Unsubstantiated OptimismLet’s face it, if you are buying a business, you’re probably excited and looking forward to it.  At the same time, you will need to be cautious and not fall into the trap of unsubstantiated optimism.  What do we mean by that?  Be sure to verify everything that you’re being told about the business.  It’s no different than buying a used car or a piece of used equipment.  And as you can guess, the devil will be in the details.  When you send in your due diligence team, they need to be aggressive, just like they are looking for a needle in a haystack.

Don’t get me wrong.  It’s not that we think the seller will be lying about everything.  Rather, you need to know exactly what you are buying and the current condition of the company.  That’s what the due diligence team is called out to do—to substantiate.

As an example, perhaps you are buying a company that has had reviews every year by their CPA firm for the past 10 years.  Sounds good right?  Not quite.  When was the last time they completed a more thorough Audit?  And, to what extent?  Reviews are sort of “once over lightly” where only a few records are sampled.  Another consideration is that there are different types of Audits.  You will want to look for and see a “Quality of Earnings” Audit.  This type is much more useful and relevant than a general Audit.  Whatever you do, don’t let any audits and reviews become a substitute for your own due diligence.

Your due diligence team should accomplish three things.  First, make sure there are no issues: financial, legal, operational, HR, etc., that threaten the future of the company you are buying.  Second, research enough of the company records to ensure that the company is in the condition that the seller claims it is.  And third, develop a transition plan for the integration of the seller’s operations, finances, etc. into your operation following the closing.

If you are wondering if there are specific areas to look in the due diligence process, you will want to begin with the seller’s financials.  If you see something there that raises some general questions, you will want to naturally investigate those items.  Beyond that, your team will want to benchmark the seller’s company against industry norms and ratios that are common in their space.

Something to be aware of are potential delays created by the seller in providing information on a timely basis.  It is a good idea to have some provisions built in to your Letter of Intent (LOI) ahead of time to cover you.  For instance, the seller may not want to give you the answers to your inquiries (due to their fear that you may negatively view the data,) and delay, hoping that the expiration time on the LOI will run out before you get to see it.  Since LOI’s typically are for a fixed period of time, you can put a clause in your LOI ahead of time for extensions under certain circumstances.

In all cases, you will want to be optimistic and believe the seller, while at the same time working to verify their claims.  This will cover you so that you don’t suffer from unsubstantiated optimism.