Erasibo

Presentations from BUSA and SACCI on SMME access to finance.

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Whether you are considering buying a business for a few thousand rand or for a few million rand or whether you are considering starting up a business, a due diligence exercise will prove most useful in providing you with a degree of peace of mind prior to putting pen to paper on the business agreement.

I want to stress that regardless of the size of the deal and regardless of who the parties to the deal are, make sure you undertake a due diligence. I will always advocate for the most thorough due diligence you can afford, this is money, time and effort you should spend in order to save you money, time and effort later. Also remember, you often get the value of service you pay for, so don’t cut corners.

In researching this article I have been staggered to see how little information is readily available on public platforms on the subject of due diligence. What is available is very pricey and usually only talks to high level issues. This is worrying considering how vital a due diligence exercise is, especially to the first time business owner.

What is Due Diligence?

For the purposes of this article, Due Diligence should be understood as an exercise to be undertaken as part of the purchase of a new business. Simply put, due diligence is an investigation into a business with the purpose of proving to the initiator of the due diligence (typically the buyer) whether the facts offered up by the other party to the deal (typically the seller) are in fact a true reflection of the business.

Who should do the Due Diligence?

In order to do a due diligence well you will need two key role players:

1. Professional Assistance: Due Diligence’s exercises are technical in nature and if you have the funds available make use of a professional firm that has done these types of exercises before. Apart from all the certificates and client references that you will get from the firm you hire, check to see if any of the people who will work on your due diligence have ever run businesses before – you cannot under estimate the value of experience.
2. You: Your personal involvement in the due diligence process is vital. The professionals you bring on board work for you, but will not always understand, amongst other issues, precisely what your vision is for the business, what your appetite is for risk is and how you would deal with problems that will be encountered.

I would encourage a more hands on, engagement with your team so that at the end of the day you are getting a due diligence report that will allow you to take an effective decision. You don’t just want a report that says, “Yes do it” or “No don’t do it”. A due diligence is not simply a synopsis on the business you want to acquire or startup. In fact your due diligence report (which will be a detailed report on all aspects of the investigation) can serve as a great tool for guiding your future business plans and strategies for the business should you acquire it.
Some finance houses and banks will offer to do a due diligence for you. Be wary of this service; be wary of any due diligence exercise where the companies doing the exercise for you will profit from your deal outside of the fee you pay for the due diligence.

A Due Diligence Model

Non-Disclosure Agreement

The due diligence exercises should always start with a Non Disclosure Agreement (NDA). Characteristics of the NDA that you should be aware of are:

• The NDA is to be signed between yourself and the seller.
• This agreement essentially protects both parties from the having their confidential business information made public.
• A confidentiality period must be specified. Please remember that the confidentially clause does not apply to illegal activity.
• The NDA should talk to you requiring a Due Diligence and it should specify the high level areas that the Due Diligence will cover. The seller must agree to this. If the seller does not agree to this, walk away.

Due Diligence Areas

A good due diligence exercise will cover the following nine areas1. In addition you (or your team) will need to acquire from the seller the following documents for your due diligence exercise. These documents should be made available to you quickly as the seller should already have these available. If the seller is unable or unwilling to provide this information this would be a cause for serious concern. The fundamentals of running a good business are record keeping.

: *please note the Due Diligence Item column is not exhaustive*

Due diligence is your safety belt, often you only realize that you need it, when the deal has gone sour and your business is in crisis. Do not make that mistake and overlook this process.

Our post “Why be the first franchisee” has been published in Your Business magazine (Volume 15 No.1).  Not a bad start to 2010.

This is the third article in our series on franchising (especially restaurant franchising). Best to familiarise yourself with our other articles which sets our tone.

Commercial banks are part of legitimate business. We trust them with our savings, we store our incomes in them, and we borrow money from them, all the time assuming that the transactions are legitimate and reasonable and regulated to some extent. We rely on them for every aspect of functioning of civilised life-homes, cars, business, school fees and personal events.  We also expect that they will exercise reason in their interactions with us because their survival depends on the patronage of their clients. So their responses to us are based on good credit lending praFFrctices and when banks make errors in planning, governments are hard pressed not to finance their recovery with taxpayer’s money, as in the case of the US recently. Banks are essential to the stability of our economy; citizens and the banks share a common investment in our economic future.

