Due Diligence

You have been searching for various businesses for sale and now you have found that perfect business to buy. The business is represented by a reputable broker. You are comfortable with the terms, and now you wish to enter into contract and proceed with the due diligence phase. Everything you have been told by the seller and broker sounds good and feels right. So what’s next? How deep do you need to dig?

Deep my friend. Yes, most brokers are very reputable. But remember they only get paid when the deal closes. And remember also that the broker is representing the seller, not you.

So what should you be digging for? Here is a partial list:

1) Negative business trends;

2) Negative industry trends;

3) Expected but undisclosed competition;

4) Any hint of a personal matter that would restrict the seller from selling;

5) Any partner, spouse, shareholder, or related party that would restrict the seller from selling;

6) Existing or past credit problems with banks or suppliers;

7) Any pending litigation against the company;

8) Any claims, liens, or encumbrances against the company or company real estate;

9) Unpaid income, sales, FICA, unemployment insurance, or other taxes;

10) Timely filing of all tax returns;

11) Expected but undisclosed loss of one or more major accounts;

12) A current disaster recovery plan;

13) A current management succession plan;

14) Stale or nonexistent policies and manuals (including personnel manual, training manual, safety manual, and sexual harassment policy)

15) Retention of key employees;

16) Retention of key accounts;

17) Recent bad publicity;

18) Expiring/ renewal of property lease;

19) Leases that are not assignable;

20) Restrictions on business or property expansion;

21) Capital assets that are at or near their expected life;

22) An established reserve for capital improvements;

23) Obsolete equipment and machinery;

24) Overvalued inventory;

25) Product obsolescence;

26) Expiring licenses, patents, franchise agreements, etc.

27) Difficulty in obtaining raw materials, products, or services;

28) Expiring vendor or supplier agreements;

29) Recent increases in all types of insurance rates;

30) Employee awareness regarding the business sale;

31) Customer awareness regarding the business sale;

32) Vendor and supplier awareness regarding the business sale;

33) Non compliance with safety and environmental requirements;

34) Potential labor union or other employee related issues;

35) Any web site related issues.

As you can see there are many issues that really need to be investigated. Many are very technical. You will likely need to enlist the help of other professionals for assistance. An attorney and an accountant are a must.

Just remember, when you are searching businesses for sale, think ahead. Do not trust everything the broker and seller tell you. You are making a huge decision; make sure it’s a good one.

Due diligence is an absolute must if you plan to team up with a Chinese partner. It’s a jungle out there, so be wary. This is no place to cut expenses or rush through things because a half-done job may cost you twice as much time and money later. Due diligence is not a particularly prevalent practice among the Chinese and they may have trouble understanding why you are “making things difficult”. If your prospective partner refuses to cooperate, don’t be afraid to walk away.

There are three main types of due diligence that you need to concern yourself with – financial, legal, and environmental. Keep in mind that these three inquiries often overlap.

Financial Due Diligence

Many Chinese enterprises (it is said) have three sets of financial records: one for the
owners, one for the tax authorities, and one for foreign investors. Accordingly, determining the value of an enterprise based on its financial records can be difficult. It might be necessary to carry out an independent assessment of the enterprise’s reputation, connections, and key employees.

Key pitfalls to watch out for are:

Double-dealing employees – it is not at all uncommon in China for senior management to have their own businesses that directly compete with their employer, and for these executives to use their employer’s confidential information to further their own private interests.

Corrupt relationships with Chinese government officials – this presents the risk of civil liability or prosecution, not only by the Chinese authorities should things take a turn for the worse, but also by the US authorities if you happen to be American or otherwise subject to the US Foreign Corrupt Practices Act (some other nations have equivalent legislation; check your home jurisdiction if you are unsure).

Intellectual property piracy – rampant in China.

Legal due diligence

Legal due diligence focuses on a variety of issues including contract rights, corporate authority, regulatory compliance, ownership of assets, and liabilities and claims against the target company. Issues that often arise include:

Scope of business issues – At the minimum, you should authenticate and inspect an original of the enterprise’s business license (the scope of business is listed thereon).

Contracts – whether contractual arrangements are adequately documented (or documented at all).

Ownership of buildings and Land Use Rights – Check to make sure all buildings are owned outright and all land is “granted” rather than merely “allocated”.

Intellectual property – make sure that trademarks, etc. used by the target company are either owned by it or licensed to it.

Constitutional documents such as Articles of Association – make sure that they are up to date (properly amended to reflect the company’s current situation).

Construction permits and approvals – these should be examined not only for construction in progress, but also for existing structures

Labor disputes – determine whether there are any outstanding disputes, and the level of employee morale.

Debts and encumbrances – make sure that these are adequately documented and not excessive.

Environmental Due Diligence

In a nutshell, you need to know whether your partner’s site environment or your FIE’s proposed site environment has been contaminated (contamination of your Chinese partner’s site could affect its financial stability even if it is not used for the FIE).