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Due Diligence: Research Before You Buy

The economic recession in the US is long gone; however, its impact on the business environment seems to be permanent. One of the main changes caused by the recession, and the focus of this post, is the importance attributed to the due-diligence examination before business acquisition. Private equity firms, joint ventures, and angel investors are not the only ones that engage in due diligence; entrepreneurs and SMB owners looking to start a new business or expand their current one by buying an existing firm or idea should also take the due-diligence process seriously.

The term “due diligence” was coined as a part of the Securities Act of 1933, referring to the investigations stock brokers had to preform before introducing any public offerings of equity investments. However, with time, the definition of due diligence was broadened to be associated with private mergers and acquisitions.

What does a due-diligence analysis include? In general, financial, legal, and operational aspects of the business should be reviewed; however, every business is unique, and therefore emphasis should be depend on the industry and business environment of the firm in question.

Financial analysis includes a review of the company’s assets and liabilities, financial forecast and structure, tax and accounting reports, equity, and profitability. This process helps assess the value of the business today (and whether it was priced right) as well as in the future. Legal documents such as agreements between owners or between the company and its previous investors; business registration documents; board/shareholder meeting records; and patent, trademark, and copyright documents should be examined closely. This part is designed to aid the investor in understanding the legal restrictions on the firm in question and protect him or her from draconian agreements that may affect the company’s survivability but are not reflected in its financial reports.

Last but not least, examining operational issues is a critical part of the due diligence process, since it ensures that the business can continue to operate smoothly after the investment is made. It is important to review the organizational structure; employee handbooks; contracts with employees, vendors, partners, property owners, and customers; and non-compete agreements.

One last thing to remember: Peter Lynch, one of the most famous and richest stock investors in the US once said, “Investing without research is like playing stud poker and never looking at the cards.” He is right, and due diligence is a big part of that mandatory research; however, before going into this tedious and pricey process, make sure that the company in question is the right one for you. Analyzing the competitive environment and understanding the business position of the firm you’re looking to invest in should always be your first step.

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