What is Due Diligence?
Due diligence is the process where a buyer of a business reviews and verifies the information the seller supplies about the business, usually before entering into a business sales contract. This could include examining the business’ records and inspecting its physical assets. Due diligence can uncover problems that can be costly or cause the business to fail. Examples include that equipment is not owned by the seller, and that important agreements cannot be transferred.. The due diligence process should include investigating:
- who owns important assets (i.e. trade marks, software, licences);
- the business’ ability to make a profit;
- the condition of the equipment (i.e. computers, ovens, vehicles); and
- whether there are any nearby businesses you will have to compete with.
This article provides an overview of the due diligence process required, and how to complete it.
Starting due diligence
When buying a business, you could undertake the due diligence work yourself. For more complex businesses, it is worth considering having a due diligence team with expertise in areas such as law and accounting to assist you. Your due diligence team should include professionals who can support you in assessing the commercial, financial and legal risks associated with your business purchase, including:
- a lawyer;
- an accountant or financial advisor; and
- your business advisor or broker.
A due diligence team will assist you by:
- reviewing the business’ records;
- giving you professional advice on the business’ viability and suitability; and
- making you aware of any existing risks and liabilities.
The due diligence timeframe
Due diligence usually takes place before entering into the sale contract. Alternatively, a due diligence period can be included in the sale contract. The contract includes a clause that allows you to terminate the agreement if your due diligence uncovers 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 lawyer or accountant), sends the seller a list of the types of business records you would like to inspect (e.g. product sale history, financial statements, equipment hire contracts, etc.). You can also ask the seller for permission to physically inspect key equipment and the premises.
2. Documentation is provided
The seller can provide you with that information in person, via email, or through a member of their own due diligence team (e.g. their lawyer). Or 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 (often called a data room) can be accessed by the seller’s and the buyer’s due diligence teams.
3. Requests For Information (RFI) process
You can ask for additional documents from the seller and ask them questions about the information they provided (an ‘RFI’ [Requests For Information]) via a spreadsheet or Word document.
4. RFI responses provided
The seller submits responses to your questions. During this process, your due diligence team assesses and reports on:
- any key concerns they have about the business; and
- potential solutions or options you can raise with the seller to reduce risks associated with the purchase.
5. Due diligence reports prepared and assessed
Your due diligence team prepares reports to assist your decision whether to purchase the business.
6. Proceeding with the Purchase
You may decide that:
- that the business’s value is such that you are willing to pay the asking price; or
- you want to try to negotiate a reduced price based on your due diligence reports; or
- the business is too risky and you will not proceed with the purchase.
When should I 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 for a business with broken or damaged equipment, expired or unsuitable contracts, unexpected financial issues, or premises with health and safety issues that you will have to rectify at great expense.
However, it is also possible to have a due diligence period clause included in the contract. This allows you to sign the contract and conduct your due diligence within a period of time (e.g. 10 business days) after signing. If you uncover something about the business you are unhappy with during this period, you can terminate the contract and walk away from the sale.
How long does due diligence take?
This depends on:
- your timing for the sale;
- 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;
- the business’ complexity; and
- how many records you want to review.
Consequently, the due diligence process can take anywhere from a week or two to several months. You should be flexible in your timing for the business purchase.
Confidentiality and non-compete
If the seller refuses to give you certain documents before you sign the contract, they may be worried about what you will do with the information. For example, they may be concerned that 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. If the sale of business contract includes a due diligence period, the contract should include confidentiality obligations to protect the seller’s information.