But have banks gotten too big for us. Do they represent something untouchable? So when they repossess homes and cars in a panic about the money that is being lost like a waterfall without following the specified due processes outlined in those contracts is this acceptable under the circumstances or is this just a case of bullying. And what really is their responsibility as the credit provider?

In responding to this question I will share with you our own insightful experience with the banking environment recently, which has been the cause of much debate within our own inner circle.

We took out a loan to finance a franchised restaurant. After the bank evaluated our application they informed us that we were not disadvantaged enough to qualify for any form of BEE preferences (the words used were “not black enough”). This opinion of the banks was nether policy nor constitutionally justifiable. However, we were in love with the business idea, so we didn’t make a scene. We put up 40% of the financing required for the franchised restaurant we wished to buy. The bank confirmed that it had done a due diligence on the restaurant and the franchisor and was extremely happy with the results and would finance the deal.

In fact the franchisor was so highly credible to the bank, that the bank offered them great deals on banking and transacting facilities for their franchisees and they offered the group an approved financing facility for all new franchise restaurant setups. Since we knew what the obligations placed on the bank were by law to thoroughly assess any new deal we felt extremely confident in all the new “benefits” the bank was offering the franchisor.

So when the figures provided to us and the bank by the franchisor turned out to be deliberately exaggerated and show that a fraud was committed by the franchisor so as to ensnare us in the business deal the issue of what exactly is the responsibility of banks in this circumstances was raised by us. The answer apparently is that the banks have no obligation. The bank completed a FICA assessment of the franchisor; their results didn’t cry out any kind of foul – it should have. There was evidence of their foul practice’s aplenty, which at the time was outside of our sphere of access.

Now that the bank is aware that there was a fraud committed by the franchisor does it discontinue giving out loans to new franchisees wishing to purchase restaurants in the same group or does it blacklist the group? No of course it does not.

Granted our matter hasn’t been to trial yet, but we can supply details (irrefutable forensic evidence) to the banks legal department and they can make a judgment about the caliber of clients they want to maintain or their obligation to new investors. If the bank continues to give out loans to unsuspecting buyers wishing to take up opportunities within the same group, would the new franchisees be able to sue the bank for facilitating a fraud since the bank has knowledge that the franchisor is suspected of fraudulent behaviour?

At the very least the bank should consider suspending any new deals pending our case going to trial and being decided on, because should we win our case the franchisor may not be able to operate anymore and new franchisees would be placed at risk of defaulting on their loans, which is a risk to the banks bottom line.

At the very minimum this franchisor has committed FICA fraud? Should the bank not have called in SARS immediately? The bank leverages their risk on personal sureties signed by borrowers – the franchisees, so whatever happens with the business, the bank will get its money one way or the other. But should they? The National Credit Act outlaws irresponsible lending and by this it means that the banks assessment of whether a borrower is suitable for credit has to do with an assessment of the borrower’s ability to pay. If the borrowers ability to pay has everything to do with the business’s capacity to generate a certain profit, and the business was in fact never able to do that as the figures provided were a fake. Is the bank not responsible for irresponsible credit provision?

I’m not suggesting that the banks share responsibility for your business decisions or mine. You go to the bank for financing not buying into your idea. But they do have a role to play in not perpetuating a fraud when they know about it and they do have a job to ensure that there facilitation is not being used for money laundering or other such activities. The new Consumer protection Act certainly talks to the issue of facilitating fraud and specifies the right to have contracts cancelled in this case. What does that mean for a bank that knowingly provides financing to fraudulent franchisors. Can those loans be cancelled and they held responsible for the transaction?

On the cross side asking the banks to take more responsibility will be ensuring that loan facilities become even harder to access and you will pay for this risk in the repayments.

If you are hoping to see your banker as a partner in your business, best check out the development bankers, such as the Industrial Development Corporation or National Empowerment Fund. Since they accept a high percentage of risk they are better at evaluating the risk with you. If the business collapses they lose their cash too. So if you have to go after a franchisor that has defrauded you have a big partner on your side and you are out a considerably less amount of cash.