Due diligence is the part of an acquisition where a buyer gets to look under the hood of a seller business. In this exercise, the buyer figures out—or tries to figure out—whether the business on offer is the business it would own after closing. Diligence can extend over a period of weeks or months, and buyers often need targeted assistance from accountants, lawyers and consultants to get comfortable. Diligence can be a lot of work, even with an organized seller.
In most deals, diligence follows the execution of a non-disclosure agreement and a letter of intent, or some other form of term sheet. Diligence may occur before or after the signing of the purchase agreement (and often through both timeframes). In many deals, earnest money deposits “go hard” once the diligence window closes. It’s usually full speed to closing after that.
To kick off the diligence process, buyers will typically provide a list of categories for sellers to address, often by populating a virtual data room with files. Buyers should understand that a seller’s initial disclosures are only a starting point. Diligence is iterative, conversational and requires sustained focus by buyer and seller alike.
A data room is not proof
The point of diligence is not to create the world’s largest virtual data room. It is to verify ownership, earnings, assets, contracts, liabilities, compliance, etc.—and then decide what those findings mean for the deal. Buyers should insist that sellers provide information in a timely and organized manner, responsive to prompts.
The buyer’s job is to test what the seller says against all available evidence. This typically includes non-public company information, like accounting data and tax records, as well as publicly searchable filings. Conversations with the seller over records will ensue, and key employees are typically brought in at some point. During the diligence process, deal terms are often negotiated and/or revised, from purchase price on down.
Right size the diligence process for the deal
There is no universal diligence timeline. I’ve run deals with diligence windows as short as 14 days, and others that stretched beyond 90. Generally speaking, the larger the deal, the longer the timeframe. And generally speaking, buyers typically want more runway; sellers want less.
Rather than haggle over abstract timeframes, the deal parties should allot time for the work they reasonably think is necessary. Wrapping up diligence early is almost never a problem, but negotiating extensions can be fraught. If a buyer seeks an extension after seller has timely produced data, the seller may use any perceived leverage to re-trade on terms. That leverage can be strong when earnest money is at stake or announcements have been made.
For buyers, a simple issue tracker helps keep things online. On each issue, the buyer should record what was found, where that information came from, who owns any follow-up, and how the data may affect the transaction. Otherwise, important problems can vanish into long email threads and obscure document folders.
The buyer should also distinguish between issues that need to be resolved before signing a purchase agreement, and issues that can be addressed between signing and closing. For example, a missing lender release may be a closing condition that need not hold up signing. A disputed working-capital item may be handled through a purchase-price adjustment. Certain risks may be manageable through indemnity, escrow, insurance, earn-out features, etc.
The important thing for buyers is to make these decisions consciously and with adequate information. A known problem is almost always easier to address before closing than after.
Start with who owns the business
Before a buyer spends undue time modeling revenue or negotiating indemnities, it should confirm who actually owns the business and can sell it. This should be straightforward—and often it is—but the number of deals with “clouds” on ownership is surprisingly high.
For a stock or membership-interest purchase, that means reviewing the company’s governing documents (including all amendments), equity issuances, board minutes and consents, and agreements among owners. Certificates of existence and foreign-qualification records help confirm the business remains in good standing with relevant state authorities.
A seller’s cap table is always important, but it should be tested against underlying records. Buyers should look for options, warrants, convertible instruments (like SAFEs), profits interests, phantom equity, promises of equity, and other rights that could affect ownership or even hold up a deal.
Transfer restrictions can also complicate closing, especially in smaller business sales. Rights of first refusal, drag-along rights, voting agreements, lender covenants, leases etc. may require notice and approvals from people who are not parties to the purchase agreement. It’s critical to get on these items early—deals are often compromised by third-party approvals.
Financial due diligence: follow the money
Financial diligence is where the buyer looks beyond headline revenue numbers and metrics like cash flow, EBITDA, or seller’s discretionary earnings.
