Due diligence is the process where a buyer reviews and verifies the information supplied by the seller about the business, usually prior to entering into a business sales contract. This could include examining the business’ records and inspecting its physical assets. When buying a business, one of the main risks that due diligence can uncover is that the equipment is not owned by the seller, or that important agreements cannot be transferred. This can be costly or cause the business to fail. As part of the due diligence process, you should investigate:
  • 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 nearby businesses that you will have to compete with.
This guide 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 by yourself. However, for more complex businesses, it is worth considering a more formal approach and having a due diligence team with expertise in such areas as the law and accounting to support you. Your due diligence team should include professionals who can assist you in assessing the financial, commercial and legal risks associated with your business purchase, including: 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.

Due Diligence Timeframe

Due diligence usually occurs prior to entering into the sale contract, but is also possible to have a due diligence period included in the sale contract. In this case, you would include a clause in the contract that allows you to end the agreement should your due diligence uncover something that could make it difficult for the business to succeed.

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 a list of the types of business records you would like to inspect (e.g. financial statements, product sale history, equipment hire contracts, etc.). You can also ask the seller for permission to physically inspect the premises and key equipment.

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 or Word document 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:
  1. any key concerns they have about the business; and
  2. 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 will be able to use them to make a decision about 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:
  1. the business is valuable and agree with the seller’s asking price;
  2. you want to try and negotiate a reduced price based on the results of your due diligence; or
  3. the business is too risky and that 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 sale of business contract. Otherwise, you risk paying a premium for a business with unexpected financial issues, broken or damaged equipment, expired or unsuitable contracts or premises with health and safety issues that you will need to rectify at great expense. However, 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 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 and Non-Compete

If the seller refuses to provide you with certain documents before you sign the contract, 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 sale of business contract, the contract 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 learn about.

What Do I Review?

You should investigate all business records, issues and assets that will help you decide whether to go ahead with the purchase. This will help you to understand:
  • 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.

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 a busy area or are there any impending developments?
Growth opportunities Is it a declining industry?
Competition Are there other similar businesses competing with yours?
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, confirming who the directors are.
Asset ownership Who owns trade marks, software etc.
The contracts in place Leases for the premises, supply 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.

Key Contracts

The key contracts that are common to most businesses and that you should review during due diligence are: 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 Agreements

  • payment terms (i.e. how does the seller get paid by clients 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 can make a claim?);
  • assignment clauses (i.e. can the seller transfer the contract to you without the client’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. to 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 sale contract 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 sale contract 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 sale contract 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 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’ 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 for the business in the contract. Warranties are promises that the seller makes to you about certain facts relating to the business (e.g. there are no unpaid superannuation entitlements 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 loss as a result of the seller’s breach.

3. Indemnities

These are contractual obligations that require the seller to reimburse you for a specific liability. Indemnities provide greater protection than warranties. An  indemnity requires you to show that you have suffered a loss in relation to what the indemnity refers but does not require you to prove that the loss was as a result of a breach by the seller. For example, 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 is included in the contract that requires the seller to reimburse you for any loss  that 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;
  • Request for additional information as needed;
  • Prepare due diligence reports;
  • Assess the information you have gathered and your due diligence reports;
  • Make a decision on whether to purchase the business;
  • Take steps to reduce your risk:
    • Negotiate purchase price;
    • Request warranties; and
    • Request indemnities.

How Can LegalVision Help?

LegalVision is a market disruptor in the commercial legal services industry. Our innovative business model and custom-built technology assist our lawyers to provide a faster, better quality and more cost-effective client experience. LegalVision is a leader in delivering legal services in Australia and was recently named the fastest growing law firm in Australia by the Financial Times. Our experienced sale of business team can assist you with the due diligence process so that you are protected in your purchase of the business. If you have any questions, get in touch with LegalVision’s business lawyers today by calling us on 1300 544 755.

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