articles and Publicity

The public perception of the existing business helps determine the business' value and asking price. You may find information in sources such as:

  • Copies of all articles and press releases relating to the company within the past three years
  • Copies of all online reviews relating to the company within the past three years, including social media

If you are concerned the company may delete negative comments before turning documents over, you can request they provide their entire social media file directly from Facebook or Instagram.

Consult a Small Business Lawyer To Help With Your Due Diligence Checklist

A key component of buying a business is understanding the background of the business along with the laws and regulations in its industry. Even if you don't think you need an attorney, an experienced small business attorney can help you avoid problems before it's too late.

See FindLaw's Buying a Business section for additional articles and resources.

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