Streamline Your Sales Due Diligence for R&D with airSlate SignNow

How to create outlook signature

fris sent me a message on Twitter wanting me to expand upon due diligence what is it how do we do it what should we be paying attention to stay tuned I'm David C Barnett and you're tuned in to small business and deal making the podcast YouTube channel and blog where I talk about buying selling financing and managing small and medium-sized businesses while controlling risk so if you're looking to take control of your future through buying a business one day or if you already own a business and you're looking to grow or exit you've come to the right place I talk about interesting things I talk to interesting people and I answer your questions every week right here so be sure to hit like and be sure to hit subscribe and let's get to it hey so today we're going to be talking about due diligence and just just so everybody understands what we're talking about here in the normal process when you buy a business you go looking for a business that might be for sale um and then there's some initial information right basic information this is what the business does this is what the revenue is this is what the earnings are uh and then typically you will make an offer or present a letter of intent or some other kind of document term sheet what have you uh which basically says based on what you've telling me being true and accurate this is what I'd be willing to do in purchasing the business and so the reason why it's important to to lay that out rather quickly is because if you're far apart from the seller and you can't come to terms then you don't want to get into due diligence because due diligence can be costly and will often involve other people Professionals of various types so you come to an agreement on this condition initial offer and one of the conditions of that initial offer is that it is subject to due diligence may also be subject to financing and maybe some other terms in there if it's a franchise can be subject to you know being accepted by the franchisor and finding the franchise or acceptable uh on the part of the buyer Etc so what does due diligence mean well in effect it's an investigation or an examination where we try to validate the information that we've been given through checking third-party data through the party's sources right so one of the initial things that people will do in due diligence is they'll ask her a bunch of information from the seller and they'll provide that information to you so there might be for example um records of uh you know Financial records from the bookkeeping they might send you a file from their QuickBooks or something like this great um do you know how QuickBook files are created you know people types information into QuickBooks and it creates a QuickBook file right so somebody could completely fabricate a QuickBook file which is probably pretty rare but what is very common is somebody who has a varying degrees of incompetence could be in charge of creating the entries into QuickBooks leading to QuickBook files that are filled with errors right which is a far more likely scenario and so this is one of the things you're going to want to investigate now I have just been through a rather exhaustive due diligence of my own and I want to draw the parallel here because I'm tired of long airport security lines and so I applied for a Nexus card which is a joint trusted traveler program run between Canada and the United States and so eight months ago I filled out an online form and I had to put you know information about my birth certificate and my passport and my driver's license and I had to list out all the countries I'd visited and I had to put all of this personal information into this website and they said uh this is great thank you very much we're going to investigate you so why and I just found and the reason it's top of mind is because I just got the email saying that I'm now ready to go do my interview so I gotta drive to the border and visit with one of the uh one of the Customs people but what then have they done in the meantime well they've sent an inquiry to Vital Statistics to make sure that there really is such a person with a birth certificate like the one I described they probably sent a thing to you know the people who issue passports in Canada verifying that the passport number I gave them was really a passport issued to me they're going to send something to the province to ask about my driver's license right they're going to investigate different you know I I put in there I've never been convicted of a crime they don't believe me they're going to then examine criminal histories and records and make sure that I don't come up as a person who has you know some crimes in my background so this is an example of a due diligence so they've gone and they've they've made all these inquiries with all of these third-party sources and then they come back and they compare it with the information I put in now that I'm ready to go to the next step so in a similar fashion when you're doing due diligence on a business well what you're looking at is all of the other actors and bits of information you want to validate them against what the seller has told you so for example you want to investigate the customers is there a customer concentration issue is there a customer concentration issue that you may not know about I'm going to I'm going to get a talk a little bit more about ignorance here in a minute you're going to look at the employees you know are all of the employees 60 years old or older that could be an issue the suppliers is there a limited number of suppliers or some sole source suppliers that could be an issue what about competitors you're going to want to know who the competitors are in the market you're going to want to investigate them a little bit as part of your due diligence absent competitors if you're buying a building supply company in a town that does not have a Home Depot you might want to investigate what market conditions typically exist when Home Depot decides to build a new store that could be important right and it's not something in the market it's something absent from the market but you may want to consider that macro economic elements so I'm meeting increasingly more and more business Searchers that are you know looking for a business wherever it may be well you know what if you're buying in a smaller community that has a pulp Mill that employs 10 of the labor force you might want to investigate the pulp Mill like what is their standing what are their prospects because if that Mill closes the whole economy of the town is going to be radically changed so these are just a few examples and I haven't even gotten into Financial due diligence but I want to I want to highlight ignorance here because this is due diligence actually knowing what you need to go and investigate part of it comes from understanding the industry that you're buying in so let me give you an example I