What is “due diligence”?
By Kobus Oosthuizen
When purchasing a home or a car, the decision is driven largely by the specifications and actual condition. While these physical attributes are easily verifiable, a thorough assessment would require that one also considers such unseen aspects as the service history of the vehicle or the electrical certificate of the dwelling.
With the purchase of a business, besides the physical condition of the fixed assets employed within the business, the general appearance of the business is not of great importance and should not significantly influence the purchaser’s decision. Instead, the valuation and assessing the possible risks inherent in the acquisition, is primarily based on what the eye cannot see.
As previously explained, the latest financial performance figures and the balance sheet position of the business are the primary indicators employed in confirming the value of the business. The practical reality is that the latest management information, which should be deemed more pertinent from a performance assessment point of view, will probably not be audited or presented in a format aligned with generally accepted accounting principles. Any valuation based on unaudited figures is subject to a certain amount of risk that profits are incorrectly stated.
When a financial institution has been approached to fund a purchase transaction, in order to confirm the value of the business, they will request certain verified information to be made available. While the principal security of the funder remains the business itself, based on past experience, they are very knowledgeable about the inherent risks. Interpreting financial and other relevant data to support such transactions is the day-to-day business of any funding institution.
Let's presume that you are a cash buyer. With no financial institution involved, analyzing the information is up to you. What information should you be requesting from the seller and what are the pitfalls to look out for? The process of acquiring the information necessary to support the valuation and ensuring the absence of factors that may materially influence the valuation is referred to as “due diligence”.
Conducting proper due diligence is a rather scientific process that can be performed on various levels depending on the value and the nature of the business. The level to which due diligence is conducted depends on the impact that incorrect or incomplete information may have, relative to the transaction amount. For example, when conducting due diligence on a small business, it may be prudent to review the service agreements of all staff members, where in the case of a larger organization this may be restricted to the contracts of management personnel only.
Although any purchase and sale agreement should include a clause whereby the seller indemnifies the purchaser in respect of any liabilities accruing to the purchaser as a result of undisclosed information at the time of the transaction, the inclusion of such a clause can never override the value gained from thorough due diligence.
It is undoubtedly in the best interest of the purchaser to identify elements that may impact on the value of the business upfront and adjust the purchase price accordingly, rather than having to institute a claim against the seller for damages suffered as a result of non-disclosure of information at a later date.
Next month we consider some of the particular aspects that must be dealt with when conducting due diligence for a franchised business. Along the way we will include some handy tips to ease you through the due diligence process.
Kobus Oosthuizen
SA Franchise Warehouse
www.safw.co.za
When purchasing a home or a car, the decision is driven largely by the specifications and actual condition. While these physical attributes are easily verifiable, a thorough assessment would require that one also considers such unseen aspects as the service history of the vehicle or the electrical certificate of the dwelling.
With the purchase of a business, besides the physical condition of the fixed assets employed within the business, the general appearance of the business is not of great importance and should not significantly influence the purchaser’s decision. Instead, the valuation and assessing the possible risks inherent in the acquisition, is primarily based on what the eye cannot see.
As previously explained, the latest financial performance figures and the balance sheet position of the business are the primary indicators employed in confirming the value of the business. The practical reality is that the latest management information, which should be deemed more pertinent from a performance assessment point of view, will probably not be audited or presented in a format aligned with generally accepted accounting principles. Any valuation based on unaudited figures is subject to a certain amount of risk that profits are incorrectly stated.
When a financial institution has been approached to fund a purchase transaction, in order to confirm the value of the business, they will request certain verified information to be made available. While the principal security of the funder remains the business itself, based on past experience, they are very knowledgeable about the inherent risks. Interpreting financial and other relevant data to support such transactions is the day-to-day business of any funding institution.
Let's presume that you are a cash buyer. With no financial institution involved, analyzing the information is up to you. What information should you be requesting from the seller and what are the pitfalls to look out for? The process of acquiring the information necessary to support the valuation and ensuring the absence of factors that may materially influence the valuation is referred to as “due diligence”.
Conducting proper due diligence is a rather scientific process that can be performed on various levels depending on the value and the nature of the business. The level to which due diligence is conducted depends on the impact that incorrect or incomplete information may have, relative to the transaction amount. For example, when conducting due diligence on a small business, it may be prudent to review the service agreements of all staff members, where in the case of a larger organization this may be restricted to the contracts of management personnel only.
Although any purchase and sale agreement should include a clause whereby the seller indemnifies the purchaser in respect of any liabilities accruing to the purchaser as a result of undisclosed information at the time of the transaction, the inclusion of such a clause can never override the value gained from thorough due diligence.
It is undoubtedly in the best interest of the purchaser to identify elements that may impact on the value of the business upfront and adjust the purchase price accordingly, rather than having to institute a claim against the seller for damages suffered as a result of non-disclosure of information at a later date.
Next month we consider some of the particular aspects that must be dealt with when conducting due diligence for a franchised business. Along the way we will include some handy tips to ease you through the due diligence process.
Kobus Oosthuizen
SA Franchise Warehouse
www.safw.co.za
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