What Is Due Diligence?

This article explains due diligence, what you can expect during the due diligence process, and gives prospective buyers a sample due diligence checklist. Use this information to provide a solid foundation of knowledge so you can finalize your business purchase with confidence, whether you use a broker or perform due diligence yourself.

What Is Due Diligence? 

Due diligence is a thorough vetting, an investigation, of the business you intend to acquire.

This investigation usually occurs after the parties have an agreed-upon offer and have signed a Letter of Intent.  And, of course, at this point the parties will have a confidentiality provision, or agreement in place, protecting the seller before they are willing to share sensitive financial and proprietary information. 

The due diligence period is a crucial time for you, as a buyer, to confirm that what you’ve been told about the business is true and to examine how the seller justifies their sales price and, ultimately, the ongoing profitability of the business. 

For our purposes, “due diligence” refers to the buyer’s investigation of the seller’s information and other verifiable details about the business. However, it is important to note that sellers also perform due diligence on prospective buyers to see if the buyer is earnest and has sufficient funds to finance the sale. Due diligence on the seller’s part usually, but not always, takes place earlier in the selling process. 

How Long Does Due Diligence Last? 

The due diligence period varies depending on the type of small business sale. It typically lasts 30-60 days, but it can be any length of time agreed on by both the buyer and seller. It is an important step in the buying process and should not be rushed. The information you learn during the due diligence period will help you decide whether to continue with the purchase, modify the terms of the deal, shift the risk to the seller for potential future problems, or abandon the purchase altogether. 

After providing the seller with your due diligence checklist, you should carefully and thoroughly review the information furnished by the seller. The goal of due diligence is to get a solid understanding of the business - financial, legal, and operational; employees, customers, and suppliers. You can (and should) ask follow-up questions or request more information if anything needs to be clarified. 

Below is a sample checklist of the information you should ask to review. You can also find sample due diligence checklists online. Use these samples as a starting point, and then customize your due diligence checklist to fit the business you are buying.

Sample Due Diligence Checklist for Buying a Business

Corporate Organization

• Articles of incorporation and all amendments
• Bylaws and all amendments
• A copy of the minute book
• Organizational Chart
• Certificate of Good Standing 
• List of assumed business names (if applicable)

Taxes

• Federal, state, and local returns from the last three years
• The last three years of state sales tax returns 
• Tax settlement documents from the last three years
• Employment tax filings from the last three years
• Tax liens, if any
• The last three years of excise tax filings
• Audit reports

Financial Information

• Audited financial statements and auditor’s reports from the last three years, including balance sheet, cash flow, and income statement
• The most recent unaudited financial statements for comparison
• Auditor’s letters and replies
• Company credit report (if available)
• The schedule of accounts receivable
• The schedule of accounts payable
• A list of outstanding business debts and contingent liabilities
• Any unrecorded liabilities you discover when interviewing the seller or their employees
• A list of collateral for any debt
• Analyst reports
• A list of assets and liabilities
• An analysis of fixed and variable expenses
• Investment policies
• An inventory schedule
• The business ledger
• Projections, strategic plans, and capital budgets
• A description of depreciation and amortization methods
• Breakdown of gross profits and sales into categories applicable to the business type and means of operation

Material Contracts

• Schedule of all partnership, subsidiary, or joint venture relationships, including copies of the related agreements
• Loan, bank financing, promissory notes, or line of credit agreements
• Mortgages, security agreements, collateral pledges, and indentures 
• Guarantees that involve the business
• Distribution agreements, agreements with sales representatives, supply agreements, and marketing agreements
• Installment sale agreements
• Standard quote, invoice, purchase order, and warranty forms

Customer Information

• A schedule of the business’s largest customers, including a description of the amount and type of sales made to them over the last two-years
• A description of the company’s purchasing policies
• A schedule of unfilled orders
• A description of the business’s credit policy
• A list of all supply or service agreements
• The results of any market research reports or surveys
• A summary of advertising programs and marketing plans
• Copies of printed marketing materials
• A summary of any ongoing research and development projects
• A list of top suppliers (if applicable) 
• A list of the business’s main competitors for the market share   

Licenses and Permits

• Copies of local, state, and federal permits, licenses, and consent forms
• Any documents related to the proceedings of a regulatory agency

Information Technology

• A list of software programs and hardware used by the business
• A summary of the costs of maintaining IT systems
• An overview of current IT system usage
• Any material contracts with IT service vendors
• Policies regarding data storage
• A summary of IT security protocols, including antivirus and anti-malware protection programs
• A description of any cyber attacks and loss of confidential information

Environmental

• A list of hazardous materials utilized in the operation of the business
• A description of how such materials are disposed
• Any environmental permits or licenses
• Copies of any correspondence related to regulatory agencies from the local level to the EPA 
• A list of environmental investigations or litigation (if applicable)
• A list of contingent environmental liabilities or ongoing indemnification warranties

Insurance

• Copies of any insurance claims for the past three years
• An extensive list of the business’s insurance coverage, including workers’ compensation, general liability, personal and property, vehicle, and intellectual property

Real Estate

• A list of all property leased or owned by the business
• Copies of all mortgages, leases, deeds, surveys, zoning approvals, use permits, title policies, and variances

Employees and Employee Benefits

• A list of all people employed by the business, with their positions and salaries
• Any employment nondisclosure, consulting, noncompetition, or nonsolicitation agreements between the business and its employees
• Resumés of the business’s most vital employees
• Descriptions of retirement plans, both qualified and non-qualified
• A copy of the business personnel handbook, including a comprehensive list of employee benefits
• A description of grievances and/or labor disputes
• A history of the business’s worker’s compensation and unemployment claims 

Assets

• A schedule of fixed assets with locations
• Any equipment leased by the business
• A list of any major equipment bought or sold over the past three years
• A list of Uniform Commercial Code (UCC) filings

Litigation

• A list of any pending litigation
• An accounting of any threatened litigation
• A list of unsatisfied judgments
• Copies of insurance policies that protect the business in the case of litigation
• Any problems with regulatory agencies such as the IRS
• Copies of documents related to injunctions, settlements, or consent decrees involving the business

Intellectual Property

• A description of patents and patent applications, both domestic and foreign
• A list of trade names and trademarks
• Any copyrights held by the business
• A summary of the means by which your business protects trade secrets
• A summary of claims regarding intellectual property
• Copies and a schedule of consulting agreements, assignments of intellectual property to or from the business, and agreements concerning inventions
• A list of patent clearance documents

Products and Services

• A comprehensive list of services and products the business offers
• A list of products and services still under development, including any studies or surveys about such products and services
• Any correspondence or documents that relate to regulatory approval of the business’s product line
• An assessment of current market share values
• A summary of warranty claims 
• A summary of consumer complaints
• A review of the business’s profitability and cost structure, including expense trends for the past five years and the valuation of fixed assets
• An overview of changing trends within the business’s industry