Significance of Due Diligence

The due diligence process enables investors to do a better job of determining the appropriate price to pay for a privately held firm. This article delineates some factors that a prospective buyer should investigate thoroughly to determine the value of a small, privately held business under consideration for purchase.

Advantages Of Buying A Business

Much attention, both scholarly and practical, has been focused on the business formation process. This attention is understandable because starting a new business is emotionally engaging as well as vital to the health of the economy. Comparatively little attention, however, has been given to the dynamics of buying established, privately held businesses.

Buying an established business is less risky than starting one from scratch. When one buys a going concern, the founder has already solved many of the most critical problems. After all, the founder selected a location, obtained the necessary licenses, created relationships with suppliers, established an accounting system, hired employees and attracted customers. By getting the business up and running, the founder made, paid for and learned from the most costly start-up mistakes (Fraser, 1996). The buyer benefits from the start-up efforts of the founder, and those benefits usually outweigh the purchase price. An on-going business has tested the viability of the firm’s business model, the wisdom of its strategy, the effectiveness of its marketing and the power of its advertising.

The acquisition process is not without its problems, however. Both the buyer and the seller may be troubled about the wisdom of their decisions when the ownership of a business changes. The seller may fret that the buyer will not be able to pay for the business, a particularly pertinent concern if the seller provides financing to the buyer. A founder, who may have spent years building a positive business image, may fear for the firm’s future reputation. In addition, a seller may worry about the welfare of his or her former employees.

The buyer also has concerns. Will he or she have the expertise to run the business successfully? Will the business generate enough cash flow to survive, let alone thrive? Will the business perform as well as the seller has promised or the buyer has been led to believe? What undisclosed problems or liabilities threaten the business’s future? Do the financial statements present an accurate picture of the firm’s condition?

An often-overlooked advantage of buying an established business is the assistance the seller may provide after the sale. The seller may stay with the firm for a time after the sale to advise the new owner about transitional issues. A seller may frequently play a key role in creating positive relationships with the firm’s employees, customers, suppliers and lenders.

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