The importance of due diligence when buying a business

Tue, 01 Mar 2011

The element of chance and risk that is inherent to the acquisition of any business or part of a business these days can be efficiently minimised by thorough due diligence by the buyer. The broadness of the term 'due diligence' indicates the broadness of the process, which if carried out correctly, will leave a buyer knowing exactly what they are getting themselves into. A thorough due diligence process will tell a buyer what needs to be fixed about a business, what and how much it will take to fix it and, crucially, whether they are in fact the right organisation or person to take it on.

The process is much more than just about the basic finances of a company. Thorough due diligence will tell a buyer all they need to know not just about the financial details of a business, but also about any legal issues concerning it, including regulatory and litigation issues; and its commercial position - where it stands in the marketplace, and how it relates to both clients and competitors. It leaves a buyer in the best possible position from which to make a decision and safeguards them against future problems.

The results of due diligence should leave a buyer with comprehensive knowledge of a company's employment terms and conditions, major contracts and orders, its operational systems, environmental issues and much more. But how and where does a buyer begin to explore their target business's background?

The first item of play is making sure that the best person or team is assigned to take care of the task. It is not unknown for buyers to take care of their due diligence themselves - if they are in a position to be buying a business, then it is not unlikely that they already have a certain standard of business acumen. This is often determined, however, by the size of a business, with specialist consultants, business brokers and accountants offering specific due diligence services for larger, more complex companies.

The process will begin after the price and terms have been agreed between the business and the seller. The period of investigation is negotiable and the deal will not be finalised during that period, although the seller will still have the option available to take the business off the market altogether during that period. Typically, for a small business, this period will be at least three to four working weeks.

The first questions asked - whether via questionnaires or on-site visits - will be concerned with the basic details of the proposition itself. 'Is the business really for sale?' seems like going over the obvious, but eventually finding that a 'sale' is actually a process of exploration for the seller and that they have no intention of completing, is more common than realised. So first, due diligence must consider the sales memorandum or the auction listing: its comprehensiveness is crucial to determining whether the listing is genuine. Other questions that fall into this period will also be whether all of the owners of a business are in agreement on the sale, and whether the seller may be 'over selling' the company.

While much will have been found out about a business prior to getting to the due diligence process, the due diligence stage will uncover considerably more: providing the buyer asks the right questions and looks in the right places. And, for ease of process, these places can be sorted under three main areas: commercial, financial and legal.

Considering the commercial issues, a buyer must have absolute clarity on the business’s fundamental operations. Is the product or service of the company clear? What position does it occupy in the wider market and among competitors? How does it rate when trading and regulatory laws are considered? Are any major outlays or machinery purchases on the horizon? If the business being sold is a division, associate or subsidiary, is there a clear path to disentangle and separate any shared processes including IT systems?

If issues uncovered are severe enough, they may necessitate a renegotiation of the heads of agreement and could ultimately lead to scuppering of the deal. At the least, operational issues will need to be identified and dealt with so that the change in ownership causes as little disruption as possible. To that end, it is also important to know about staffing deals and regulations prior to taking the business on. Simply, the mantra 'prior knowledge is preferable to later litigation' is behind every aspect of due diligence.

Financial diligence will let a buyer know exactly what there is to play with and when - if - a purchase is completed. An effective accountant would be able to set a decent gauge on the company and probe into their asset values, cash flows, financial statement history, as well as future projections. A buyer should be looking for a stable and unambiguous explanation of the revenue streams, and should make sure every area is explored in search of anything that could be somewhat hidden - whether it is intentional or not.

Due diligence on anything concerning the company's legal position will serve to iron out any creases and minimise the threat of potential minefields looming into view. It is here that the legal expertise of a professional with considerable due diligence experience will play an important role.

Tax registration certificates, articles of incorporation, board meeting minutes: there must be evidence of all of these documents for full legal due diligence of a company. Uncovering any legal cases that may concern the company is also crucial, whether they are past, pending or in the form of threats of action. If there are cases in a company's history, then all litigation-related material should be provided as well as any settlement documents.

The legal due diligence will also uncover the most basic documents of the physical sale: mortgage deeds, titles, leases, etc. should all be unearthed during the process, as well as evidence of ownership of any relevant intellectual property.

There is no such thing as a complete list of questions that are necessary to ask during a process of due diligence: each business is different, each buyer has different priorities, and each seller has different intentions. A little wisdom, a lot of common sense and some tried and trusted advice during due diligence, however, can contribute to the optimum result for everybody and every business involved.


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