A Simple Definition
The official definition according to Oxford Languages is: “Reasonable steps taken by a person in order to satisfy a legal requirement, especially in buying or selling something.” This is a legal term used to indicate what buyers and sellers typically perform before finalizing a transaction.
Due Diligence In Business Sales
In business sales, the process of due diligence typically describes the process that the business buyer goes through to adequately and thoroughly exam a business prior to completing the business purchase. Sellers will also perform due diligence on the buyer in some situations but by far and away, the majority of due diligence in business sales applies to buyers.
The buyer will typically examine business records, financial statements, lease agreements, the premises and other key elements of the business. Usually the business purchase agreement provides that a business is purchased based on several contingencies. The main contingency is the business performance meeting with the buyer’s satisfaction.
To determine adequate business performance, the buyer requests business records from the business seller and then will study the information. This is essentially the process of due diligence. Usually, the buyer will perform due diligence with hired professional such as an attorney, accountant and/or industry specialists. Sometimes different types of attorneys are hired such as an employment lawyer for possible employee issues or a patent lawyer for trademark issues. The business broker or M&A professional does NOT perform the due diligence but will assist the parties in securing the information and coordinating due diligence.
The buyer will normally perform this process after the parties have entered a business sale agreement. If the due diligence proves that the business is not satisfactory to the buyer, then buyer will not remove the business performance and will not proceed with the sale.
Significance of Due Diligence In Business Sales
Since due diligence can destroy a sale, it should go without saying that process should be handled very carefully. Sellers are well advised to take this process very seriously and provide a complete set of records. The idea is to be as thorough as possible and to provide the information on a timely basis.
It is also wise for the seller to prepare all relevant documents prior to putting their business on the market. This helps move a sale forward by organizing the records before they are requested. Thus, when the information is requested, the seller’s quick and thorough response makes a favorable impact on the buyer. Nothing frustrates a business sale like unnecessary seller delays.
Example of Due Diligence In Business Sales
This following is an EXAMPLE of a due diligence in business sales list. This should NOT be used as an actual due diligence list because it is a general list and not customized for a particular business. It is provided here for educational and informational purposes. It may serve as a good guide for sellers to anticipate the kinds of requests that a buyer will make. It can also help buyers as a guide to develop their own due diligence request.
- Organization Chart
- Company Structure and affiliates, subsidiaries, etc.
- Percentage of ownership
- Jurisdiction of the organization and each subsidiary.
- Entity (corporation, LLC, etc) charter documents plus amendments
- All state records pertaining to the entity
- All minutes of meetings of boards of directors, committees and shareholders for the past five years.
- All stock transfer and certificate books, ledgers and records of the Company. For each class of stock, a listing of current shareholders indicating name, number of share owned and special restrictions (if any).
- Review agreements relating to the purchase, sale or issuance of securities, including any warrants or options.
- List of officers, directors and key management/supervisory personnel with appropriate background information regarding credentials.
- Number of employees with relevant information & by functional group (Sales, Marketing, R&D, G&A, etc.) with labor costs.
- A listing of debt holders.
- All voting agreements, voting trusts, proxies relating to capital stock of the Company.
- A listing and appropriate details regarding investments in other corporations or entities.
- Listing of all corporate and fictitious names used by the Company and any predecessors in the past five years.
- The Company’s professional advisors, including attorneys, auditors, lenders and investment bankers.
C. LEGAL ISSUES
- Copies of all litigation or arbitration, claims and proceedings (whether pending or threatened) where the Company or any affiliate or any officer or director of the Company is a party.
- All attorneys involved in the related proceedings
- All litigation files relating to any pending or threatened legal proceedings in which the company, affiliate, officer or director is a party.
- All consent decrees, injunctions, judgments, other decrees or orders, settlement agreements, and other agreements to which the Company is bound.
- All relevant reports, files, significant correspondence and documentation relating to any investigation or proceedings by any federal, state or other governmental regulatory agency in respect to the Company.
- All documents relating to any ongoing tax disputes between the Company and the federal government, the IRS, any state or local government or taxing authority, and any foreign jurisdiction or foreign taxing authority.
- All information pertaining to any charges that may be pending against the Company by any federal or state agency regulatory body or agency.
- Any relevant information regarding the Company’s officers, directors or employees that have been involved in criminal proceedings regulatory commission violations or significant civil court litigation.
- Any relevant information regarding international legal issues.
