When you are buying a business, due diligence is your investigation of that business before
completing a purchase. It is used to verify the seller’s claims and uncover legal, financial and
commercial risks. Under UK law, the principle of caveat emptor, or buyer beware, applies, so
the buyer takes the business as is and carries responsibility for hidden liabilities not
addressed in the purchase agreement.
A thorough review will help you understand the target’s strategic position, financial records,
and legal standing, and will feed directly into the price, warranties, indemnities, and
conditions precedent negotiated in the sale and purchase agreement. Your findings let you
decide whether to proceed, renegotiate, or walk away. This article explains how due
diligence works and why it is essential before committing to a business purchase.
What Due Diligence Involves
Due diligence is not a singular activity but a series of detailed investigations into different
aspects of the business. While the exact scope may vary based on the business’ size and
complexity, there are three main areas of focus:
- strategic (i.e commercial);
- financial; and
- legal.
Strategic Review
The first stage of due diligence often involves a strategic review of the business. This phase
assesses the company’s:
- market position;
- business model; and
- long-term growth prospects.
Publicly available information is typically used at this stage, providing a broad overview that
helps determine whether deeper, more costly investigations are worthwhile.
Financial Review
Financial advisers or accountants will conduct a thorough review of the business’ finances.
This includes analysing:
- financial statements;
- tax returns;
- cash flow records; and
- any debt arrangements.
Understanding the company’s financial health is essential to evaluating its profitability and
stability. It also allows for adjustments to the purchase price and negotiations around
warranties in the purchase agreement.
Legal Review
A legal team will conduct an in-depth review of the business’ legal standing, including
scrutinising:
- constitutional documents;
- key contracts;
- licences;
- employment records; and
- any outstanding obligations.
Their aim is to flag legal risks and draft appropriate conditions precedent, warranties and
indemnities into the purchase agreement.
Why Due Diligence is Essential
There are several important reasons why you should approach due diligence carefully:
Full Financial Insight
Examining the numbers rather than relying on the seller’s assurances gives you a realistic
view of past performance and future potential. It also helps verify that the asking price aligns
with value.
Better Questioning and Clarity
Due diligence often leads to further questions and clarifications. For instance, if you uncover
unexplained debt or irregular revenue patterns, detailed inquiries and documentation can
help you understand the true cause of these issues. Having all the facts allows for more
informed decision-making.
Reveal Deal-Breakers Early
A thorough due diligence review can identify risks, such as:
- liabilities;
- litigation risks; or
- contractual issues that might make the transaction less attractive, or even unwise to
proceed with.
Identifying these risks early can help you avoid costly mistakes and prevent acquiring a
business with hidden issues.
Protect Your Investment
Buying a business involves a substantial financial commitment. Due diligence helps ensure
that you understand what you are buying and that you are not taking on unforeseen liabilities
or obligations.
What Happens After Due Diligence?
Once due diligence is complete, buyers usually choose one of three paths:
- proceed with the transaction on the agreed terms;
- renegotiate aspects of the deal based on the findings; or
- decide not to proceed.
Any issues identified during due diligence are typically addressed through adjustments to the
purchase agreement, including:
- tailored warranties;
- indemnities; or
- conditions that must be satisfied before completion.
Key Takeaways
Due diligence allows buyers to understand the true legal, financial and commercial position
of a business before committing to a purchase, supports more informed negotiations on
price and contractual protections, and reduces the risk of inheriting unexpected liabilities or
problems after completion.
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Frequently Asked Questions
What is the purpose of due diligence when buying a business?
Due diligence helps the buyer assess the legal, financial, and commercial position of the
business, ensuring there are no hidden risks or liabilities. It allows buyers to make informed
decisions and negotiate better terms.
What is the difference between a warranty and an indemnity in a
purchase agreement?
A warranty is the seller’s promise that a particular aspect of the business is as stated. If it is
untrue and you suffer loss, you can claim for breach. An indemnity is a promise to reimburse
you if a specified event happens.
Should I structure the deal as a share sale or an asset sale?
A share sale transfers the whole company, including all assets and liabilities, and is often
more tax efficient. An asset sale transfers only specified assets, generally carries fewer
risks, and usually has a shorter due diligence phase. The right choice depends on your
commercial and tax position.
What is a share purchase agreement?
A share purchase agreement is the primary document guiding a share purchase. It sets the
price, timeline, warranties, indemnities, conditions precedent and limitations of liability, giving
both parties commercial certainty and reducing the risk of future disputes.
