Due diligence when you're buying a business

Due diligence is the buyer’s investigation of the business before committing to buy it. The seller knows the business far better than you do, and the law gives a buyer very little protection by default, so this is your chance to find out what you’re actually paying for while you can still change the price, ask for protection in the contract or walk away.

This page is about the buyer’s side, where I ask the questions, read what comes back and tell you what it means for the deal. If you’re selling, there’s a separate page on due diligence for sellers, and the buying a business page explains how due diligence fits in with the rest of a purchase.

Legal, financial and commercial due diligence

There are three strands, and they’re usually done by different people. Financial due diligence, which includes tax, is done by your accountant, who will look at the accounts, the management figures, the working capital and the company’s tax history. Commercial due diligence is really your own job, as you’re the one who knows the sector and can judge whether the customers, the staff and the market are what the seller says they are. Legal due diligence is the part I deal with.

The three strands need to be joined up, so if your accountant finds that most of the profit comes from two customers, I need to know so that I can look closely at those two contracts, and if I find that one of them can be ended when the company changes hands, your accountant needs to know because it may change what the business is worth.

What the legal due diligence covers

I send the seller’s solicitor a set of legal enquiries, adapted to the business and the deal, and the seller answers them and uploads the documents to a data room. The enquiries cover much the same ground on most deals, starting with the company itself, its statutory books, its share capital and whether every share issue and transfer was done properly, which matters a great deal on a share purchase because what you’re buying is the shares.

After that come the contracts with the main customers and suppliers, and in particular whether any of them can be ended or renegotiated on a change of control, or need consent to be transferred on an asset purchase. Then the employees, which means the contracts, any restrictive covenants, anyone treated as self-employed who might not be, and any grievances or claims. On an asset purchase the employees will normally transfer to you under TUPE on their existing terms, so you need to know what those terms are.

I also look at the intellectual property and whether the company actually owns it (a website or software written by an outside developer often isn’t owned by the business unless the rights were assigned in writing), any licences or regulatory permissions the business needs to trade, data protection, insurance, and any disputes, whether they’ve started or are only threatened. Alongside the enquiries I run my own searches at Companies House and the usual insolvency and charge checks.

The premises are dealt with separately, and if the business has a lease or owns its building, I’d recommend that a commercial property colleague at Nexa reviews the lease and runs the property searches, so that you know what liabilities you’re taking on. That’s quoted separately, and I’ve written more about it in my guide to commercial property when buying or selling a business.

What you get from me

Once the replies are in, I report to you on the points that affect the price, the timetable or the protection you need in the agreement. For most owner-managed deals that’s a note of the issues that matter, with what I recommend doing about each one, rather than a long report setting out everything I’ve read. A full legal due diligence report is available if your lender or investors want one, but it costs more and is often out of proportion to the price, so I’ll quote for it separately if it’s needed.

I should say that due diligence is only as good as the answers the seller gives, and it can’t uncover something the seller doesn’t disclose and doesn’t leave a paper trail for. That’s one of the reasons the warranties in the sale agreement matter as much as they do.

What happens with what I find

Most of what due diligence turns up isn’t a reason to walk away. Some things can be put right by the seller before completion, such as a missing filing at Companies House, an unsigned employment contract or IP which needs assigning to the company. Some justify a lower price or part of the price being held back as a retention. Where a specific problem has been found, such as an HMRC enquiry or a dispute with a former employee, the usual answer is an indemnity, so that the seller pays pound for pound if it turns into a cost.

A known problem needs an indemnity rather than a warranty because a warranty often won’t help you with something you already knew about. The seller will disclose anything found in due diligence against the warranties, which generally stops you claiming for it, and many agreements also say that you can’t claim for anything you knew about before completion. If you’ve found a problem, it needs dealing with expressly in the share purchase agreement or asset purchase agreement rather than left to the general warranties.

Sellers sometimes try to use the disclosure letter to disclose the whole data room, or everything a buyer could have found out, and a buyer should usually refuse that, which I’ve explained in what is a general disclosure and why should a buyer refuse it.

How long it takes and what it costs

Due diligence starts once heads of terms are agreed and normally runs for most of the middle part of a purchase, alongside the first drafts of the sale agreement. On a deal which takes two to three months it usually accounts for a good part of that time, and the main thing that slows it down is how quickly the seller replies. That’s why a buyer usually wants a period of exclusivity in the heads of terms, so that the seller can’t take your offer elsewhere while you’re paying for the investigation.

The legal due diligence is normally part of my fixed fee for the purchase as a whole. Every quote is specific to the deal, but as a guide my fee will be between 0.5% and 5% of the deal value. Under £1m it’s usually 3% to 5% and over £1m it’s usually 1% to 2%, although it does depend on the business, the price and the commercial terms. The minimum fee is £3,500 plus VAT, and on lower value deals I can quote for a reduced, more standard service. Property work, overseas subsidiaries and anything under a law other than English law fall outside my standard scope.

Next steps

If you’re buying and want me to run the due diligence, send me the details, including what the business does, whether you’re buying the shares or the assets, the price and the heads of terms if you have them. I’ll come back to you with a fixed fee and a scope of work.