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Due diligence is when potential buyers evaluate factors relating to a transaction, such as finances, assets, legal issues and external issues to gain a better understanding of the business. Essentially, it is a deeper dive investigation or audit into a specific situation/area relating to a business, that takes place before a formal contract is drafted and agreed on.
It can be compared to when a house gets investigated before it is purchased. As for businesses, it may be financially disastrous if they fail to perform due diligence.
How does this relate to purchasing a business?
Due diligence is a process that the potential buyer of another business will conduct before entering into a contract to purchase a business. They then review and find information about the business they are planning on purchasing. This is especially important as you take over the liabilities and debts the business currently has and helps you to make an informed decision.
Whether that information is found by the buyer or given by the target business, the buyer will review and verify the information.
If after comprehensive due diligence, they are still interested in purchasing the business, then the negotiations will proceed.
Moreover, the due diligence stage will include evaluating the target company. This determines how much your purchase price will be after taking into account all areas of the business.
Why is it important to conduct due diligence?
Due diligence must be performed before purchasing a business. A thorough investigation of the target business will ensure you do not get surprised after you enter into the agreement. It will help you to evaluate the legal, financial and commercial position of the business. If this is not done, you may encounter unplanned costs, which leads to a more costly purchase than expected.
Thus, due diligence ensures you are making an appropriate and informed business decision. This ensures the purchase will be successful in the long term.
What does Due Diligence for Purchasing a Business Involve?
The process of due diligence is the actual investigating of different factors. This task is usually done by legal advisers, where they research the following areas.
Generally, factors that may be evaluated include:
- Legal Position
- Financial Position
- Tax Position
- Commercial aspects
- Business prospects
- Operational information
More specific issues that due diligence may covers:
- Business legal structure
- Business company structure
- Financial obligations to undertake (debts, loans)
- Licenses and permits a business owns
- Tax compliances (financial records, tax returns)
- Material contracts
- Ownership and Use of Information Technology
- Intellectual and real property
- Physical assets
- Employee arrangements
- Litigation and compliance with the law
- The reputation of the business and public perception
- Media reports relating to the Business
- Competitors
It is also common in Hong Kong for there to be a vendor due diligence report when there is a controlled sale process (where all assets are transferred). This is where the seller will provide information on their business. It helps to speed up the sale process and to address the complexities involved in the transaction.
Usually, vendor due diligence reports can be relied on by the potential buyer. But oftentimes, the buyer will conduct their own confirmatory due diligence to gain a detailed evaluation of the business and the transaction.
Key Takeaways
- Due diligence is a process the buyer will undertake to find out more information about the target company before deciding to purchase another business
- It is important to help reveal any risks, opportunities and liabilities involved in the transfer of ownership. This helps with long-term success
- Examples of factors that are investigated during due diligence include financial issues, future business prospects and physicals of the target business