C. REGULATION AND PERMITS
- All compliance records re: environmental, equal opportunity employment, OSHA requirements or other regulations or requirements peculiar to the industry. If not, determine what compliance will cost.
- Information as to whether there are products that need governmental review and approval. If so, determine the current stage of the approval process.
- All copies of all governmental licenses and permits required for the Company’s business as currently conducted or planned.
D. INTELLECTUAL PROPERTY
- All documentation regarding patents held and applications made by the Company and all related material correspondence.
- All trademarks documentation held and applications made by the Company.
- All copyrights held and applications made by the Company and all related material correspondence and documentation.
- All trade names used by the Company.
- All licenses for any form of intellectual property held by or granted by the Company.
- Any pending or threatened infringement claims by or against the Company.
E. FINANCIAL AND ACCOUNTING MATTERS
- All financial statements for the past 5 years including tax returns, balance sheets and P&L statements
- Detailed breakdown of sales and costs
- Detailed breakdown of general and administrative expenses
- Detailed breakdown of selling and marketing expenses
- Detailed breakdown of working capital accounts
- Detailed breakdown of fixed assets
- Depreciation and capital expenditures.
- If needed, name and address of auditors/accountants and any prior auditors/accountants and dates they worked on Company’s finances.
- Any and all correspondence with taxing authorities.
- Analysis of total receivables due from customers, officers, employees and others
- Aged trial balance of receivable accounts
- Terms of sale
- Number of customers
- Names of large customers and amount of annual sales to each by product line
- Credit policies
- Turnover data
- Collectibility of receivables
- Are assets pledged as collateral.
- Is Company’s in compliance with loan obligations.
- All relevant documentation about all financial liabilities, recorded or contingent
- All Contracts and agreements
- Warranty guarantees
- Product liability
- Unfunded past service costs of pension plans or unfunded retirement benefits.
- With respect to accounts payable, review an analysis of payables by type (vendor, taxes, payroll, etc.) and determine payment practices for each.
H. BUDGETS AND FORECASTS
Determine the budgeting process, including capital budgeting, if applicable.
- All tax returns or copies of extensions of time within which to file such reports filed by the Company with the Federal government, the Internal Revenue Service, any state or local government or taxing authority, and any foreign jurisdiction or taxing authority, for the past 3-5 fiscal years
- Review for state franchise or similar tax liabilities of the Company plus scheduling as to when payments are made and due.
- All information regarding real property taxes.
- All information regarding ongoing tax disputes, together with copies of revenue agents’ reports, correspondence, etc., with respect to any pending federal, state, provincial or similar tax proceedings
J. MATERIAL AGREEMENTS
- All documentation relating to real property owned or leased by the Company (purchase agreements, leases, title policies, title reports, surveys, easements, rights of way, licenses and deeds).
- Information regarding all mortgages and other security documents relating to any of the properties or assets (real or personal) of the Company.
- All contracts with dealers, distributors, agents and others.
- All general sales conditions of the Company; model contracts, orders and invoices.
- Product warranties of the Company.
- Warranty claims during the last three years, and determine significant or unusual claims.
- All contracts and agreements relating to the Company to which any officer, director, employee or stockholder of the Company is a party or in which any officer, director, employee or stockholder of the Company has an interest including secrecy, confidentiality, nondisclosure, assignment of inventions and non-compete agreements.
- All equipment leases (operating or capitalized) to which the Company is a party or is bound or in which the Company has an interest.
- All agreements and contracts concerning any acquisition or disposition in the past five years by the Company of any substantial properties or assets, whether real or personal, outside the ordinary course of business.
- All loan agreements, guarantees, indentures, promissory notes, debentures, line of credit and related documentation in connection with any loan or other indebtedness of the Company or loans made by the Company to an officer, director, employee or shareholder of the Company.
- All license and royalty agreements to which the Company is a party or in which the Company has an interest.
- All sales, marketing and distribution agreements to which the Company is a party or by which it is bound (including documentation with any brokers and other independent sales persons or entities).
- All contracts and agreements with suppliers of services, raw materials, finished or semi-finished materials, or products of the Company.
- All standard forms of purchase orders, sales orders, supply contract, service contracts and sales contracts used by the Company.
- All agreements to which the Company is a party or by which it is bound, for the delivery, manufacture or supply of goods or services.
- All government contracts and subcontracts
- Insurance policies, and a claims history and any correspondence between the Company and the insurer.
- All certificates of insurance (casualty, property, liability, errors and omissions, officer and director, etc.). Determine to the extent coverage has changed during the past three years.
