What is due diligence?

Due diligence is the investigation a buyer (or investor) carries out into your business before an acquisition, disposal, refinancing or similar transaction. It's a bridge that has to be crossed in almost every deal, and without it, the risk of problems along the way increases for the buyer. In plain terms, its purpose is to give both sides enough understanding of the business to make an informed decision.

When does due diligence happen?

Due diligence starts once initial discussions have led to broad agreement on the key terms, usually set out in a Heads of Agreement. The typical sequence runs: initial approach from a third party, initial discussions, Heads of Agreement, due diligence, renegotiation and warranties/indemnities, then the Purchase and Sale Agreement.

A few things make this stage different from other business projects you'll have run:

• It's time-driven. Once the Heads of Agreement is signed, the buyer usually has a short exclusivity period to investigate fully, so this can be an intense, query-heavy stretch.
• It pulls heavily on your finance team and senior management, which brings its own risk of taking your eye off day-to-day operations.
• Its purpose is risk management for the buyer, to validate the risks and opportunities in your business.
• Much of it is outside your control, though you can proactively keep highlighting the opportunities and supporting them with good data.
• Poor management of the process creates real risk on both sides: for the buyer, missed risks or opportunities; for the seller, lost credibility, errors and delays that can affect price or completion.

The four types of due diligence

Financial due diligence

Typically covers a five-year window (three historical years, two forecast), reviewing tax compliance, bookkeeping accuracy, key financial metrics and margins, and the quality of your management reporting. It covers: historical financials, your tax compliance track record, gross profit, operating profit and EBITDA percentages, client and project profitability, cost of sales and overheads, cashflow management, and your budget/forecast structure.

Commercial due diligence

Aims to understand the direction of the business, its strategy, and how that's driven growth. It looks at business strategy, new business pipeline and any lost clients or projects, business strengths and potential weaknesses, customer relationships and contract lengths, competitors, and the assumptions behind your budgets and forecasts.

Operational due diligence

Focuses on how involved the new owners will need to be to hit the post-acquisition budget. That means reviewing your management team's structure, background and skills, how the wider business is organised, whether teams are over or understaffed, internal processes and systems, and other issues like disaster recovery and data protection.

Legal due diligence

Checks whether the business holds together legally: customer and supplier contracts and terms, any onerous terms with landlords, employment contracts appropriate to seniority, ownership of assets and IP, accuracy of shareholder and debt registrations, and any commercial, employee or other disputes.

What happens after due diligence?

Once the process completes, outstanding queries, financial risks, potential liabilities and any concerns about future direction should be clearly resolved, leading to one of three outcomes: the deal proceeds to a Sale and Purchase Agreement, one side walks away, or issues raised lead to further discussion, price renegotiation or additional legal terms, which may still end in completion.

How to prepare for due diligence before you sell

Given that selling your business is likely the largest financial transaction of your career, and given how intense the process can be, our advice to clients considering an exit is straightforward:

• Prepare for due diligence well in advance of a sale.
• Resolve any "fixable" issues before you go to market.
• Build credibility by making sure your basic financials and compliance are solid.
• Build a strong management team that can operate without you.
• Keep any disruption to day-to-day trading to a minimum.

Frequently asked questions

How long does due diligence take when selling a business?

It depends on the size and complexity of the deal, but the exclusivity period a buyer is given to investigate is usually short and intense, expect a demanding few weeks to a few months of queries and document requests.

What documents do I need ready for due diligence?

At minimum: three years of historical financials plus forecasts, tax compliance records, key contracts with customers and suppliers, employment contracts, and evidence of asset and IP ownership. Having these organised in advance speeds everything up.

Can due diligence cause a sale to fall through?

Yes. An unresolved risk, a credibility gap in your financials, or delays in providing information can all lead a buyer to walk away, or to renegotiate price. Good preparation is the best protection against this.

What happens next?

We help clients prepare in advance for an expected due diligence process when they're considering an exit in the medium term, and we help clients who are already in the middle of one. If you have any questions, get in touch with Damian Connolly.