Due diligence: what to check and in what order

Costs rise as diligence goes on. The first week mostly costs your own time. Then come accountants, lawyers drafting a purchase agreement, lender fees and perhaps specialist reports. A finding that ends the deal costs least when it surfaces early.

So the sequence follows a simple rule. First, check what would stop you buying at any price: whether the earnings are real, whether the revenue will last and whether the business can pass to you. Then look for what the contract needs to protect you against, and for costs that change what the business is worth to you. Last, confirm the figures that set the exact amount you pay.

Build stop points into the plan. At the end of each stage, decide whether to continue, renegotiate or walk away, and write down in advance what would make you walk. Money already spent on advisers makes it harder to stop, and a line drawn before you started helps you hold to it.

The order bends to the business. For a software company, the code and its security belong near the start, because the code is much of what you are buying. For a manufacturer with ageing machinery, the condition of the equipment may matter as early as the earnings. Use the sequence below as a default and move stages forward where the business demands it.

A few hours of preparation can save weeks.

• Send a document request list soon after signing. The diligence document request list is a starting point, and online business diligence adds what SaaS, ecommerce and content businesses need.
• Ask for a data room: a shared, indexed folder. Keep your own tracker of what you requested, what arrived and what is still outstanding.
• Engage advisers with a staged scope. An accountant for financial diligence and a lawyer (a solicitor in the UK) for legal diligence are the usual core. Ask for fee estimates stage by stage, so you can stop without paying for work you no longer need.
• Ask your lender early what it needs to see, such as particular reports, an asset valuation or a business plan, so its requirements do not arrive late.
• Agree a weekly call with the seller or broker, and keep one running list of open questions.
• Carry forward what you already know: your notes from earlier calls, the figures in the information memorandum and any desk research or dossier findings, so nobody repeats work that has been done.

The price rests on earnings. If they are not there, nothing else you check will matter.

• Match revenue to the bank. For a sample of months, tie reported sales to deposits, and to payout reports from card processors or marketplaces where they apply.
• Compare the management accounts with filed accounts and tax returns, and get an explanation for every material difference. See tax returns that do not match the accounts.
• Rebuild the trailing twelve months month by month. Look for lumpy months, revenue pulled forward from the following period and one-off revenue.
• Test each add-back against invoices, payroll records or bank entries. Add-backs: which hold up and which do not explains the common ones.
• Track gross margin by month and, where possible, by product or service. A sudden improvement shortly before a sale deserves an explanation.
• Look for costs that are missing: family members working unpaid, rent paid below market to a landlord the owner controls, or services supplied cheaply by another business the owner runs. See related-party transactions.

On larger deals, or where a lender or investors require it, commission a quality of earnings report from an independent accountant. On smaller deals, a narrower review focused on revenue, margins and add-backs may be proportionate.

By the end of this stage you should have your own normalised earnings figure. If it is materially below the figure your offer relied on, pause and discuss it with the seller before you spend more.

Earnings can be real and still fragile.

• Break revenue down by customer for several years. Look at the share held by the largest customers and how that list has changed. Customer concentration and why buyers discount for it explains why this moves value.
• Read the contracts behind significant revenue: their term, renewal and termination rights, and any clause that ends the contract on a change of control.
• Measure how well the business keeps its customers, in the way that suits the model: churn and net revenue retention for subscriptions, repeat purchase rates for ecommerce, renewal rates for service contracts. Watch refunds and chargebacks as well.
• Find out where new customers come from, and how exposed the business is to a single channel, search engine or marketplace.
• Compare current trading with the same months last year, and look at orders or bookings already in hand.

Speaking with key customers is often the most useful check and the most sensitive. It usually happens later in the process, with the seller's agreement and often framed as an introduction. Make sure it happens before you are committed to complete, not after.

A profitable, stable business is worth little to you if its premises, licences or relationships stay behind with the seller. Many of these checks are quick, and any one of them can end a deal, so start them in the first week alongside the earnings work rather than waiting for it to finish.

• Ownership: confirm from the company registry and the seller's own records that the people selling own what they are selling.
• Premises: the remaining lease term, whether the lease can be assigned or survives a change of ownership, whether the landlord must consent and when the rent is next reviewed. See a lease ending soon or needing landlord consent.
• Licences and permits: whether they transfer, must be applied for again or are personal to the owner. See licences or permits that do not transfer.
• Intellectual property, domains, software and online accounts: who owns them and in whose name they are registered. See intellectual property held by the owner or freelancers and domains or accounts held in personal names.
• Suppliers: the terms of key supply agreements, especially exclusive distribution rights or single-source supply.
• The owner's role: which relationships and tasks must be handed over, and whether the agreed transition period is long enough to do it. Owner dependence and how to test it goes into detail.
• Key staff: who is essential and whether they are likely to stay. Plan any conversations with them together with the seller. See key staff not tied in.

