Due diligence: what a buyer will check, and how to prepare

01

What due diligence is, and why it matters

Once a buyer has agreed terms in principle, usually in heads of terms, they will want to check that the business is what they think it is. That examination is due diligence. It covers the numbers, the tax position, the legal and commercial foundations and the people, and it is carried out by the buyer and their advisers, and by anyone funding the deal.

ICAEW’s Corporate Finance Faculty describes the purpose of financial due diligence in its guideline: it is key to enabling informed decisions about proposed investments or divestments, and it supports sellers, buyers and providers of finance by improving what they know about how the business has performed financially. In a sale, it can help identify red flags and risks, test the deal, and support the valuation of the business being acquired.

For a seller, that last point matters most. What a buyer finds can change the price, the structure, or the protections they ask for in the sale agreement. The best defence is to look first.

Many of the problems uncovered in due diligence aren’t new. They were already in the business; the process simply brings them into view.

02

The strands of due diligence

ICAEW describes the work of transaction services as carrying out financial, tax, vendor, commercial and operational due diligence. On a typical sale of a private company, expect the buyer’s advisers to look at:

• Financial: historical results, how sustainable the earnings are, cash flow, working capital, debt and forecasts.
• Tax: the company’s tax compliance, any open matters with HMRC, and anything that could become a liability after the sale.
• Legal: ownership of the shares, the company’s records, key contracts, intellectual property, property, disputes and regulatory matters.
• Commercial: the market, the competitive position, the customers and the credibility of the business plan. ICAEW’s guideline on commercial due diligence notes that it is typically undertaken for transactions including acquisitions, mergers, capital raises and management buyouts.
• People: employment contracts, key staff, pensions and any disputes.
• Operational: systems, suppliers, technology and how the business actually runs.

The depth varies with the buyer, the size of the deal and how it is funded. A buyer using borrowed money or outside investors will usually go further, because their funders will want assurance too. The British Business Bank’s guide to selling your business quotes two M&A practitioners who describe due diligence on a trade sale as typically less onerous than in a private equity transaction.

03

A seller’s checklist

The checklist follows the order most buyers work in. Tick what you could hand over today, complete and current. Anything you cannot tick is a preparation priority.

04

What buyers most often find

Most issues that surface in due diligence are not dramatic. They are gaps that could have been closed months earlier:

• Numbers that do not reconcile between the management accounts, the statutory accounts and the bank.
• Adjustments that cannot be evidenced, when profit is normalised for one-off costs or for how the owners are paid.
• Contracts that are missing, unsigned or out of date, or that let an important customer walk away if the company changes hands.
• Intellectual property owned by the wrong person, such as a founder, an agency or a contractor. GOV.UK’s overview of intellectual property explains how ownership arises.
• Dependence on the founder or on a few customers. The British Business Bank lists a business that relies on its owner or on a single customer among the reasons an exit may not be viable.
• Company records not kept up to date, including the register of people with significant control.

Each one gives a buyer a reason to slow down, to ask for extra protection in the sale agreement, or to revisit the price. Our guides on owner dependency and customer concentration risk cover the two biggest in depth.

05

Build a data room before you need one

A data room is the organised set of documents a buyer’s advisers work through, usually in a secure online folder. Building it early does three things: it shows you the gaps while there is time to fix them, it shortens the transaction, and it tells a buyer that the business is well run.

Start with a simple document index:

1. List every document a buyer is likely to ask for, under the headings in the checklist above.
2. Note where each one is, who is responsible for it, and whether it is complete and current.
3. Fix the gaps, starting with those that affect value: the numbers, the contracts and ownership.
4. Keep it current. An index that is a year out of date is a project, not a resource.

GOV.UK’s guide to company and accounting records sets out the records a limited company must keep, which are the foundation of any data room.

06

Vendor due diligence

Some sellers go a step further and commission due diligence on their own business before going to market. Known as vendor due diligence, it is carried out by advisers acting for the seller, and the findings can be shared with buyers. ICAEW’s financial due diligence guideline covers the different forms of due diligence, including vendor assistance.

It costs time and money before any buyer is committed, so it is not right for every sale. But it lets you find problems on your own timetable, and it can make a buyer’s own work faster. Ask your accountant whether it suits your circumstances.

07

During due diligence: keeping it moving

• Answer quickly and completely. Every unanswered question costs time, and invites more.
• Keep the business performing. A dip in trading during the process gives a buyer reason to pause or to renegotiate. Someone other than you needs to run the business day to day.
• Keep it confidential. Use confidentiality agreements, and keep a short list of who knows.
• Disclose properly. Your solicitor will explain how known issues are disclosed against the warranties in the sale agreement. Problems disclosed early are far easier to deal with than problems found late.
• Handle employee matters carefully. Where TUPE applies there are duties to inform and consult. GOV.UK’s guide to business transfers, takeovers and TUPE explains the basics.

08

How Stratworth helps you prepare

In SCALE2SELL® this is the Exit Readiness pillar: preparing for due diligence long before a buyer arrives, with records, contracts and risks in order. The other pillars build the evidence due diligence tests, from the numbers in Financial Clarity & Drivers to the processes in Operational Efficiency & Systems. Exit Programme clients also have a quarterly review of their management accounts and data-room readiness.

We prepare and guide; your accountant, solicitor and tax adviser carry out and advise on the transaction work. To see where your business stands, score it with the free Readiness Assessment, or book a complimentary Founder Conversation with Nik.