In Short
- Due diligence is the process of reviewing a business before purchase to identify risks.
- It helps you decide whether to proceed with the purchase, renegotiate terms or walk away.
- Financial, legal and operational checks reduce the chance of hidden problems after the sale.
Tips for Businesses
Before buying a business, carry out due diligence with help from legal and financial advisers. Review financial records, contracts, leases and compliance with laws. Ask questions, request warranties, and use indemnities where needed. If key information is withheld, consider this a warning sign and proceed carefully.
Table of Contents
Due diligence is the process where the buyer reviews information supplied by the seller about the business, usually prior to entering into a business sale agreement. The goal of due diligence is for the buyer to understand the risks and liabilities they may be assuming in purchasing the business. Consequently, they can be better placed to decide whether or not to proceed with the acquisition or renegotiate the terms of the deal.
This article will provide you with an overview of the due diligence process required when buying a business and how to complete it.
Starting Due Diligence
When buying a business, you could undertake the due diligence work yourself. However, for more complex businesses, it is worth considering a more formal approach and engaging a due diligence team to assist you. Your due diligence team should include experts who can assist you in assessing the financial, commercial and legal risks associated with your business purchase, including:
- an accountant or financial advisor;
- your M&A lawyer; and
- your business advisor or broker.
A due diligence team will assist you by:
- reviewing the business’ records;
- providing you with professional advice on the business’ viability and suitability; and
- making you aware of any existing risks and liabilities.
Know which key terms to negotiate when buying a business to protect your interests and gain a favourable outcome.
The Due Diligence Process
1. Request Documentation to Review
You, or a member of your due diligence team (such as your accountant or lawyer), sends the seller (or their lawyer):
- a list requesting the business records you would like to inspect (e.g. financial statements, product sale history, equipment hire contracts, contracts with customers etc.); and
- a list of questions you want to ask them about the business.
2. Documentation is Provided
The seller can submit that information to you via email, in person or through a member of their own due diligence team (e.g. their lawyer). Alternatively, they can upload the information to a secure document-sharing platform (like Dropbox or Google Drive) for you to access and download. This type of platform is often called a data room and can be accessed by both the buyer’s and seller’s due diligence teams.
3. Requests For Information (RFI) Process
You can ask for additional documents from the seller and submit a list of questions to them about the information they have provided. This is called an ‘RFI’, which stands for requests for information. You can submit your RFIs to the seller via a spreadsheet, Word document or through a Q&A mechanism in the data room so they can fill in their responses.
4. RFI Responses Provided
The seller will then prepare and submit responses to your questions. During this process, your due diligence team will also assess and report on the following:
- any key concerns they have about the information provided; and
- potential solutions or options you can raise with the seller to help reduce risks associated with the purchase.
5. Due Diligence Reports Prepared and Assessed
With the requested information, your due diligence team can now prepare the necessary reports. Once these reports have been prepared, you can use them to decide whether you want to purchase the business.
6. Proceeding With the Purchase
How you proceed with the sale is ultimately a commercial decision. You may decide that:
- the business is valuable and agree with the seller’s asking price;
- you want to try and negotiate a reduced price based on the results of your due diligence; or
- the business is too risky, and you will not proceed any further with the purchase.
When Should You Undertake Due Diligence?
The due diligence review process generally takes place before you enter into a formal business sale agreement. Otherwise, you risk paying a premium for a business with unexpected financial issues, damaged equipment, expired or unsuitable contracts or premises with health and safety issues that you will need to rectify at great expense.
It is also possible to have a due diligence period clause included in the contract. This type of clause allows you to sign the contract and conduct your due diligence within a certain period of time after signing (e.g. 10 business days). If you are unhappy with anything you uncover about the business during this period, you can terminate the contract and walk away from the sale.
How Long Does Due Diligence Take?
This depends on the following:
- the business’ complexity;
- how many records you want to review;
- how quickly the seller provides you with the requested information;
- how long your due diligence team needs to prepare the relevant reports and discuss them with you; and
- your timing for the sale, generally.
As a result, the due diligence process can take anywhere from a week or two to several months. You will need to factor this into your timing for the business purchase and be flexible in the event of a delay.
Confidentiality Considerations
If the seller refuses to provide you with certain documents before you sign the business sale agreement, they may be worried about what you will do with the information. For example, they may think you will disclose it to third parties without their approval or use it to compete with their business. In this situation, you should ask the seller why they have not provided the requested documents.
