What is Due Diligence in the Context of Buying or Selling a Business?

In short, it’s a comprehensive information gathering exercise. In a similar vein to buying a house, the purchaser wants to find out everything they can about the target to check that there are no hidden surprises, and that the target is worth the price.

The due diligence process comprises financial due diligence and legal due diligence. The financial due diligence will reveal information about the profitability of the business, its financial performance, and tax compliance. This work is usually managed and analysed by accountants.

The legal due diligence will uncover any legal and commercial risks involved in buying the target company.

Why Due Diligence is Important for Buyers

In UK law, the overriding principal for a buyer is ‘caveat emptor’. Literally it means ‘let the buyer be aware’. In practice it means that it’s the buyer’s responsibility to find out all the information it can before it buys the target.

It is usually the buyer (and their representatives) who leads the due diligence exercise. They request information and documents from the target company. However, if it’s an auction sale then the seller will prepare an electronic data room of documents for prospective buyers to peruse.

When the buyer acquires the business, it takes on all historic and current liabilities, whether known or unknown. The due diligence process will illuminate any risks involved in the business which could materially affect the purchase price.

Depending on what’s discovered in due diligence, it may lead the buyer to negotiate the price of the business, or request indemnities from the seller for protection against the risks. In rare cases, the due diligence process reveals an insurmountable issue for the buyer, which results in them walking away from the deal entirely.

Sellers: What you Need to Know About Due Diligence

For sellers, the due diligence process is mainly about protecting yourself from potential claims post-sale. If you’ve given all the relevant information to the buyer, they cannot plead ignorance after they sign the SPA and seek compensation if they discover a problem later down the line.

The due diligence exercise will inform other key parts of the transaction like preparing your disclosure letter and drafting the warranties. Again, these are crucial elements of the process to protect you from future claims.

The Role of Due Diligence for Brokers

Brokers are also interested in the results of the due diligence. Part of the broker’s role is preparing a valuation of the business and negotiating the price. The information revealed by the financial and legal due diligence will inform the broker’s valuation.

Moving beyond the hard facts, figures and finances, it also helps the broker to find a buyer who is a good match for the business. Documents shared during due diligence give the broker and insight into the buyer’s values, goals, and approach to business.

With that information, the broker has a better understanding of the target business and will market it more effectively. They will have a better feel for the sort of buyer who will ‘suit’ the business and maintain business continuity as far as possible.

Due Diligence Checklist for Buying a Business

The size and scope of the due diligence exercise will vary from one transaction to another.

To give you an idea of the documents and information that is commonly included in due diligence, this is an indicative checklist:

• Financial information

o Management accounts

o Financial statements

• Customer information

o Who are largest customers?

o Information about the sales pipeline

• Supplier contracts

o When will they expire?

o Are there any onerous obligations?

o Are you likely to lose any on completion of the sale?

• Property

o Which properties are owned or leased by the business

o Copies of leases, including rental costs for each premises

• Employment issues

o Who are the key employees and is it business-critical if they leave on completion?

o Pension arrangements and liabilities

• Data protection

o Accreditations and safeguards for keeping data secure

o Any recent breaches?

• Litigation

o Are there any claims commenced or contemplated against the company?

• Insurance

o What insurance policies does the company have in place?

• Intellectual property

o Does the company hold any patents or trademarks to protect its IP?

This list is not exhaustive but gives you an idea of the detail that a buyer can elicit from the due diligence process.

How Long Does Due Diligence Take When Buying a Business?

How long the process takes depends on the size of the target business and how co-operative the other side is.

The first step is identifying the documents you want from the seller. It can take time for the seller to collate and send the relevant documents. Then the lawyers review the documents with a fine tooth comb and report back on their findings.

For smaller companies, the process can take a matter of weeks. For larger companies with multiple entities, then the process can take months.

For example, for the sale of a business of 10-20 employees, with an annual turnover of £3m the due diligence process could take 8-12 weeks from signing the heads of terms to completion.