- Any and all other contracts, agreements or documents material to the business of the Company or any affiliate including management service and tax sharing agreements, performance guarantees, bonds and indemnification agreements, noncompete and confidentiality agreements.
- Any independent or self-employed consultants agreements.
K. SALES AND MARKETING
- Determine how potential customers are identified.
- Determine detail regarding the average dollar sale and time requirements to close a sale.
- Top 10 customers for each major business segments and determine the total sales for the past three fiscal years.
- Review a list of the top 10 suppliers.
- Company brochures, marketing materials, promotions and advertisements.
- Sales pipeline process and determine the current sales backlog.
- For each major business segment, review a sales breakdown (dollars and percent) by distribution channel.
- Determine whether future changes in sales or distribution strategies are required.
- Review any cyclical factors or seasonal factors with respect to the sale of the Company’s products and services.
- Customer support organization and services provided.
- Determine any significant quality problems within the past 36 months and describe problems or returns by product line.
- Determine each major competitor (size, products, profitability, financial strength, organization, etc.).
- Evaluate each of the competitor’s strengths and weaknesses in each product line.
L. EMPLOYEE, DEFERRED COMPENSATION AND BENEFITS MATTERS
- Review all collective bargaining and labor agreements to which the Company is a party or is bound.
- Review any stock option maintained by the Company.
- Review all employee benefit plans, trusts, determination letters, IRS filings (including tax returns), filings and actuarial reports relating to any deferred compensation arrangement to which the Company is a party or by which the Company is bound.
- Review all documentation relating to any severance arrangement between the Company and any employee, officer, director or consultant
- Review all documentation relating to any welfare benefit plan, health insurance, disability insurance, life insurance or other benefits given to employees, officers, directors or consultants of the Company.
- Review any employment contracts of the Company, for each category of employees, and indication of any difference for individual employees. Review all individual employment contracts.
- Confidentiality agreements
- Non competition agreements
- Employee handbook
- Labor union documentation
- Compensation plans
- Any key personnel positions unfilled
M. ENVIRONMENTAL MATTERS
- Review all environmental litigation or proceedings currently involving the Company, including claims, amounts, names of counsel and assessment of likely outcomes.
- Review policy memoranda, programs, procedures, training courses, emergency plans etc. relating to the environment.
- Review any emissions into air or water; wastewater and other discharges; noise pollution; waste produced.
- Review discharge production, storage and related environmental risks.
- Any studies, analyses, examinations of discharges and emissions, whether produced internally or by external consultants; description of material problems or risks.
- Removal methods of waste; cleaning methods for discharges/emissions; state of compliance with law.
- Review waste removal contracts and any agreements relating to environmental matters (pollution clean up, etc.)
- History of any accidental discharges and the results and measures taken to clean up and prevent future occurrences.
N. PERMITS AND LICENSES
- Review all environmental permits and licenses required for the Company’s’ activities including licenses with respect to manufacture, labeling and sale of products.
- History and current status of permits Company’s compliance with and licenses.
- Procedure for transfer of licenses or permits when the business is sold – Assets vs. Stock.
- Obligations of Company to file reports or studies with authorities with copies of reports.
- Any inquiries, inspections, examinations, investigations, etc., by environmental authorities and results
- Copies of documentation/correspondence; description of suspensions or withdrawals of any permits or licenses; significant correspondence for the last five years.
- Any surrounding/adjacent conditions which could give rise to liability for the Company.
- Any environmental claims history.
- Any injuries or illnesses of personnel, accidents, during the last five years, with effect upon environmental matters.
R. REAL ESTATE AND EQUIPMENT
- All real property owned by the Company (and appraisals, if available); nature of the title held, and any mortgages, liens or encumbrances on the property; title documents confirming ownership; report by person authorized to conduct title searches.
- Any property rented or leased by the Company; nature of leasehold interest; copy of the leases; description of significant or unusual clauses.
- Any limitation on the Company’s real estate or business as a result of historic preservation or similar laws or regulations.
- Review title insurance or title searches.
- Leasing agreements with respect to machinery, equipment, automobiles not owned by the Company.
- Documentation of liens and security interests granted on machinery and equipment.
- Review a list of surplus or idle equipment plus summarize annual maintenance expenditures
- List of all property and leases held by Company over the past 10 years.
If you are interested in buying or selling a business, contact our office. As you can see the process of due diligence in business sales is complicated and requires experienced and knowledgeable support in order to assure a through and transparent business sales process.