Due diligence: what buyers check and how to prepare
Due diligence tests the information the offer was built on, so that price, warranties, indemnities and conditions can be set with more precision.
What it is and when it happens
Usually after heads of terms have been signed, the buyer and its accountants, lawyers and other advisers review the company with staged access to financial, tax, employment, legal and operational documents.
The timetable depends on size, scope and the quality of your information. Six to twelve weeks is a common range for an SME. During that period the buyer normally has exclusivity.
The aim is to confirm the assumptions behind the offer, identify risks and decide how to deal with them: in the price, the completion mechanism, conditions, warranties, specific indemnities or a decision not to proceed. A finding does not automatically mean a price cut.
The five areas
Financial
Quality of earnings: whether the EBITDA you presented is sustainable and whether the normalisation adjustments are justified. Margin trends by product and customer. The real level of debt, including items not labelled as debt. Working capital and its seasonality. Reconciliation of the accounts to the bank. On larger deals this becomes a formal financial due diligence report from an accounting firm.
Tax
Corporation tax, VAT and PAYE compliance, open HMRC enquiries, Time to Pay arrangements, R&D tax credit claims, transfer pricing with related companies and the tax treatment of any reorganisation. HMRC can generally go back four years, six for careless errors and twenty for deliberate ones, which is why tax warranties often run for seven years.
Employment
Headcount, contracts, pay, holiday pay calculations, pension auto-enrolment, any defined benefit pension scheme, disputes and contractors whose status might be challenged under IR35. On an asset sale the buyer will also look at TUPE, because employees transfer automatically with the business.
Legal
Title to the shares, the register of members and people with significant control, the articles and any shareholders' agreement, charges registered at Companies House, customer and supplier contracts, change of control clauses, disputes, insurance, property leases, licences, data protection compliance under UK GDPR, and intellectual property. Ownership of trade marks, domains and software must match what is being sold.
Operational and technical
Depending on the sector: condition of sites and equipment, environmental and health and safety compliance, certifications, IT systems and cyber security, and dependence on critical suppliers.
Common findings and how they are usually handled
| Finding | Usual effect |
|---|---|
| EBITDA adjustments without supporting evidence | Excluded from normalised EBITDA, or further evidence required |
| Key contract with a change of control clause | Customer consent, a condition to completion, a price adjustment or contractual protection |
| Long-term contractors who look like employees | Assessment of the IR35 and employment exposure, or a specific indemnity |
| Open tax years with questionable positions | Tax covenant, retention, W&I cover or a specific indemnity |
| Trade mark or domain registered to the owner personally | Transfer to the company before completion, or a licence |
| Customer concentration higher than presented | Revised forecasts, price, earn-out or warranties |
| Differences between the accounts and the bank | Extra reconciliation work and a closer look at everything else |
The common thread is a gap between what the offer assumed and what the documents can prove. Separate the financial impact, the likelihood, the period affected and whether the matter was disclosed before the price was set.
How to get through it without surprises
Review yourself first. On larger deals the seller commissions vendor due diligence: an independent report on its own company, prepared before going to market. It costs money, and its value is that you find and fix the problems instead of the buyer finding them during exclusivity. On smaller deals a lighter "red flag" review by your accountant and lawyer can do much of the same job.
Disclose problems with context. Explain the scope, amount, likelihood and plan before the buyer prices the deal on a different assumption. Early disclosure does not remove the impact, but it protects your credibility and lets you shape how the issue is dealt with.
Set up the data room early. An organised repository with an index, version control and staged access. Sensitive information does not need to be open to every bidder from day one. See our guide to setting up a data room.
Appoint an internal coordinator. Someone who handles requests and answers so the process does not consume you, the person the business depends on.
Put a timetable in the heads of terms. Start date, milestones, owners, an initial request list and a target date. Agree how extra requests are handled and what happens to exclusivity if the buyer runs late.
Protect personal data and competitive information. Anonymise personal data and limit commercially sensitive material. With a competitor, a clean team or restricted access may be needed so that prices, customers and strategy are not shared too early, which can also raise competition law issues.
How to respond when the buyer wants to change the offer
If the buyer proposes to change the price or terms, separate three situations:
A real, quantifiable finding. Say an unpaid holiday pay liability of £40,000. It can be dealt with through the price, a retention, a specific indemnity, a condition or a mix. Check whether it is already reflected in the EBITDA, the debt or the working capital, so it is not counted twice.
A real finding you had already disclosed. If you raised it before heads of terms and it was clearly in the information provided, check whether the offer already took it into account. Keep a record of what was disclosed, when, and how the buyer responded.
A bundle of findings. Ask for each item to be quantified separately, with its likelihood, accounting treatment and proposed contractual remedy. Splitting them stops incompatible risks being added together or counted twice.
How hard you can push back depends on that disclosure record, the heads of terms, the exclusivity period and the alternatives you still have.
Frequently asked questions
How much does due diligence cost?
The buyer pays for its own. If you commission vendor due diligence, the cost depends on the scope (financial, tax, legal, commercial, technical), the number of companies in the group and the quality of your information. Get comparable quotes and decide whether you need a full report or a review focused on the main risk areas.
Can I refuse to hand something over?
You can hold back highly sensitive information, such as margins by named customer or salary data, until later stages and release it under specific protocols. Refusing without explanation is a bad idea, because it breeds suspicion.
What happens if something serious comes up?
It depends on its impact, likelihood and whether it can be resolved before completion. It may affect the price, lead to a specific indemnity or escrow, become a condition to completion, or make one side walk away. Avoid accepting two remedies for the same risk without a reason.