had a 101 phone consultation with someone who bought a flood and fire restoration company and the seller told him that they had they were doing work for over 45 insurance companies and so the buyer assumed that that meant that there was no customer concentration issue but because the buyer had no experience in the flood and fire restoration industry they didn't know about tpas third party administrators so TPA companies basically manage insurance claims on behalf of insurance companies so while there were over 40 different insurance companies that these guys were billing there were only three tpas so those three tpas basically were the centers of influence that directed those over 40 insurance companies to bring them business and within a year after taking over one TPA went away and so he didn't lose one customer he lost a third of his customers but he didn't understand that that's how the industry worked because he was an industry Outsider and this is this is why I keep harping on the idea that you want to have some kind of industry knowledge of the industry that you're getting into and if you don't you want to immerse yourself this is why you need to choose an industry so that you can dive you know face first into that industry figure out who's talking about it on YouTube read the books that are available on Amazon you know find out if there's a conference attend the trade shows get into that industry interview people that have retired from the industry meet people that are in the industry in other geographies who would not be competitors you might be able to talk to you need to learn that business as much as you can so that you know what is important in the due diligence process okay um Financial due diligence so when we look at bigger companies there is something out there called a quality of earnings report where you can hire a company that's a q of e company that will come in and do an in-depth investigation into the financials great product you know valuable report sometimes banks will require it for a big enough deal but you're talking about a five figure expense and if you're going to buy a business for three to a hundred thousand to a million to 1.3 million you're probably not looking to invest that kind of money into an investigative report of that depth right so so what then do you do well you have to do a little bit of this on your own and you're going to need the help of perhaps an accountant specifically an accountant who has some degree of experience in helping people buy businesses or doing some investigation or audit work or I don't know maybe someone who used to work for the tax man who has some experience and how to look at a business looking for foolishness or you know hanky-panky or whatever other term you want to use so in the financial due diligence again we're looking for third party validation so if they're reporting sales of a million dollars a year well one of the things you can do is ask for all their bank statements and add up the deposits and if the deposits over the year were a million dollars then likely the sales are a million dollars now you want to be careful though because if some of those deposits are particularly round I think is a good way to put it like you know if you see deposits you know transfer from stripe you know the payment processor uh seven thousand one hundred and twenty two dollars and fifty two cents right that's clearly a bunch of transactions being lumped into the account in one day but if you see deposit for twenty thousand dollars well is that really a sale depends on the industry right so if you're talking about a construction company that might take a customer deposit on a big job that could very well be part of a sale right it's a it's a deposit um but if you're talking about a retail store very rarely do they have sales that end in round numbers like that that could be the seller investing more of his own money into the business because there's a cash flow problem right and so what we're looking for in due diligence is we're not looking to answer all of our questions we're looking for more questions so when you see that deposit of twenty thousand dollars I would ask I would put it on my list what was the twenty thousand dollar deposit on that day and can we relate it back to something that makes sense so if they can explain yeah it was part of a sale or maybe it was you know money they had to put in I don't know maybe it was a weekend Festival where they operated a food truck and the sales are almost thirty thousand dollars but they only deposited 20 000 of it I don't know what the story is but you want to ask and that's the whole point of going through this exercise is to figure out what you need to ask about so purchases you can look at the purchase invoices of the business and you can compare them with uh what they say their cost of goods sold is for example in their QuickBooks um but when it comes to purchases if you're examining the 2021 year and the 2022 year what has been changing recently is supply chain issues and inflation right so if you find out that they've been buying widgets in 2022 at ten dollars each are they still ten dollars right so you're going to want to have a very recent purchase invoice or maybe even be able to go out and find pricing information if you can online if it's something that is advertised with a price online you're going to want to go look and so the March 2023 purchase invoice from the same supplier might indicate those price is very different and then you're going to want to look at the pricing of the company you're buying to see if they've had if they have the pricing power to push through these cost increases and maintain their margins because if not then when you're doing your normalizing adjustments when you're evaluating what the company's worth to you you may want to go and put a lower gross margin in you may want to bump up the cost of goods sold because the cost of goods sold has changed and if it's a particularly discretionary type of business like maybe if it's a restaurant or something like that you may not be able to increase your prices at the same rate that the costs are going up that's going to be a problem you want to know that before you buy the business and so and I also had margins there um and how have mergers changed exactly right so you go through you dig through all this stuff you come up with more and more questions you keep posing the new questions to the seller and then here's the thing and this is the part that freaks out a lot of people and if it freaks you out really bad make sure you head over to business buyeradvantage.com and sign up for my online course because I deal in great detail about this stuff so you do your due diligence and then you have to figure out what you have not been able to satisfactorily evaluate in the world of small business there will always be something in due diligence that you will not be able to square away to your complete satisfaction you need to accept that this is not you're