What is “due diligence” in a business sale and how does it work?

What is “due diligence” in a business sale?

Due diligence is the name for the questions that a buyer will ask a seller before buying a business. It is a bit like in a house purchase where the buyer’s solicitor sends the seller’s solicitor a questionnaire asking questions about the property – such as who owns the boundary fences? Does the central heating work? Etc….

Except in a business purchase the questions are more lengthy and go into every area of the business – equipment, contracts, accounts, insurance, employees, property, trademarks, etc……

Like in a house purchase, this also takes the form of a questionnaire sent from the buyer’s solicitor to the seller’s solicitor.

Why is it necessary?

Due diligence is not a legal requirement for a business purchase. The buyer does not have to ask questions and can decide to purchase “unseen”. The sale is still just as legally binding without doing the due diligence process.

The reason almost every buyer invests their time and legal fee in doing the due diligence is that it allows a buyer the opportunity to find out information before buying to determine if the business being bought is a viable business. A good due diligence process should highlight any risks of the purchase and find any skeletons hiding in the closet.

A business is harder to assess than a house. The biggest factors influencing a house value are its location and size, which can be determined with a brief tour of the property. It is far harder to put a value on a company – there are far more factors that may influence how much a buyer should actually be paying for a company. The due diligence process should help a buyer decide if they are overpaying or getting good value.

How does it work?

The due diligence starts with the buyer’s solicitor emailing a questionnaire to the seller’s solicitor. This usually happens after the parties have agreed the heads of terms outlining the headline terms of the dela in principle, but before the sale contract is drafted. Sometimes, the buyer will not want to make an initial offer and name a purchase price without having done a little bit of accounts due diligence first. The buyer and seller may have already entered into a Confidentiality Agreement (also called a Non-Disclosure Agreement) before the seller starts to share sensitive information about its key customers, suppliers, and finances.

The seller will answer the due diligence questionnaire by providing written answers and supporting documents (e.g. copies of last 3 years accounts, copies of employment contracts, customer contracts) in response to the buyer’s questions. After the initial answers from the seller, the buyer will often follow up with further questions until the buyer is satisfied that it is happy to continue and/or make a concete offer for the business.

Sometimes, a buyer will decided not to go ahead with the purchase after the due diligence stage – and this is usually due to a lack of information being provided by the seller or worrying information being disclosed.

What areas of the business do the due diligence questions cover?

Contracts – who are the major customers? What terms have they agreed?

Employees – who are the key employees? How much are they paid?

Property – how long is there left on the lease? What is the rent? Are they any problems with the landlord?

Regulatory and compliance – has the business ever been investigated?

Equipment – is the equipment all in working order? Is the business about to buy any more equipment?

Insurance – has the business had any insurance claims?

Litigation and disputes – has the business ever been sued? Is the business suing anyone – e.g. for non-payment of invoices?