Due diligence questionnaire when buying a business: what to ask and how to use the answers

What is a due diligence questionnaire in M&A, and how is it used? It is the list of questions a buyer sends to the seller about the state of the target business, and the answers are what you use to decide whether to buy and at what price. The easiest way to explain it is with a scenario I see often: an established business owner looking at a bolt-on acquisition.

What is a due diligence questionnaire for?

Imagine a successful construction business owner who is looking to buy an electrician's business. He sees plenty of opportunity for synergy between his existing company and the electricians. But he is unsure whether he has enough information about the electrician business to make an informed decision about whether buying it is the right call.

This is where the due diligence questionnaire comes in. It is a document containing a list of questions that the buyer will want to ask the seller about the state of the target business. Its job is to help the buyer uncover potential risks and red flags, so that the decision to buy, or not to buy, is a well-informed one rather than a guess based on the seller's pitch.

In practice the questionnaire is prepared with the buyer's lawyers and sent to the seller, who responds in writing and usually supplies supporting documents.

What to ask: legal, financial and operational

A due diligence questionnaire will normally have at least three main sections.

• Legal. The buyer will want to know whether the electrician business is being sued, whether it owns any patents or trade marks, and what kind of contracts are in place with its clients. Disputes, intellectual property and key contracts are the three legal areas that most often change the shape of a deal.
• Financial. The buyer will want to see the books of the business and to know about any liabilities, whether those are owed to creditors such as banks or to HMRC. Undisclosed debt is one of the most common nasty surprises in a small business acquisition.
• Operational. The buyer will want to know how good the team is, and what processes the business has in place to make sure the work is consistently of high quality. In a trade business like this one, the people and the systems are a large part of what you are paying for.

These are the minimum. Depending on the business, you may add sections on property, employment, regulatory compliance, data and so on. But legal, financial and operational cover the ground that matters in most SME deals.

How to use the due diligence responses

Once the seller's responses come back, what should the buyer do with them? There are three things, and they follow in order.

• Identify red flags. First, go through the answers looking for anything that could make the purchase unviable. A major unresolved dispute, a liability the business cannot cover, or a contract that would fall away on a change of ownership can each be enough to stop the deal.
• Build a valuation. Second, use the information shared to form your own view of what the business is worth, and use that as the starting point for negotiations. The seller's asking price was set before you saw any of this; your offer should be based on what you now know.
• Reduce the purchase price. Third, and building on the negotiations, use any areas of concern as grounds to reduce the price. Every problem the questionnaire surfaces is a cost or a risk that you will be taking on, and it is legitimate to ask the seller to reflect that in the number.

A well-run questionnaire therefore does two jobs at once. It tells you whether buying the business is a good idea, and it gives you the evidence to negotiate a lower price if you go ahead.

Why the questionnaire matters more than it looks

It is tempting to treat the due diligence questionnaire as a box-ticking exercise, or to rely on a few conversations with the seller instead. In my experience that is a mistake. Written questions produce written answers, and written answers can be checked, relied on and, where the sale agreement is drafted properly, tied to warranties. A seller who has to answer specific questions in writing is far more likely to tell you about the dispute, the tax arrears or the key contract that is about to expire than one who is simply asked "is everything in order?"

Next steps

If you are considering an acquisition, have a due diligence questionnaire prepared and sent to the seller before you commit to a price, and review the responses systematically for deal-breakers, valuation points and price reductions. Speak to a corporate solicitor with M&A experience about drafting the questionnaire, so the questions are tailored to the business you are buying rather than lifted from a generic template.