The deal structure changes this stage. In a share purchase (a stock purchase in the US), contracts and licences generally stay with the company you are buying, although change of control clauses can still apply. In an asset purchase, each contract, lease and licence usually has to be assigned, transferred with the other party's consent or issued again. Your lawyer will confirm what applies in your case.

By now the deal is more likely to go ahead, and detailed legal work earns its cost. What you find here shapes the protections in the purchase agreement and sometimes the price.

• Tax: whether returns and payments are up to date, including payroll taxes and sales tax, VAT or GST, and whether any enquiries from the tax authority are open. In a share purchase, historic tax stays with the company you buy. In some countries, certain tax debts can follow a business even in an asset purchase. In many US states, for example, a buyer of a business's assets can become liable for the seller's unpaid sales tax unless the state's notification or clearance steps are followed. See unpaid taxes a buyer could inherit.
• Disputes: current and threatened claims, customer complaints and correspondence with regulators. See pending or threatened litigation.
• Employment: contracts, holiday pay and overtime, pension or benefit obligations, and contractors who are employees in practice.
• Data protection: how customer data was collected, whether consent was valid and whether there have been any breaches. See customer data collected without valid consent.
• Sector rules: health and safety, environmental permits, product safety, food hygiene or professional regulation, as they apply.
• Security and guarantees: charges or liens registered over the business's assets, which will need to be released at completion, and any guarantees it has given for others.

Legal findings feed into the purchase agreement. Warranties are statements the seller makes about the state of the business. Indemnities promise to reimburse you if a specific, known risk turns into a loss. The disclosure letter (disclosure schedules in the US) is where the seller lists exceptions to the warranties. Read it as carefully as any diligence document, because a matter fairly disclosed there is usually one you cannot claim for later.

This stage rarely ends a deal, but it shapes your costs in the first year and your plan for the first months.

• Equipment and vehicles: age, condition, service records and any deferred maintenance or capital spend that will fall to you.
• Processes: whether the way work gets done is written down or held in people's heads. See undocumented processes.
• Systems: accounting, stock control, customer records and the website, who holds administrator access and whether software licences are in the business's name.
• Software businesses: code quality, security, hosting and third-party dependencies, if you have not already moved them earlier. See code quality and security debt in software.
• Insurance: current cover and the history of claims.

Close to completion (closing in the US), the work turns to the numbers that decide exactly what you pay.

• Working capital: agree how it is measured and the normal level the business must be handed over with. Working capital, inventory and what the price includes explains the mechanics.
• Inventory: arrange a count close to completion and agree how slow-moving or damaged stock is valued. See ageing or written-down stock.
• Debt and cash: list every loan, overdraft, finance lease and debt-like item to be settled at completion, and agree how any cash left in the business is treated.
• Trading since the letter of intent: ask for monthly management accounts up to completion. Check that sales have held and that the seller has not stretched payables or pushed customers to pay early.

Sort every finding into one of three groups, the same way Loupe's red flag library rates severity.

• Deal breaker: the problem goes to the heart of what you are buying, such as earnings that do not exist or a lease that cannot be secured. Unless it can be put right before you commit, this is usually a reason to walk away.
• Price it in: the business is still worth buying, but for less or on different terms.
• Fixable: the issue can be resolved before completion or dealt with in the contract.

For the second and third groups you have several tools: a lower price, more of the price deferred through seller finance or an earn-out, an amount held in escrow or held back, a specific indemnity, or a condition that must be met before completion, such as landlord consent.

Negotiate from evidence. Show the seller what you found and the arithmetic behind any change you ask for. Take a fictional example. Karoo Cold Chain, a South African refrigerated transport business, is under offer at R20,000,000. Diligence finds R1,000,000 of overdue vehicle maintenance and an unresolved dispute with a former employee. The buyer asks for R1,000,000 off the price for the maintenance and a R500,000 holdback until the dispute is settled, and shares the service records and correspondence behind both requests. A seller can argue with a demand. It is harder to argue with a service record.

Walking away after diligence is not a failure. Often it is the process doing its job.

Some checks do not need the seller at all. Company registry filings, directors and owners, litigation and insolvency notices, domain history and review patterns can all be checked from public sources before you sign an NDA. A Loupe dossier covers those checks on a listed business and shows you where to look first. It does not replace diligence by your own accountant and lawyer.