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Due Diligence: What It Is and How to Do It

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Last updated on March 11th, 2019 at 05:03 pm

Due DiligenceThe term ‘due diligence’ often gets used in a business setting. In fact, it can apply to any situation.

It is something that you will almost certainly have heard of but may not be entirely sure of what it is; or how to do it.

Being able to practice due diligence is essential to assist in reducing your stress and making the right choices.

To understand why this is the case, you should gain complete knowledge of the concept behind due diligence and the best way to apply it:

Dictionary Definition of Due Diligence

Due diligence is an investigation of a business or person prior to signing a contract, or an act with a certain standard of care’.

This is the definition according to Wikipedia.  An alternative way to put this concept is to consider what action you should take before entering into a contract.

The purpose of the action is to keep you and your assets safe.In essence, completing due diligence literally means knowing who you are dealing with and minimizing any risks before you commit.

In a business sense this is generally the process adopted before you undertake a business to business commitment; you would not want to knowingly place your own business in danger.

Due diligence is also something that can be applied in real estate transactions.  You should know what you are purchasing before you commit.

The Process of Due Diligence

Understanding the concept is a good first step; you will naturally want to protect yourself, your loved ones and your assets.

However, it can be difficult to know the best way to put this process into action.

The best way to fully understand the process is by example.  In the case of purchasing a competitor’s business then you would need to complete the following steps:

  • Find out why the business is ready to sell and what potential it can offer you.
  • Consider the completion; their loyal customer following may be the best way of entering a new market sector.
  • You should examine the cash flow of the business to assess whether it has sufficient income.
  • It is also important to be able to identify these funds; businesses have been known to artificially inflate their sales when trying to sell.  This tactic can make a business look far more attractive than they actually are.
  • A viable business will have a list of assets. You will need to verify that they do belong to the company and that their declared worth is genuine.
  • Exam their accounts; you should be looking for anything which has not been disclosed.
  • Liabilities are a particular concern when purchasing a business. They can be passed on to you and leave you with a large debt.  Indeed, undisclosed liabilities can significantly alter the profitability of the business.
  • Verify all the facts by studying the bank statements; specifically all outgoing payments should be represented within the books.
  • It is essential to look at and confirm the financial forecasts for the business. The emphasis placed on these forecasts can make a significant difference to the future earnings potential
  • All filings for the business must be up to date; this will help you to confirm that the firm is being level with you and there are no nasty surprises waiting.
  • You should pay particular attention to the taxes owed, due and paid. Check that all figures are genuine.  You may not be liable for an old tax bill but you will not want the hassle involved in explaining this.
  • The business may lease property. You must clarify when the lease is due to expire.  Whilst an expiring lease can provide you with an exit if the business is not functioning as well as it should be; it can also alter the cash flow of the business significantly.
  • Insurance is essential. Check what, if any polices are included.  The current policies or new ones should cover the risks involved in running the business.
  • Alongside this you should confirm all employee records are present and up to date.

This list is, by no means, exhaustive.  There are steps which will be unique to the business transaction you are undertaking.

You must look at every aspect of the business to ensure there is no risk that you are not aware of.  You will not be able to purchase a business without risk; but you can take steps to minimize that risk.

Property

Instead of buying a whole business, you may find yourself looking to acquire a second business premises; or even relocate your existing one.  Due diligence in this instance will involve:

  • Inspecting the building properly. The safest way to do this is to use a qualified inspector.  This will help to identify any issues with the property.  They can also establish whether all past contractors have been paid and whether there are any outstanding liens on the building.  An important part of this process will also be ensuring that the building complies with the relevant building code.  You do not want to run into issues with zoning or safety the moment you complete your purchase.
  • The location of the property is important. It should be near main supply routes; this will allow your suppliers to get to you.  You will also need to confirm that the necessary power facilities are already on the premises.  Electricity and gas will probably be essential.  If they are not already connected you should verify where they are, and, how much it will cost to connect them to your new premises.
  • Ideally a quick review of the current business based on the premises will be beneficially. This will help to tell you the actual running costs for the building and whether it is viable for you and your business.
  • Finally, you may also want to consider any environmental issues. Any property with asbestos or lead paint or even radon gas will need to have work carried out to ensure it is safe.  The cost of this must be factored into your purchase and the viability of the project.

Again, this is not every possible scenario; you must evaluate your intended purchase to ensure you have not missed any important figures.

New Vendor

Another example of when you may need to complete due diligence is if you are considering switching vendors.

Before you can start being supplied by a new firm you should confirm the following facts:

  • Are you free of contract with your existing vendor?
  • How easy is it to order the items you need and is the delivery timetable acceptable?
  • Are the costs of delivery similar to your previous supplier or will they add a significant amount to your purchase price? Equally you will wish to check the average delivery time.  It can be exceptionally damaging to your business if you suddenly take twice as long getting products for your customers.
  • Checking the terms of the sale is vital. You need to know when they will bill you and when they will expect to get paid.  If they offer you unique terms it is safest to get this in writing.
  • When you switch vendor it is important to feel certain that they will be able to provide for your needs. Are they a big enough supplier and do they have a good reputation?

New Employee

This is another example of when your business may be placed at risk.

You must perform due diligence for any new employee.  This will ensure you are getting the skills you think you are!

  • If they have relevant qualifications for the post then you should see a copy of their certificates. This does not prevent you from requesting they complete a range of tests as well.
  • References are essential for any new employee. They will confirm their employment history.
  • You may wish to perform a range of background checks; including a credit one. Of course, you will need permission from your employee; it must also be relevant for the job they have applied for.
  • Ideally, every prospective employee should have two interviews, by two different people. This will ensure they are a good fit.

The Importance of Due Diligence

There is no doubt that it is easier to simply commit to an employee, business idea or even a property.

Completing the due diligence process is time-consuming.

However, it is also beneficial to ensure you are protected from a wide range of future issues.

The principle which you must remember is that you need to know as much about the other party in any transaction as humanly possible.  This is the only way you can safely commit to a transaction and obtain the desired results.

Every situation you find yourself in can have a due diligence process applied to it.  To condition yourself to apply these processes every time, you should start creating a guide for every situation you find yourself in.

You will become more aware of how beneficial due diligence can be.  In addition it will become automatic.

At some point in the future this approach will be guaranteed to save you funds; it may also prevent you from losing assets and capital.

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