If the seller continues to refuse to provide you with certain documents, take it as a red flag. There may be issues with the business or 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 proceed with the purchase. This will help:
- uncover any issues you should be concerned about;
- you to understand how the business has been operating recently; and
- inform your decision on how to proceed with the purchase.
|Balance sheets||Including accumulated entitlements to annual leave or other employee benefits|
|Sales records||To check how the products or services of the business perform (i.e. which product line is most valuable)|
|Profit and loss statement||This shows how much money or profit the business is making|
|Tax returns||To understand the revenue of the business and the tax required to be paid each year (on average)|
|The valuation of the business||This is how much the business is worth|
|Competition||Are there other similar businesses competing with yours?|
|Growth opportunities||Is it a declining industry?|
|Business suitability||What experience do you have in the industry?|
|Location||Is it a busy area or are there any impending developments?|
|The condition of key assets||For example, computers, ovens, vehicles 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?|
|Corporate information about the seller||If they are a company, confirming who the directors are.|
|Asset ownership||Who owns trade marks, software etc.|
|Compliance with laws and regulations||Confirm if appropriate licences are in place, such as liquor licences, food licences etc.|
You should review some common legal documents. For example, documentation that confirms ownership of particular assets, and the seller’s contracts with third parties.
Contracts common to most businesses that you should review during due diligence include:
- client agreements;
- supply contracts;
- leases; and
- employment contracts.
As these documents may be transferred to you if you purchase the business, it is important that their terms are agreeable to you. You should review the following clauses in these agreements.
- 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?);
- payment terms (i.e. how does the seller get paid by clients and when?); and
- handling of personal information (i.e. is the seller handling data in compliance with the Australian privacy laws (if relevant)?). assignment clauses (i.e. can the seller transfer the contract to you without the client’s consent?).
- 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?);
- payment terms (i.e. what kind of payment arrangement does the seller have with the supplier?);
- assignment clauses (i.e. can the seller transfer the contract to you without the supplier’s consent?); and
- services (i.e. what kind of services are to be provided and are these suitable?).
- rent (amount and increases);
- outgoings, or additional expenses associated with the premises (i.e. council rates, garbage collection costs, maintenance and repair costs, etc);
- 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?);
- 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);
- permitted use (i.e. does the lease allow you to operate the type of business you want to operate);
- 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); and
- other licences required to operate the business (i.e. food premises licence, liquor licence).
- type of employment (i.e. are the employees classed as permanent or casual?);
- award (i.e. and ensuring that they are covered by the correct award);
- entitlements (i.e. to annual leave, long service leave, personal leave and parental leave);
- role and responsibilities (i.e. what is their job description?);
- 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?); and
- salary (i.e. how much are they being paid?).
Many businesses have, by incorrectly applying award wages, underpaid their employees. This is not a problem you want to risk inheriting, especially if you plan to hire those employees to work in the business.
If the business has assets that you want to ensure the seller fully owns (so they can be transferred or assigned to you as part of the purchase), you should 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.|
|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?|
|Content||Who owns marketing material?|
|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; and
- contain an indemnity for outstanding fees. This allows you to recover the cost of these fees from the seller if you must pay them to maintain the relevant registrations.
How to reduce your risk
Buying a business involves risks. Whilst performing due diligence will help you make an informed decision about the business, it will not eliminate all risks. You can reduce the potential impact of these risks by asking the seller for at least some of the following:
1. Purchase Price Reduction
If you have uncovered issues with the business which may adversely affect it’s value (e.g. if the business’ financial statements reveal that it suffered a bigger loss than you initially thought), consider asking the seller to reduce the purchase price.
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 (provided you can show that you suffered loss as a result of the seller’s breach).
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 connected to the indemnity but does not require you to prove that a breach by the seller caused the loss. For example, the seller is involved in a dispute with one of their manufacturers. To protect yourself against potential loss from that dispute, you can request inclusion of an indemnity in the contract requiring the seller to reimburse you for any loss you may suffer in connection with that dispute.
Due diligence checklist
- Assemble due diligence team;
- Request documentation and information from the seller, including:
- Financial documents; and
- Business assets;
- Request additional information as needed;
- Prepare due diligence reports;
- Assess information gathered and due diligence reports;
- Decide whether to purchase the business;
- Take steps to reduce your risk;
- Negotiate purchase price;
- Request warranties; and
- Request indemnities.
How can we help?
We can assist you with the due diligence process so you are protected in your purchase of the business. If you have any questions, contact us on 0451118644 or 02 47593742.