Due Diligence – The importance of doing your homework

Due Diligence - The importance of doing your homework

Picture this, you have just found a business that has sparked your interest and they have something you want. Maybe you see a potential for growth, a one of a kind customer list, a killer workforce, or maybe they are your only competition. After the right conversations and decision making processes, you have decided to put an offer forward to acquire what it is you desire.

There are two common deal structures when acquiring a business in the traditional sense: asset deals and equity deals. Asset deals, as the name suggests, consist of a purchase agreement whereby, the purchaser agrees to buy the underlying assets of an entity while leaving the equity and ownership of the entity to the current owners. Equity deals are ones where the purchaser agrees to buy the common shares of the entity taking full ownership of the entity and all that it owns.

Each deal structure has its’ own benefits. In a perfect market, a purchaser would typically want an asset deal as they could pick and choose which assets they would like to acquire, and more importantly, which liabilities they would like to leave behind. When an equity deals happens, the new owners assume all of the existing contracts, commitments, known liabilities, and hidden liabilities of the entity. The first three items may not be a bad thing; however, it is the hidden liabilities that could turn a great deal into a flop.

A hidden liability can present itself in many forms and be present in both asset and equity deals. If you were to acquire any asset which could pose a threat to the environment, and you operate in a country where environmental clean-up laws are prevalent you could be faced with a liability down the road of which you may not have recourse over from the prior owners.

Another common example of a hidden liability prevalent in equity deals would be unresolved tax and legal matters. You would not want to be in a position where you have just acquired a new business only to discover there is a massive debt or legal action pending with the Canada Revenue Agency.

But what about those liabilities that are a little more complex? Think of a company which offers a 10-year warranty on its products. How certain are you as a purchaser that in year nine all one-million units that were sold begin to fail? Or how about an entity which operates in a highly-regulated industry? How certain are you as a purchaser that a major product recall is not on the horizon?

Due diligence procedures can be designed to detect such hidden liabilities and provide peace of mind to the purchaser in both asset and equity deals. If you are considering purchasing a business, do your homework. Talk to the experts at WelchGroup Consulting before you have an unwanted surprise on your hands after closing.

Matthew Blostein, CPA, CA
Welch LLP