Types of due diligence when buying a business: financial, legal, operational and marketing

What is due diligence in law, and what role does it play when you buy a business? Due diligence is the work a buyer does to find out what they are buying before they commit to it. Done properly, it is the single most effective way to reduce the risk of an acquisition. This guide covers what due diligence means, the four main types, the benefits for a buyer, and the common pitfalls of not doing it.

What is due diligence?

Due diligence refers to the efforts a buyer makes to find out more information about the business they are looking to acquire, known as the target business, before deciding whether to proceed with the purchase.

Broadly speaking, it entails three things: asking a lot of questions of the seller, waiting for the seller to provide documents in answer to those questions, and reviewing those documents. The questions are usually put in a written questionnaire, the documents come back through a data room, and the review is where the real work happens. It is an investigation, and like any investigation it is only as good as the questions you ask and the attention you pay to the answers.

Types of due diligence: financial, legal and more

Due diligence is not only legal. There are four main types a buyer should think about, and each answers a different question about the business.

Financial due diligence

Financial due diligence looks at the financials of the business. That means the profit and loss account, the balance sheet, and the debtors and creditors: who owes the business money and who the business owes money to. This is typically accountants' work, and it tells you whether the numbers you have been shown hold up, whether the business is actually being paid by its customers, and what it owes that may not be obvious from a headline profit figure.

Legal due diligence

Legal due diligence looks at the contracts the target business is a party to, because if you buy the business you will be bound by them. It also covers employment regulation compliance, and whether any regulatory approval is required before you can buy the target business at all. If an approval is needed, it affects the timetable and may be a condition of the deal, so it is something to find out at the start rather than the end. On the legal side, see what lawyers look for in due diligence.

Operational due diligence

Operational due diligence looks at the operations of the business itself. What kind of products or services does it offer? What are the profit margins like? Where does it find its customers? It is about understanding how the business actually works day to day, rather than what the accounts or the contracts say about it. A business can look sound on paper and still depend on one process, one supplier or one person that nobody has written down.

Marketing due diligence

That last question brings us to marketing due diligence, which looks at how the target business finds its customers. There are two reasons to look at this closely.

• Is it sustainable? Is the business spending less to acquire customers than it receives from them in revenue? If not, the growth you are paying for is costing more than it earns.
• Where do the customers come from? If all of the target's customers currently come through the seller, who may be the key person in the business, then once the seller leaves you may find it very difficult to maintain the same financial performance. A business whose customers follow one individual is a very different purchase from one with a repeatable way of winning work, and the price should reflect that.

Benefits of due diligence for buyers

Why go to all this trouble? The main benefit of due diligence is risk minimisation through finding out relevant information. You cannot protect yourself against a problem you do not know exists. Once you have that information, as a buyer you can do two main things with it.

• Negotiate warranties and indemnities. You can negotiate warranties and indemnities to be included in the sale and purchase agreement, aimed at minimising your risk in relation to the specific issues you have identified. If due diligence finds a potential problem, the SPA can allocate the cost of that problem to the seller: a warranty that the problem does not exist, or an indemnity that the seller pays if it does.
• Negotiate a lower price. You can use the information as a bargaining chip. Issues found in due diligence are a legitimate reason to revisit the price you offered before you knew about them. The seller may not like it, but a buyer who has done the work is in a far stronger position than one relying on the seller's description of the business.

In my practice we help buyers do both: turn findings into protections in the SPA, and into a better price.

Risks of skipping due diligence

The main pitfall of not conducting due diligence is simply not being aware of critical information about the business you have bought. The business does not change because you did not look at it. The only thing that changes is that its problems are now yours. Some of the issues that can arise include:

• Pending litigation. If there are claims against the target business, those claims may continue to be brought after ownership has transferred to you. You will then be the one who has to resolve them, and if things do not go well, pay out the claimant.
• Non-compliance with laws. If the target business has not been complying with the laws that apply to it, the consequences may land on you as the new owner.
• Unpaid taxes. If the business has not been paying its taxes, that may be something you end up having to pay for.

Each of these is the kind of thing due diligence is designed to surface before you sign, when you can still walk away, reprice or get an indemnity. After completion, the options narrow to whatever protection you managed to negotiate into the SPA, and if you did not look, you will not have negotiated any.

Next steps

Due diligence is a critical part of buying a business. It enables you to make an informed decision on what you are buying, minimise risks and keep the process smooth. Appoint a corporate solicitor and an accountant to cover the legal and financial sides, make sure the operational and marketing questions are asked too, and feed what you find into the SPA and the price. My detailed series starts with corporate records due diligence and continues with finance due diligence, commercial contracts and property due diligence.