A responsible buyer will reconcile the seller’s earnings representations to financial statements and tax returns. Supporting records like bank statements, payroll reports and customer invoices should substantiate these statements and filings. In larger deals, a quality of earnings report may help test whether revenue is recurring. It will also show whether expenses are properly normalized and working capital is adequate.
Revenue concentration is also important. A customer representing 20% of sales may be a safe bet in the context of a long contract term--especially if that customer has previously "re-upped" with the business and has multiple relationships within the seller entity. A smaller customer may be less stable if the relationship depends entirely on the owner, or if that client can terminate as soon as the deal closes.
With smaller businesses, “add-backs” are often an area of concern in financial statements. Add-backs are expenses that are non-standard or personal to a seller. As such, they won’t be included in a buyer’s future P&Ls, and will have a downward effect on net income moving forward. Buyers will want to “add these items back” to net income in order to paint a fairer picture of business financials, and ultimately, value.
Finally, working capital is a key consideration in closely-held business sales. Buyers should understand the company’s historic accounting practices, seasonality, receivables, payables, inventory, reserves, etc. Each of those items will affect the working-capital target at close, and will determine whether the buyer receives a business with the resources needed to operate on day one.
Tax issues
Tax diligence is often treated as a technical workstream with lower priority than “threshold” diligence matters. That can be risky. Like other financial issues, tax matters can affect deal structure as well as post-closing liability. I typically advise buyers to onboard tax professionals early on, to review the target company’s tax matrix.
Note: non-stock buyers will sometimes treat tax diligence less seriously than equity purchasers. After all, the purchase agreement will protect these buyers from liability for past company income tax. That’s a mistake, though. Asset purchasers may experience successor liability for sales and payroll taxes under state-specific statutes, or they may acquire assets subject to liens. In many cases, it’s also important to ensure correct purchase price allocation for depreciation benefits.
Make sure the assets are not pledged to someone else!
Debt and lien diligence is one of the most practical parts of the acquisition process. A buyer needs to know what debt will be paid off, and when; what liens must be released prior to closing; and whether all acquired assets will transfer free and clear.
This exercise starts with reviewing debt instruments, as well as any capital leases, guaranties, letters of credit, etc. The debt schedule should match the company’s financial statements, as well as lender statements and any available public-record searches. If reconciliations are needed, now is the time.
Note that any lien search should use the seller’s correct legal names—including former names where appropriate—and should cover the jurisdictions where filings are likely to exist. Depending on the business, that a lien search may include UCC records, real-property records, tax liens, judgment liens and IP-related filings.
Contracts are key
A contract list limited to the seller’s largest customers is rarely enough. The buyer should survey the seller’s full suite of contracts, from customer to vendor agreemetns.
With contracts, it’s important to remember that the main agreement is not always the whole deal. Purchase orders, statements of work, emails, and course-of-dealing practices may fill in—or even modify—important economic terms.
In an equity purchase, the seller remains the party to its contracts; however, a change-of-control provision may still create a sticky, third-party consent right. In an asset deal, the buyer usually needs to take an assignment of the acquired contracts, and the underlying contract language will determine whether the counterparty must consent.
Contract review should focus on what might change after closing. Can a customer leave? Can a supplier reprice? Does a landlord need to consent? Could an exclusivity provision limit future growth? Here, experienced legal counsel should be able to identify key issues for buyer consideration.
Finally, it’s worth noting that many contracts may not reflect the contract parties’ course of dealing. Oral agreements and modifications may be enforceable, but these create a different kind of risk. A buyer should understand how key contracts are observed, and how business relationships work in practice— beyond what the four corners of each document.
Intellectual property needs a chain of title
Businesses regularly assume that they own the trademarks, customer data, and other intellectual property used in their operations. A good diligence process will test that assumption.
The seller should identify the intellectual property the company uses to run its business. Ownership often turns on the documents. A contractor may have been paid to build software, write content, or create a design; but payment alone does not necessarily transfer the copyright. Under 17 U.S.C. Section 204, a copyright transfer generally requires a signed writing. Patent assignments similarly must be in writing under 35 U.S.C. Section 261. Usually these assignments are recorded with the USPTO, but sometimes they are not.
