When looking to acquire a company, it is necessary to do a thorough investigation of its current state of affairs. This research is known as due diligence and should include a multidimensional analysis of all internal financial, legal, and administrative data as well as extensive external market and industry research. Although it can be time consuming and difficult, excellent due diligence is the key to selecting a valuable company for acquisition. One of the biggest mistakes made is evaluating a target company only in the context of a smooth acquisition. It is important to remember that all data should be analyzed beyond that to determine if the target will be of the proper short- or long-term value to your company. The key is to analyze the data with an eye for unreliable assumptions and flawed logic.

Financial and Accounting Data

The first indicator of a strong acquisition candidate lies in its financial data. You and your accountant should carefully examine the past three to five years of accounts as compared to the representation you were given by the sellers. Check for the profitability of the business thus far as well as the cash flow. There are many tricks that can be used to exaggerate the value of the company, so you should be careful to look for any irregularities. This is only the first litmus test; you should also review the company’s tax returns. This is a good way to verify that all financial activities are consistent with tax codes. A company’s good financial condition is perhaps only a threshold requirement to determine its eligibility for acquisition. You must continue your investigation.

Legal Documentation

Another, perhaps more important, aspect is to examine the company’s legal standing. To ensure that you will not face any post-acquisition lawsuits, begin by reviewing all entitlements including intellectual property, real estate, and legal action settlements. Ensure all relevant laws have been adhered to and that the company is in good standing with the appropriate government agencies. Additionally, have your attorney explain all implications of past legal action and examine existing lawsuits filed by or against the seller. It is important to understand all of this to form an independent opinion of the legal obligations you may have after the acquisition is complete.

Administrative Organization

The management team of a company is another strong indicator of the company’s strengths and weaknesses. Talking to administrative as well as other personnel will give you a glimpse into the company’s morale. Much of a company’s success or failure can be dependent upon the strength of its management. In addition, paying close attention to shareholder satisfaction is a good indication of the current state of affairs of the seller.

Market and Industry Research

This segment of research is perhaps the most telling in its nature. Examining the financial data, legal standing, and administrative personnel can give important but limited insight into the post-acquisition value of the company. Analyzing the company in the context of its industry will help determine what, if any, value the company would provide to you. Consider an American company that makes VHS players. Compared to the technology available in 2012, this device has little to no relevance in most American homes. With the widespread use of DVDs and the rising popularity of Blu Ray discs, most video productions are not even released on VHS. Regardless of its efficient finances and strong legal standing, this company’s products are bound to be irrelevant in the long term as the demand for its product dwindles. You and your business must evaluate the target company’s value in terms of its future in the market. In the long term, the service or product the seller provides must be relevant and not easily squeezed out by competition.

Completing the due diligence process is an essential part of buying or selling a business. Consult with a professional if you have questions.