Due diligence is your opportunity to properly investigate a business before you buy it.
By this stage, you will usually have agreed the main commercial terms of the acquisition and have a good understanding of the business. Due diligence is about testing that understanding.
You are looking to confirm the financial performance, understand the risks and identify anything that could affect the price, deal structure or your decision to proceed.
The exact scope will depend on the size and complexity of the acquisition, but most buyers should consider the following areas.
Financial due diligence
Review:
- historic statutory accounts
- current management accounts
- monthly revenue and EBITDA
- gross margins and profitability
- cash flow
- working capital requirements
- debt and financing arrangements
- capital expenditure
- budgets and forecasts
- any adjustments made to EBITDA
- one-off or exceptional income and costs
Pay particular attention to how profit converts into cash and whether the earnings presented by the seller are genuinely maintainable.
Revenue and customers
Understand:
- revenue by customer
- largest customer relationships
- customer concentration
- recurring versus one-off revenue
- customer retention
- contract lengths and renewal dates
- pricing arrangements
- recent customer wins and losses
- sales pipeline
- revenue already contracted for future periods
If a small number of customers account for a significant proportion of revenue, investigate those relationships carefully.
Commercial position
Look at the wider market in which the business operates.
Consider:
- market size and growth
- key competitors
- barriers to entry
- the company’s market position
- pricing compared with competitors
- customer buying behaviour
- regulatory changes
- technology or other potential disruption
The aim is to understand whether the historic performance of the business is likely to remain achievable.
Employees and management
Review:
- organisation structure
- key employees
- salaries and benefits
- employment contracts
- bonus and commission arrangements
- staff turnover
- vacancies
- pension arrangements
- length of service
- management responsibilities
Identify which people are particularly important to the business and what would happen if they left.
You should also understand how much responsibility currently sits with the owner.
Legal
Your legal advisers will normally review areas including:
- company ownership and structure
- shareholder arrangements
- material customer and supplier contracts
- employment agreements
- property leases
- financing agreements
- insurance
- intellectual property
- licences and regulatory approvals
- current or historic disputes
- any threatened litigation
The purpose is to identify obligations or liabilities that you could inherit through the acquisition.
Tax
Tax due diligence may include:
- corporation tax
- VAT
- PAYE and National Insurance
- historic tax returns
- tax reliefs
- outstanding liabilities
- HMRC enquiries or disputes
- the tax treatment of particular transactions
Tax issues identified during due diligence don’t necessarily stop a deal, but they may need to be addressed through the transaction documents or reflected in the price.
Suppliers
Understand the relationships that the business relies on.
Review:
- major suppliers
- supplier concentration
- contract terms
- payment terms
- pricing arrangements
- alternative suppliers
- any dependency on a particular supplier
If the company depends heavily on one supplier, consider what would happen if that relationship ended or prices increased significantly.
Property and assets
Depending on the business, review:
- property ownership
- leases
- rent and service charges
- lease expiry dates
- equipment
- machinery
- vehicles
- stock
- asset condition
- maintenance requirements
- future capital expenditure
Make sure you understand what assets are included in the transaction and whether significant investment will be required after completion.
Technology and intellectual property
For businesses where technology or IP is important, investigate:
- ownership of intellectual property
- trademarks
- domains
- software licences
- internally developed software
- IT infrastructure
- cybersecurity
- data protection
- third-party technology dependencies
Make sure the company actually owns or has the right to use the technology and intellectual property it relies on.
What happens if due diligence identifies a problem?
It is unusual to complete due diligence without finding anything that requires further discussion.
Some issues simply need clarification.
Others may result in additional protections in the legal documents, changes to the transaction structure or a request to resolve something before completion.
More significant findings can lead to a price renegotiation or, in some cases, a buyer deciding not to proceed.
The purpose of due diligence isn’t to find a perfect business. It is to make sure you understand the business you’re buying and the risks you’re taking.
Don’t treat due diligence as a box-ticking exercise
Professional advisers can help investigate the financial, legal and tax position, but the buyer still needs to understand the commercial reality of the business.
Ask questions.
Challenge assumptions.
Speak to management where appropriate.
Understand where the cash comes from, which relationships matter and what could realistically change after you become the owner.
Due diligence should leave you with a much clearer picture of both the opportunity and the risks.
That is ultimately what allows you to make an informed decision about whether to complete the acquisition.
Find businesses and the right professional support on The Brokerage
The Brokerage connects buyers with business owners, brokers and advisers bringing businesses to market. Create your buyer profile, define your acquisition criteria and discover opportunities that match what you’re looking for. You can also use The Brokerage’s Professional Network Directory to find advisers who can support you through the transaction, including legal, financial, tax and due diligence specialists. Having the right professional team around you can help you investigate an acquisition properly, identify potential issues early and move through the due diligence process with greater confidence.