not buying IBM you're not buying a strictly formalized business with a lot of controls and everything in place you're not buying a big publicly traded company that has an internal audit Department you're buying a small business where a lot of the times the bookkeeping is an afterthought done at night when someone has Spare Time done by someone who isn't really qualified their annual tax returns and financial statements are produced by the accountant who's willing to do it for the lowest cost who does no verifications who will just simply fill out a tax return to the best of their ability because they're trying to do thousands of them and get the owner to sign it and submit it right and so it is very very very common number one to discover errors in the seller's bookkeeping and accounting during the process of due diligence be ready for that it's quite common number two it is very common to have black holes in your understanding of the business so you could finish your due diligence process and I and I mean I haven't even talked about legal due diligence which is typically done by lawyers investigating to make sure there's no outstanding lawsuits or claims and the tax filings are up to date and that kind of stuff um but you will you will come to the end of your due diligence after you look at the business and you will say I don't fully understand this or this or this now what are you going to do you've got two options you can run for the hills or you can say without understanding this what am I willing to pay or under what terms am I willing to still purchase this business okay and that and that's what it comes down to because what many other advisors would tell you is they would say well if you don't understand that and you think it's a risk you need to adjust your price to reflect that and the price adjustment is what happens when we don't use tools like seller financing so you basically have to say to yourself if these risks exist if there's something in here that could get me what am I willing to pay for the business to live with that degree of risk and obviously the answer is uh you know I'm willing to pay less maybe than what my initial offer was and so then you go back and you offer less and what will happen is the seller will be offended they won't want to do it they'll say I thought we had a deal blah blah blah blah and um it could end up being a difficult situation however if you're properly structuring your deals and you have some degree of seller financing then what can happen is you can come back and you say look after going through due diligence these are the problems I'm not satisfied with I'm willing to keep our price but I need to adjust the terms to deal with the risks implied in these scenarios and so what does that mean it might mean lower down payment higher seller financing it might mean breaking the seller note into multiple pieces Each of which has different terms and conditions it might mean having part of the note subject to offset if certain conditions aren't met that were promised by the seller you know they made certain claims about the business that you can't quite validate and you say well I'm going to need part of the purchase price that I pay you to be tied to that or maybe there's going to be some kind of know component and this is all going to vary upon Where You Are what kind of Bank financing you have in place what rules the lender may have because of course any Banker that's involved is going to be able to dictate certain terms and conditions to how these deals come together so um I'm getting off track of what due diligence I'm talking about deal making here now but it's all part and parcel the same thing for most small business deals the due diligence has got to be captained by you do not think that you're going to Outsource this people ask me all the time David can you do the due diligence for me and my answer is always no I have coached people through the due diligence process where I've met with them I've got a few checklists that I've accumulated over the years I'll share some with them and I'll talk about the checklist what you can expect what you can expect I'll explain the process that I need to go through in their thinking and sort of Coach them along but it's something you have to know and understand and do yourself because at the end of the day as the person buying the business you are the entrepreneur you are the investor the buck stops with you and when you get into business yes there's all kinds of great opportunity and upside but it comes with great responsibility and the primary responsibility is towards your own Equity Capital the money you're putting in your down payment um you know your family's future Etc you're buying a business because you want to reduce risk you want to buy a business that's already profitable do not get yourself into trouble by you know doing something you shouldn't by not understanding exactly what it is you're buying and when you realize that there are certain things you won't understand except that this is going to happen there's going to be things that you won't understand that you will modify your deal in such a way that you can live with the risk and I've seen people do that I've seen people make an offer get into due diligence amend their offer negotiate a whole other set of rounds you know back and forth back and forth work at a deal that they could live with given the unknowns do deals and then some of the unknowns bite them and because they reformulated their deal properly they were able to manage it and survive versus somebody who Maybe borrowed all the money from a bank and then there's no real agree course because they still owe the bank right anyway food for thought thanks for tuning in to the channel again head over to businessbuyeradvantage.com if you want to learn more about how to buy a business in a risk controlled way um that works and is done by people all the time all over the place and uh with that we'll say see you later and I'll head out with a message from uh from our Channel sponsor this year special thanks quote to today's video sponsor Mark Willis of Lake growth financial Mark helps people better manage their personal wealth and business finances through the bank on yourself Insurance strategy this is something I've done personally and I've gotten lots of positive feedback from people I've worked with over the years go to newbankingsolution.com to find a playlist of all the interviews I've done with Mark and to learn more about the advantages of these programs while there sign up to arrange a conversation about what this solution might look like for you so how can you learn more about buying selling financing and managing small and medium-sized businesses easy head over to my blog site at davidcbarnet.com you'll find hundreds of Articles and videos all for free you'll find links to my books and online courses and you can sign up for my email list and get emails covering topics that interest you and be notified of new videos