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What is due diligence? When and how should you do it? Here are the due diligence meaning and guidelines to help you decide what factors to investigate before you buy a business or make other costly business decisions.
Due diligence is one of those terms that you may understand on the surface but don’t know how to put into practice. Let’s learn about due diligence and how to use it in a real-world setting.
What is due diligence?
The dictionary definition says that due diligence means “the care that a reasonable person exercises to avoid harm to other persons or their property.” In plain English, due diligence means doing your homework. Before putting your business funds to work on anything, you should make yourself an expert. Often, due diligence means the investigation done before purchasing another company, so let’s start there.
How do I perform due diligence?
Let’s assume that you’re 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’s tough for your business to reach. Before you purchase the business, you (often with the help of professionals) will perform due diligence. The due diligence process would include getting answers to questions such as these:
- Does the business have healthy cash flow?
- By looking at the books, can you tell where the revenue stream is coming from?
- How reliable are its financial projections, and what multiple is it placing on those earnings?
- Are profits going up or down?
- How big is the market for the company’s products or services?
- Is the market growing, shrinking, or stagnant?
- Are there any major new competitors in the area or coming into the area that could negatively impact earnings?
- What kind of online presence does the business have, and how does it compare to its competitors?
- If the company has physical assets, are they valued correctly and fairly?
- Are there any hidden liabilities?
- Are the company documents complete? (for example, 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’re not in the market to buy a business. Maybe you’re planning to buy a new building or add a new vendor or product line. There are plenty of decisions you are likely to make where proper due diligence is key.
Due Diligence for 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? Get business information like profit/loss statements if possible.
Due Diligence for 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?
Due Diligence for Hiring 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 see if 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.
- Perform a background check.
- With the candidate’s permission, perform a credit check if the position involves access to financial accounts.
- 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.
Above, we’ve given 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.
Disclaimer: The content on this page is for informational purposes only, and does not constitute legal, tax, or accounting advice. If you have specific questions about any of these topics, seek the counsel of a licensed professional.
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