- if they are concerned about confidentiality, offer to first sign a non-disclosure or confidentiality agreement; or
- if you have built a due diligence period into the business sale agreement, the agreement should include confidentiality obligations to protect the seller’s information.
If the seller still refuses to provide certain documents to you, take it as a red flag. There may be issues with the business or certain documentation they do not want you to discover.
What Do I Review?
You should investigate all business records, issues and assets to help you decide whether to proceed with the purchase. This will help you to understand the following:
- how the business has been operating recently;
- whether there are any issues you should be concerned about; and
- inform your decision on how to proceed with the purchase.
During the due diligence process, you should also investigate the following:
- the business’ ability to make a profit;
- the condition of the equipment (i.e. computers, ovens, vehicles);
- who owns important assets (i.e. trade marks, software, licences); and
- whether there are any businesses that you will have to compete with.
Financial Issues
| Key Issues/Documents | Explanation |
| Profit and loss statement | This shows how much money or profit the business is making |
| Balance sheets | Including accumulated entitlements to annual leave or other employee benefits |
| Tax returns | To understand the revenue of the business and the tax required to be paid each year (on average) |
| Sales records | To check how the products or services of the business perform (i.e. which product line is most valuable) |
| The valuation of the business | This is how much the business is worth |
Commercial Issues
| Key Issues/Documents | Explanation |
| Location | Is it operating in a busy area, or are there any impending developments? |
| Growth opportunities | Is it a declining industry? |
| Competition | Are there other similar businesses competing with the business? |
| Business suitability | What experience do you have in the industry? |
| The condition of key assets | For example, computers, ovens, vehicles etc. |
Legal Issues
| Key Issues/Documents | Explanation |
| Corporate information about the seller | If they are a company, confirm who the directors are. |
| Asset ownership | Who owns trade marks, software etc. |
| The contracts in place | Leases for the premises, supply contracts, customer contracts, etc. |
| Employees | Whether they have valid contracts and are employed under the appropriate awards? |
| Compliance with laws and regulations | Confirm if appropriate licences are in place, such as liquor licences, food licences etc. |
Key Legal Documents
There are some common legal documents that you should review. For example, the seller’s contracts with third parties and documentation that confirms ownership of particular assets.
The key contracts that are common to most businesses and that you should review during due diligence are:
- leases;
- supply contracts;
- client agreements; and
- employment contracts.
It is important that these documents contain terms suitable for you as they may be transferred to you if you purchase the business. You should ensure that you review each of the following key clauses in these agreements.
Leases
- rent (amount and increases);
- outgoings or additional expenses associated with the premises (i.e. council rates, garbage collection costs, maintenance and repair costs, etc.);
- permitted use (i.e. does the lease allow you to operate the type of business you want to operate);
- term of the Lease (i.e. can you renew your lease for another term at the end of the initial period? How long is left on the term?);
- guarantors (i.e. a requirement to personally guarantee the tenant’s obligations, such as the obligation to pay rent and maintain the premises in good repair);
- maintaining the premises (including whether there is a ‘make good obligation’ to leave the premises in the same condition as when you entered the lease); and
- other licences required to operate the business (i.e. food premises licence, liquor licence).
Supply Contracts
- payment terms (i.e. what kind of payment arrangement does the seller have with the supplier?);
- services (i.e. what kind of services are to be provided and are these suitable?);
- liability exclusions and caps (i.e. is there a maximum amount to which the seller can make a claim against the supplier if they do not deliver goods on time?); and
- assignment clauses (i.e. can the seller transfer the contract to you without the supplier’s consent?).
Client/Customer Agreements
- payment terms (i.e. how does the seller get paid by clients/customers and when?);
- liability exclusions and caps (i.e. if the seller does not deliver the goods/services on time, is there a maximum amount to which the clients/customers can make a claim?);
- assignment clauses (i.e. can the seller transfer the contract to you without the client/customer’s consent?); and
- handling of personal information (i.e. is the seller handling data in compliance with the Australian privacy laws (if relevant)?).
Employment Contracts
- type of employment (i.e. are the employees classed as permanent or casual?);
- role and responsibilities (i.e. what is their job description?);
- salary (i.e. how much are they being paid?);
- entitlements (i.e. annual leave, long service leave, personal leave and parental leave);
- award (i.e. and ensuring that they are covered by the correct award); and
- key employees (i.e. are there any employees who are key for the continued operation of the business? Does the business sale agreement contain a condition that these employees must sign a new employment agreement with you prior to the completion of the sale?).