The intellectual property inquiry overlaps significantly with contract review. Buyers must look carefully at employment and contractor agreements, licenses and settlement documents. Missing assignments and other ownership problems should be identified early, with the seller required to resolve them before closing whenever possible.
Privacy and cybersecurity are transaction issues
Privacy and cybersecurity diligence is not only for large technology companies. Any business that collects personal information from employees or customers has data-related risk.
The buyer should compare the seller’s actual data practices against its privacy policy (if applicable) and applicable law. The buyer should understand what information the seller collects and how it stores and uses that information. The buyer should also understand which payment processors, payroll platforms and others off-site vendors receive sensitive information. Standard contract terms with these providers often merits review, especially if the target is a services-based business.
The buyer should also review security incidents, backups, and incident-response procedures. If a cybersecurity incident occurred, the buyer needs to know whether the seller remediated the problem and preserved a defensible record of its response.
People, claims and compliance
For many businesses—and especially service-based businesses—employees are the core asset bought and sold. Business purchases can be structured to mandate the retention or transfer of designated employees, and buyers often condition purchases on acquiring key operational talent. In asset purchase agreement, the seller will typically be required to terminate all employees at closing, at which point the buyer re-hires them (or whichever employees it selects). In a stock deal, the buyer simply inherits the roster of employees on hand at close.
Employment diligence should reconcile the employee roster to payroll records and written employment agreements. The buyer should also understand more than just compensation (including accrued leave) and employee classifications. Issues like immigration status, invention assignments and pending workplace claims are each important. Even if a company has no single catastrophic claim, a buyer will inherit its culture and patterns.
Finally, the question of whether employees may be bound by noncompetition agreements—which may be difficult or impractical to enforce—is also worth understanding.
Real estate, environmental risk and insurance
If the business owns or leases real property, the buyer should understand not only the property itself, but whether the company (in the case of a lease) can continue using it after closing.
Owned-property review will usually start title review, often starting with a public records search, and acquisition of a preliminary title report. Leased-property review should cover the lease, including any guaranties and assignment restrictions.
Environmental diligence is scary for many sellers, and can raise cost and timing considerations for buyers. Inquiry should be tailored to the property’s history and the company’s operations. That said, environmental diligence shouldn’t be skirted: CERCLA can impose liability on current owners and operators for certain environmental cleanup costs, subject to statutory defenses and liability protections.
Insurance deserves a historical review as well. A current policy may not cover a claim arising from an older event. The buyer should review all policies, and whether the transaction requires consent, tail coverage, or other adjustments.
Representations and warranties insurance can help in the right deal, but it is not a substitute for diligence. Known problems, exclusions, and the quality of the underwriting record all affect whether a policy will provide meaningful protection.
Use diligence to improve the deal
It's important to remember that diligence isn't just a rote exercise. Diligence should lead somewhere. Each material finding should result in a documented deal response.
Sometimes the response is simple: the seller pays off a loan, obtains a landlord consent, or fixes a corporate records problem. Other issues may call for a more significant deal revision: anything from an excluded liability to a purchase-price adjustment. In some deals, a modification cannot be agreed upon, or a buyer may elect to simply walk away.
The purchase agreement’s disclosure schedules are part of this final step. They should be checked against the diligence record, updated and approved by both parties, and they should never replace the buyer’s own investigation. Seller disclosures may qualify representations, identify exceptions, or trigger new questions that need to be answered before closing. These schedules typically serve as final "exhibits" to any purchase agreement, and tie in directly to representations and warranties made by seller parties.
Due diligence: the practical takeaway
The buyer’s goal in due diligence is not to eliminate every uncertainty. No acquisition comes with that guarantee.
The goal is to learn about the seller’s business, and to identify hotspots before the buyer loses the ability to walk away. Once a material issue is known, the buyer can request that the seller fix it. Alternatively, the buyer may suggest a contract modification to re-allocate risk, or even a change in purchase price terms.
For earlier posts in this series, check out the following:
