- Due diligence covers far more ground than most sellers anticipate and can take anywhere from 30 to 120 days depending on how prepared both parties are.
- Sellers who enter due diligence without their materials organized face longer timelines, more disruption, and greater risk of a reduced purchase price.
- Whether you are a buyer or a seller, a structured, prioritized approach to due diligence protects your time, leverage, and deal outcome.
What is due diligence?
Due diligence serves two principal functions. First, it’s the process by which a buyer evaluates a seller’s business to confirm their assumptions. Second, it’s used to set up the integration of the seller’s business following closing.
In a typical M&A transaction, when the buyer and seller begin exploring a potential deal, the seller shares limited information (hopefully under a non-disclosure agreement) so the buyer can formulate an offer. After some back-and-forth, the parties negotiate a letter of intent that covers the purchase price, deal structure, and other pertinent terms.
The letter of intent will include a provision that the buyer—and sometimes their financing sources and lenders—must be satisfied with due diligence to close.
To get there, the buyer will have made specific assumptions about the business, its operations, and its ability to generate future revenue and cash flows.
Note for venture capital: Due diligence from a venture capital investor follows the same general process as private equity or strategic buyers, but places greater emphasis on team capabilities, addressable market, and business plan. With less operating history available, these three elements are particularly important in the investment decision.
Due diligence process
Most due diligence processes start with an extensive request list from the buyer—typically a 10–20 page document listing hundreds of items the buyer or their advisors will want to review, including:
- Financial and tax records
- Contracts and legal records
- Internal reports
- Real and personal property details
- Intellectual property documents
- Employment and HR records
- Insurance policies
- Litigation summaries
The buyer delivers this list at the time of the letter of intent. Then, the seller collects and organizes responses in an electronic data room. Many answers will be “not applicable,” while other requests require additional analysis or to see underlying contracts or documents.
The buyer and their advisors review all materials, then schedule calls to ask follow-up questions, clarify issues, and dive deeper into areas of concern. For example, a buyer will commonly request your accounts receivable aging and follow up on specific accounts over 60 days to determine whether those amounts are collectible or may need to be written off.
That level of detail extends across topics such as company background and history, strategy, marketing and positioning, team, financials, products and services, customers, and more.
This cycle of document review, Q&A calls, and follow-up requests can go on for a while—sometimes maddeningly long.
Most sellers grow frustrated by the end: questions get asked multiple times, the buyer’s team may not be communicating internally, and sellers begin to worry about purchase price adjustments.
The buyer uses all this information to prepare a due diligence report for their lenders and internal investment committee, documenting their findings.
Because missing an issue is “career-limiting,” buyer personnel and advisors will be exhaustive in their review.
We have been through hundreds of transactions, and in every case, our client has been surprised at how extensive the process is. Their common refrain is: “I had no idea how involved, time-consuming, and complex this process would be.”
What are the types of due diligence?
Due diligence covers a lot of ground. Below is a breakdown of the types of due diligence buyers will conduct.
Financial
Financial due diligence has three primary purposes: confirming the historical financial results presented by the seller before signing the letter of intent, determining whether the seller’s projections for future financial performance are credible, and determining if the company’s financial records and systems are adequate to support future growth.
To accomplish this, the buyer will examine:
- Annual and quarterly financial information
- Sales and gross profits
- Accounts receivable
- Past results and future projections
- Pricing history
- Business tax details
- Debt summaries
- Summary of all current investors and shareholders
- Litigation summaries
When reaching over $10 million in transaction value, the buyer will also employ an outside accounting or “quality of earnings” firm to perform financial due diligence. The quality of earnings review is extensive and will examine every aspect of a seller’s financials and forecasts. Internally, we refer to this as an “audit cubed” because this review examines whether the business can continue to grow and generate increasing amounts of cash flow on top of a traditional financial audit.
Operational
Operational due diligence examines a company’s lead-to-cash processes, manufacturing processes (if applicable), hiring practices, depth of team, operational scalability, systems, and other relevant areas to confirm the business is run well and can scale to support future growth. This can be completed by the buyer directly or through an outside firm.
Legal
Legal issues might range from potential litigation exposure to contracts that require the consent of the other party prior to being lawfully assigned to the buyer. A buyer will usually hire an outside law firm to review a seller’s contracts, regulatory requirements and compliance, prior and current litigation, and business practices to identify any legal risks post-closing.
Information technology (IT)
Businesses increasingly depend on their own IT infrastructure to manage operations. As a result, buyers are keenly interested in confirming that the seller’s IT systems can support current and future operational requirements. They will also scrutinize security measures taken to protect user and customer data given significant data privacy regulatory requirements, and evaluate accounting and enterprise resource planning (ERP) systems to determine if they can accommodate future growth.
Intellectual property (IP)
For companies that rely on proprietary software, patents, trademarks, or other proprietary information, buyers typically engage a combination of specialist attorneys and outside firms to perform IP and software code audits. The goal is to confirm:
- The company owns all relevant intellectual property rights to conduct its business and sustain its competitive advantage.
- The company is not infringing on others’ intellectual property rights in a way that could create liability or disruption post-closing.
Common questions in this process include whether the company is aware of any information that could make its IP unpatentable or invalid, whether it has received notice from a third party or obtained a formal or informal opinion from counsel, and whether the company has been involved in or anticipates any IP-related disputes.
Human resources (HR)
Buyers—through their own team, an outside law firm, or an HR due diligence specialist—will evaluate a seller’s HR policies, practices, and procedures for compliance with applicable law. This includes identifying any risk of future liability from employment practices, such as wrongful termination or discrimination claims. They will also seek to understand any unique employment policies that could create issues post-closing, like a conflict between an “unlimited” vacation policy and a more traditional one.
Employee benefits
Employee Retirement Income Security Act of 1974 (ERISA) is a federal law governing how companies provide benefits to employees, with hundreds of complex requirements. Many companies are unaware of potential ERISA issues until they are surfaced in due diligence by sophisticated buyers that understand the liabilities ERISA can create.
Environmental
For any company that owns real estate and handles hazardous materials, buyers will likely perform environmental due diligence—typically starting with a Phase I assessment of the property, followed by a Phase II if issues are identified. Environmental liabilities can be substantial and are often assumed by the buyer post-closing, making this an important area of due diligence.
Insurance
Buyers will typically use an outside insurance broker to evaluate a seller’s insurance policies and prior claim history, covering liability, director and officer, property and casualty, health, and other coverages. The buyer wants to understand the costs of these policies, whether they would change under their ownership, and what coverage will remain for anything that happens prior to closing.
Cultural fit
Buyers—whether private equity or strategic—have a unique culture. Particularly in the case of a strategic buyer, if the culture of the seller’s company is at odds with the culture of the buyer’s company, there will likely be operating challenges post-closing that could adversely impact business performance. Buyers will typically want to talk with several members of a seller’s team to evaluate cultural fit. If conflicts exist, buyers might walk from the deal or work with the seller to develop an integration plan to address those differences.
Regulatory
For companies subject to specific regulatory requirements, buyers will hire an expert to evaluate the seller’s compliance. With dozens of state and federal regulatory agencies and hundreds of thousands of requirements, buyers do not want to inherit a situation where they could be subject to fines, penalties, or operational disruption following closing.
Background checks
It‘s often surprising to sellers that buyers conduct background checks on all key management personnel. That’s why we recommend sellers perform their own background checks on critical team members—particularly those involved in financials or cash management—before a transaction. If you are aware of any specific issues that might come up, let the buyer know ahead of time so they do not think you are hiding anything.
Facilities and equipment
In equipment-intensive businesses, buyers will examine the seller’s equipment and facilities to understand their condition and expected useful life. Acquiring a company with aging equipment means the buyer will need to invest additional dollars in repairs or replacements. Similarly, if facilities are not large enough to accommodate future growth, the buyer will need to account for those investments post-closing.
Customer interviews
During our M&A process, we typically wait until the last week before closing to allow the buyer to interview customers. While buyers understandably want to assess customer satisfaction and identify any potential issues, these conversations can be extremely disruptive if the transaction does not close. We typically ask buyers to present themselves as a company conducting a customer satisfaction survey—or better yet, hire a third-party firm to do so.
Market studies
Market studies are performed by third parties to evaluate the overall state of the market for a seller’s company, including how the seller is perceived by competitors and customers. Most strategic buyers will already have this knowledge because of their market presence and will not commission a study. Private equity firms, however, often hire a market research firm to include this information in their due diligence report and to evaluate whether there are opportunities to increase pricing following closing.
Employee interviews
Similar to customer interviews, buyers want to assess a seller’s team—particularly their management team and capabilities for growth. For managers who are aware of and participating in the transaction, these interviews can happen any time during due diligence. For those who are not aware, it is best to defer until the final steps before closing. The buyer will also attempt to discern how dependent the business is on the seller, recognizing that the seller’s involvement and motivations could shift significantly after the transaction.
How to prepare for due diligence as a seller
If you are an owner looking to raise money or sell all or part of your company, preparing for due diligence ahead of time is critical. One of the biggest mistakes we see is owners entering negotiations without their diligence materials in order. This leads to endless back and forth, significant disruption to you and your team, and potentially a lower purchase price as the buyer uncovers issues that impact business value.
Step 1: Get a sample diligence request checklist
In Appendix B of our book, Harvest, we provide a sample diligence request list. You can also find them online or through your attorney or investment banker.
Step 2: Collect and organize your due diligence materials
Starting with the most important materials (your investment banker can help you prioritize), collect and organize everything in an electronic data room. Use the request list as a guide.
Step 3: Get help reviewing your materials
Ask your corporate or M&A attorney to review your diligence materials to identify any specific problems that need to be addressed before presenting them to a buyer.
Step 4: Hire an outside firm to perform a quality of earnings review
A seller-prepared quality of earnings review not only surfaces issues and opportunities early; it also signals to buyers that you are a serious seller and allows you to control the financial review agenda.
Step 5: Address diligence issues ahead of time
For any issues you or your advisors identify, address and resolve them prior to buyer due diligence if time allows. If not, make sure to explain and position the issue prior to signing your letter of intent, when your negotiating leverage is at maximum.
Step 6: Control the agenda
Too many sellers let buyers dictate the pace and terms of the diligence process. With the right preparation, you can set the agenda with timelines, milestones, and weekly check-ins to keep things on track. An investment banker can also serve as an intermediary, helping to manage buyer demands and protect you and your team throughout the process.
How to conduct due diligence as a buyer
If you are planning to buy a business, you will need to be equally disciplined about your due diligence process. Otherwise, you risk wasting valuable time, money, and energy on a deal that isn’t advantageous.
Step 1: Identify “dispositive negatives”
Before diving in, get clear on exactly what issues would prevent you from doing a deal and what attributes must be present for you to be interested in a seller’s business. Without this clarity, you will waste a lot of time talking with companies that are not a good fit.
Step 2: Compile a list of questions and document requests
For each item identified in Step 1, develop a list of questions and document requests that will help you quickly determine whether a company meets your requirements. Getting these answered early can save significant time on companies that don’t meet your criteria.
Step 3: Develop a prioritized due diligence request list
At Class VI, we use two different lists, one for initial discussions and one for full due diligence. As a buyer, we recommend developing your own prioritized version. First priority items should help you quickly understand the business, its financials, and future prospects. Second priority items might be specific risks that would materially impact valuation, and third priority items cover everything else.
Prioritizing your list also helps manage the seller’s time. There is no bigger deterrent to a seller engaging in negotiations than having a buyer with an unreasonably long initial diligence checklist.
Step 4: Make your decision
Once you’ve received your high-priority diligence items, determine whether you are ready to proceed with an offer. If you can come to terms with the seller, move to Step 5.
Step 5: Hire your team
It is unlikely you will have the technical expertise required to complete a full diligence review on your own—particularly if you have not purchased a business before. At a minimum, engage outside legal counsel and a quality of earnings firm.
If the target is asset-intensive, consider an asset appraisal firm. If it relies heavily on IP, consider an outside firm for a code evaluation. Your diligence team should be built around the areas that are most critical to a successful acquisition.
Step 6: Manage the process
Sellers grow frustrated when buyers are disorganized or fail to coordinate across their teams. Answering the same questions multiple times leads to deal fatigue, which is unproductive for everyone. As a buyer, organize your efforts, adhere to milestones, and make the process as straightforward as possible for the seller—otherwise you risk losing their interest.
Step 7: Address diligence findings
Keep in mind that for most sellers, this is their first time through a diligence process. Focus on items that will impact valuation if you intend to renegotiate and let smaller issues sit if you are not—there is little to gain from criticizing a business the seller has spent years building. For anything requiring attention post-closing, prioritize those items early so you can align with the target company’s team.
Frequently asked questions
Here are answers to the questions we most commonly hear from business owners about the due diligence process.
How long should due diligence take?
If the seller is reasonably prepared and the buyer is experienced, due diligence should take 30–60 days. If the seller is disorganized or the buyer is inexperienced, it can extend to 90–120 days or longer. Having an investment banker manage the process can shave time off, but the best way to ensure a shorter diligence period is to come fully prepared.
How does due diligence relate to an “exclusivity period”?
Due diligence happens after the buyer and seller have signed their letter of intent. In almost all letters of intent, the parties will agree to an exclusivity period—typically 30–90 days—during which the seller agrees not to talk with any other potential buyers. If diligence and deal negotiations are proceeding on schedule, both parties might agree to an extension. If the seller believes the buyer is dragging their feet, they may refuse an extension.
Can a buyer back out of a deal during due diligence?
In short, yes. In practice, buyers don’t enter a diligence period expecting to walk away after investing significant time and money. However, almost all letters of intent are based on the buyer’s assumptions about the seller’s business. If those assumptions prove incorrect and the parties cannot agree on different terms or a reduced price, the buyer or seller can exit the deal.
Who is involved in the due diligence process?
Both the buyer and seller need to determine who from their own organizations will participate in diligence and whether they need outside help. Ideally, buyer personnel are experienced and efficient with their requests, and the seller’s team has done enough pre-planning that the process is not overly distracting. In almost all cases, the seller will need to involve their head of finance, as many diligence items will be financial in nature.
What is third-party due diligence?
Third-party due diligence refers to the work performed by outside advisors to a buyer, including attorneys, accountants, consultants, insurance providers, environmental assessment firms, benefits consultants, code auditing firms, and other specialists. In the letter of intent, a buyer will often reference third-party due diligence requirements. If you are a seller, insist on the buyer identifying the outside firms they will be using and confirm the buyer has a way of coordinating their requests. Your investment banker can help you manage this.
How much does due diligence cost?
Costs can range widely—we have worked on deals where they ran into seven figures and others where they were under $100,000. Not including the costs of both parties’ internal teams, attorney costs might range from $5,000–$150,000, quality of earnings reviews from $30,000–$300,000, and market studies from $150,000–$350,000, with additional consulting fees on top. Due diligence is expensive and time-consuming, which is exactly why buyers do not want to go through the process only to end up with a busted deal.
What is a due diligence or break-up fee?
Some buyers will negotiate a break-up fee to cover their diligence expenses in the event the seller walks away from a deal agreed to in the letter of intent. Break-up fees may cover all of the buyer’s third-party expenses or be set at a specific dollar figure.
We recommend against sellers agreeing to this type of provision. The seller should also be performing due diligence on the buyer at the same time, and if the buyer turns out to be a poor fit, the seller should be free to walk away.
How Class VI can help
Due diligence is a critical part of any transaction—confirming assumptions, surfacing risks, and laying the groundwork for post-closing integration. Both the buyer and seller benefit from approaching the process in an organized, disciplined way.
If you are considering buying or selling a company and have questions about how an investment bank can help, contact us or reach out to chris@classvipartners.com directly to discuss your goals and how we can assist.