Many businesses have been caught underpaying their employees because they have not correctly applied award wages. While this may have been done inadvertently, it is not a problem you want to risk inheriting, especially if you plan to hire those employees to work with you in the business.
Business Assets
If the business has key assets that you want to ensure are fully owned by the seller (so they can be transferred or assigned to you as part of the purchase), it is important to consider the following:
| Key Business Assets | What to Consider | |
| Intellectual Property | Trade marks, designs and patents | Are they registered and owned by the seller? A search of IP Australia will confirm ownership. |
| Content | Who owns marketing material? | |
| Business names | Is there a registered business name? A search of ASIC Connect will confirm ownership. | |
| Contact details | Does the seller have social media accounts, email addresses, websites that need to be transferred? Who owns these accounts? | |
| Software | Who owns the source code? | |
| Equipment | Equipment lease or hire to purchase | If a security interest in respect of equipment is listed on the PPSR, someone else may have a claim to that equipment if their arrangement with the seller is not fulfilled. The business sale agreement should state that the seller is transferring all equipment to you free of any other interests and that they own all equipment outright. |
| Title to equipment and physical assets | Does the seller have documents of title or payment receipts/invoices showing their purchase of key items? |
For intellectual property registrations, the business sale agreement can state that the seller must pay all outstanding fees. It can also contain an indemnity for outstanding fees. This allows you to recover the cost of these fees from the seller if you need to pay them to maintain the relevant registrations.
How to Reduce Your Risk
Buying a business will always involve risks. Performing due diligence will help you make an informed decision about the business, however, it will not eliminate all risks. You can reduce the potential impact of these risks by requesting all or some of the following from the seller:
1. Purchase Price Reduction
If you have uncovered issues with the business that make it less valuable, consider asking the seller to reduce their asking price.
For example, if the business’s financial statements reveal that it suffered a bigger loss than you initially thought, it may be commercially sensible to ask the seller to reduce the purchase price.
2. Warranties
You can ask the seller to provide warranties about the business in the business sale agreement. Warranties are promises the seller makes to you about certain facts relating to the business (e.g., no unpaid superannuation entitlements are owed to any employees).
If you purchase the business and then learn that this statement was untrue, then you will have a breach of contract claim against the seller and can claim compensation as a result. You will need to show that you suffered a loss due to the seller’s breach.
3. Indemnities
These are contractual obligations that require the seller to reimburse you for a specific liability. Indemnities can provide greater protection than warranties. An indemnity requires you to show that you have suffered a loss in relation to what the indemnity refers to but does not require you to prove that the loss was a result of a breach by the seller.
For example, suppose the seller is involved in a dispute with one of their manufacturers. To protect yourself against potential loss from the dispute, you can request that an indemnity be included in the contract that requires the seller to reimburse you for any loss you may suffer in connection with that dispute.
Key Due Diligence Checklist
- assemble your due diligence team;
- request documentation and information from the seller, including:
- financial documents; and
- business assets; snf
- material contracts.
- request for additional information as needed;
- prepare due diligence reports;
- assess the information you have gathered and your due diligence reports;
- decide on whether to purchase the business;
- take steps to reduce your risk, such as:
- negotiate purchase price;
- request warranties; and
- request indemnities.
Key Takeaways
Due diligence enables a buyer (and their team) to undertake checks on a business they are interested in purchasing. Due diligence enables you to uncover various financial, commercial and legal matters to help you decide whether to proceed with the sale, renegotiate the business sale agreement, or walk away.
For more information, our experienced sale of business lawyers can assist as part of our LegalVision membership. For a low monthly fee, you will have unlimited access to lawyers to answer your questions and draft and review your documents. Call us today on 1300 544 755 or visit our membership page.
Frequently Asked Questions
Due diligence is the process where the buyer reviews information supplied by the seller about the business, usually prior to entering into a business sale agreement. The goal of due diligence is for the buyer to understand the risks and liabilities they may be assuming in purchasing the business.
The due diligence review process generally takes place before you enter into a formal business sale agreement. Otherwise, you risk paying a premium for a business with unexpected financial issues, damaged equipment, expired or unsuitable contracts or premises with health and safety issues that you will need to rectify at great expense.
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