Due diligence when buying a business: the checklist

Due diligence exists to answer one question: is this business what it was described as?

It is not an attempt to find a reason to walk away. Most of what it turns up is neither fatal nor free, and the normal outcome is a deal that proceeds with an adjusted price, a specific indemnity, or a condition attached.

Work through it in six areas.

1. Financial

Ask for: three years of statutory accounts; monthly management accounts for the current and previous year; the reconciliation between the two; the adjusted profit schedule with evidence for every line; aged debtors and creditors; the bank facilities and any security; a fixed asset register; the stock valuation and the policy behind it; and the current year forecast with its assumptions.

What you are testing:

• Are the management accounts reliable? Reconcile them to the filed accounts. A gap with no explanation means every other number needs verifying independently.
• Do the add-backs hold? Go through the adjustment schedule line by line and ask for the document behind each. This is where price moves.
• Is the revenue real and collected? Look at debtor days and at the ageing. Revenue booked and not collected is not revenue yet.
• Is there deferred capital expenditure? Compare capital spend to the asset base. A business that has not reinvested for six years has flattered profits and a bill coming.
• What is the working capital cycle? You need to fund it from day one. A business that collects in ninety days and pays in thirty needs cash you must have available on completion.
• Is the trend real? Look at monthly revenue over twenty-four months, not annual totals. Annual figures hide a decline that started eight months ago.

2. Legal and corporate

Ask for: the certificate of incorporation and articles; statutory registers; share certificates and transfer history; any shareholders agreement; board and shareholder minutes; details of any litigation current, threatened or concluded in three years; licences and permits with renewal dates; intellectual property including trade marks and domain ownership; and the insurance schedule and claims history.

Check independently at Companies House: the filing history for late or amended accounts, the charges register for debentures and secured lending, and the persons with significant control.

What you are testing:

• Can the seller sell what they are offering? Missing share transfers, unwaived pre-emption rights and undocumented option promises all stop deals.
• What is secured against the assets? A registered charge has to be released on or before completion.
• Who owns the intangibles? Trade marks, the domain and the social accounts. Domains registered to a former developer's personal account are common and fixable, and much cheaper to fix before completion.
• Is there litigation you are inheriting? In a share purchase, the company's history comes with it.

3. Commercial

This is the part to do yourself.

Ask for: revenue split by customer for three years; the material customer and supplier contracts; standard terms of business; the pipeline; any exclusivity or minimum volume commitments; and details of any change of control provisions.

What you are testing:

• Concentration. What percentage is your largest customer? Your largest five? If one customer is 40 per cent, everything else is secondary to the question of whether they stay.
• Change of control clauses. A clause letting a major customer terminate when the business is sold converts your largest revenue line into your largest risk. Ask for a waiver, or price for it.
• Whose relationships are they? Long-standing customers of a business are an asset. Long-standing customers of the owner are a risk that transfers with a handshake and a hope.
• Contract length and renewal history. Contracted beats repeat beats one-off, and an actual renewal rate beats an assertion about loyalty.
• Why do customers buy here? If the answer is price, and a competitor can go lower, you are buying a position rather than a business.
• Supplier dependency. Sole source supply, exclusivity, and personal terms that do not transfer.

4. Employment

Ask for: an anonymised schedule with role, start date, salary, hours, holiday, notice period and any benefit; contracts and the staff handbook; pension scheme details and funding position; details of any grievance, disciplinary, dispute or tribunal claim; and confirmation of right to work checks.

What you are testing:

• Who actually runs the business? Identify the two or three people the operation depends on, and work out what keeps them.
• What are you inheriting? Under TUPE, employees transfer with their terms and their continuity of service. Long service carries redundancy and unfair dismissal exposure, and you should know the number.
• Are the contracts in order? Missing written particulars, unenforceable restrictive covenants, and holiday accrued but unrecorded are all common.
• Is anything live? A grievance in progress transfers with the employee.

5. Property

Ask for: the lease in full with every variation, licence to alter and licence to assign; the rent review history; service charge accounts for three years; any schedule of condition; dilapidations correspondence; and the landlord's position on the sale.

What you are testing:

• How long is left? A short unexpired term limits what you can invest and what you can sell the business for later.
• Is it protected? Whether the lease is inside or outside the security of tenure provisions of the Landlord and Tenant Act 1954 determines whether you have a right to renew.
• What is the dilapidations exposure? Potentially a substantial sum at the end of the term, and one buyers routinely fail to quantify.
• Does the landlord have to consent? Many leases treat a change of control as requiring consent. That can take months and is outside both parties' control.
• What are the outgoings? Rent, business rates, service charge and insurance together, not rent alone.

6. IT, data and systems

Ask for: the systems in use and their licences; hosting and support arrangements; the backup and recovery position; data processing agreements; the privacy notice; and the record of processing activities.

What you are testing:

• Are the licences transferable? Some are not, and re-licensing on a change of ownership can be expensive.
• Who holds the keys? Administrator access to the systems, the domain registrar and the accounting software. Get a written list and change everything on completion day.
• Is there a backup that has been tested? Not "we have backups". When was one last restored?
• What is the UK GDPR position? You are inheriting the customer database and the obligations attached to it.

Running it well

Agree scope and fees first. Tell your accountant and solicitor the size of the deal and ask for a scoped quote. Uncapped due diligence on a small acquisition can cost a disproportionate amount.

Use a single request list. One document, numbered, with a status column. Drip-feeding requests is how due diligence takes twelve weeks instead of six.

Keep a record of what you received and when. If a dispute arises later about what you were told, the audit trail is the answer. A data room that logs who opened which document, and when, does this automatically.

Watch the timetable. Your exclusivity period is finite. If the seller is slow, raise it early and in writing rather than at the end.

When you find something

Almost every business has something. Sort what you find into four buckets:

| Finding | Response | | --- | --- | | Quantifiable and one-off | Reduce the price by the amount | | Contingent and specific | Ask for an indemnity covering that risk | | Fixable before completion | Make it a condition | | Changes what the business is | Withdraw |

The last is rare. The most common genuine reasons to withdraw are a revenue decline that was not disclosed, a customer concentration that turns out to be a relationship with the seller personally, and a lease position that makes the investment unrecoverable.

Everything else is a negotiation, and you are in a considerably stronger position to conduct it than you were before you started.