Due diligence: the parts worth your attention

Every claim in a listing eventually arrives here. Diligence is not an audit. A financial audit asks whether the accounts comply with a standard. Diligence asks a narrower and more aggressive question: is the business I have been told about the business I would own?

Everything a buyer's team does in those weeks reduces to three questions. Sellers who understand them stop experiencing diligence as harassment and start seeing which of their own answers is weak.

What to take away

Question one: are the earnings real?

Not "are the accounts correct": they may be perfectly correct and still describe something other than the business a buyer is purchasing. What a buyer wants is the figure that will recur under new ownership.

So the work goes after the difference between reported profit and sustainable profit. Revenue is tested for whether it was actually earned in the period claimed, and whether it was collected. Margins are examined for drift, and any improvement in the run-up to a sale gets particular attention.

Costs are examined for anything suppressed: maintenance not done, a role left unfilled, marketing quietly cut. Working capital is examined to see how much cash the business consumes to operate at its current size, a question most sellers have never had to answer.

Then test each adjustment the seller proposed, one at a time. An add-back traced to records and shown to be genuinely non-recurring usually survives. One that rests on the seller's recollection usually does not.

A discretionary cost that the buyer can see is operationally necessary does more damage than its own value. It recasts the whole set of adjustments as advocacy, not accounting.

For larger transactions this becomes a formal quality-of-earnings review. For smaller ones an accountant does the same work less ceremonially. The purpose is identical.

Question two: do the earnings survive the owner leaving?

This is the question that decides the price of an owner-operated business, and it is answered by evidence rather than assurance.

Revenue concentrated in a few accounts gets examined for durability as well as size: contract terms, notice periods, switching costs, relationship length, and whether anything is about to change.

Buyers, who have usually spent months on a search by this point, ask customers and staff about this only late and carefully, because a leak damages the business they are trying to buy. Mostly they infer it from documents, from how the seller answers, and from what the seller cannot produce.

Question three: what comes attached?

The third strand is about everything that follows the business into new ownership whether the buyer wants it or not.

Live and threatened disputes, and the pattern of past ones. Employment arrangements, who is actually entitled to what, and any accrued obligations. Leases and their assignment terms. Licenses and permits and whether they survive a change of control. Loans, leases, guarantees and any security registered over the assets.

Whether the business owns what it says it owns: including its name, its software, its designs, and any work created by contractors. Tax positions that have been taken and not yet tested. Whether the business does what it does in compliance with whatever regime governs it.

The structure of the transaction changes how much of this a buyer inherits, which is why this strand and the choice between an asset sale and a share sale are argued together rather than in sequence.

What kills a deal and what merely reprices it

Sellers assume any bad discovery is fatal. Most are not. The distinction is close to a rule, and it is worth learning.

A discovery reprices the deal when it is quantifiable, bounded, and honestly presented. It becomes a number, and the number is deducted, escrowed, or converted into an indemnity. Both sides find this normal.

A discovery kills the deal when it cannot be sized, when the liability has no visible ceiling, when it makes the business unfinanceable, or when it destroys the buyer's belief that they are being told the truth.

The line running through the right-hand column is not severity. It is unboundedness and dishonesty. Buyers price risk for a living. They cannot price a risk with no edges, and they will not price anything at all once they conclude the seller has been managing what they see.

In a sale, the most expensive mistake is concealment of something that would have cost far less to disclose. A problem raised in the first meeting becomes a term of the deal.

The same problem uncovered late renegotiates everything, including settled parts, because the buyer must reexamine what else they accepted on trust.

The seller's side of the process

Diligence is survivable and often improvable if you treat it as a project rather than an ordeal.

Do it to yourself first. This is the last stage of preparing to sell. Have your accountant review the business as a buyer would, before anyone is looking. What they find is what the buyer will find, minus the cost of finding it during a negotiation.

Build the file in advance. Financial statements over enough years to show direction, tax filings, the customer list by revenue, supplier terms, contracts, leases, permits, employment records, the asset register, loan and guarantee documents, and anything about a dispute. Assembling this while a buyer waits sends a message you do not want to send.

Answer fast, completely, and consistently. Response quality is itself evidence. It is also the one part of diligence entirely within your control.

Disclose deliberately, in writing. Volunteering a problem lets you frame it and propose how it should be handled. Being asked about it puts you on the defensive; being caught at it ends the conversation.

Protect confidentiality anyway. A confidentiality agreement is necessary and is not sufficient. Stage the release of sensitive material (customer identities, pricing, supplier terms), so the most damaging information goes out last, to a buyer who has already committed. This is a large part of what an intermediary is for.

Keep running the business. Sale processes take months and consume the owner's attention. A business whose performance sags during diligence has just handed the buyer a reason to reprice, and the sag is usually the process itself rather than the market.

The buyer's side of the process

Buyers make a different set of errors.

Scope before you start. Diligence expands to fill whatever time and budget exist. Decide first what would make you walk away, and investigate that. The most valuable finding is the one that stops you spending on the rest.

Do not let advisers set the priorities alone. Each specialist will find issues within their own field; nobody is paid to say the deal is fine. Somebody has to weigh a legal finding against a commercial one, and it has to be the person taking the risk.

Separate what you are buying from what you plan to change. Buyers routinely pay for their own improvement plan. What the business earns today under its current management is what you are purchasing. Your plan is your upside and belongs to you, not in the price.

Test the story, not just the numbers. The most useful hours are usually spent understanding why customers buy, what would make them stop, and what the seller does that nobody has written down.

Know what you will do with what you find. Every finding leads somewhere: a price reduction, a retention or escrow, an indemnity, a condition to be satisfied before completion, or a decision not to proceed. A finding that leads nowhere was research, not diligence.

The one thing that survives the whole process

A transaction of this size warrants a broker, an accountant and a lawyer. Diligence is where the accountant and lawyer earn their fee: the accountant on whether the earnings are real, the lawyer on what comes attached and how the agreement allocates it.

But the variable that decides most outcomes is not technical. It is whether the buyer still believes the seller. Deals survive bad news constantly. Very few survive the discovery that the good news was managed.

Common questions

Can a seller refuse a diligence request?

Some requests, reasonably, such as customer identities before a buyer has committed. A blanket refusal reads as concealment and is usually priced as one.

What happens if diligence finds something serious?

It leads to a lower price, a change of structure, a condition, an indemnity, or a decision not to proceed. Which of those it leads to is the negotiation.

Does a clean process mean the business is sound?

It means nothing was found within the scope that was set. Scope is chosen, so a narrow examination and a sound business are not the same thing.

Who should run it for a small purchase?

An accountant on the numbers and a lawyer on what comes attached, both instructed by the buyer. The work scales down; the disciplines do not.