Due diligence when buying a business

When you are buying a business, you will need to conduct due diligence to investigate all aspects of it before you make a binding decision to buy.

Due diligence involves taking reasonable steps to make sure that you are not making risky or poor decisions, paying too much or breaking any regulations or rules. When purchasing a business, you are responsible for assessing the business thoroughly to confirm that it is as ethical, compliant and profitable as claimed.

Actions you will take during due diligence investigations include reviewing:

  • contracts – for the sale of the business, existing agreements between the business and staff and suppliers, and partner agreements
  • records – income, profit and loss statements, and tax returns
  • expenses – bank loans, utility accounts, lease agreements
  • business operations – intellectual property, stock, tools and equipment.

A part of due diligence involves identifying any potential risks that the purchase of the business may pose to you and ways to manage them.

Completing due diligence can help you make informed decisions about the business purchase, the right price to pay and how it should be handled.

Preparing for due diligence

Due diligence needs to be conducted before any contracts are signed to ensure you have a full picture of what you are purchasing. The process can take a week to several months, depending on the scale and complexity of the purchase and how long it takes to obtain and review the information about the business.

You can include a period of due diligence in the sales contract that will allow the agreement to be terminated if any issue is uncovered that could seriously affect the business's success. The period is generally limited to 5–10 business days after the contract has been signed.

For example, a workplace health and safety issue may not be disclosed by the seller and when identified during due diligence, the business purchaser could terminate or re-negotiate the sale.

Processes for due diligence are:

  • gathering and reviewing documents alongside accountants and advisers using resources and computer programs
  • storing and sharing information through emails and file-sharing systems
  • setting up a 'data room' that the buyer and seller and their advisory team can access (e.g. shared online application)
  • preparing requests for information (RFIs)—RFIs are formal documents used to seek information during the due diligence process, which allow the buyer to ask for specific information from the seller to help with negotiations and decision-making.

All documents should be inspected by lawyers and accountants, including:

  • legal information about the business structure (e.g. company and shareholders)
  • financials (e.g. loans)
  • contracts with suppliers and customers
  • human resources (e.g. staff contracts).

Learn more about working with business advisers.

Example of the importance of due diligence

A buyer is interested in purchasing a business with a large amount of stock in a warehouse. The records indicate stock turnover for various products is very slow, in some cases longer than a year.

The RFI questions this and the response indicates some stock was meant to service older model equipment and machinery still used by industry.

Consequently, the buyer negotiates the removal of the older stock from the sale agreement, reducing the sale price for the business and making the warehouse space unnecessary.

Researching a business

Take your time when doing your research into options for buying a business.

Initial sources you could research are:

  • real estate listings
  • business broker websites
  • commercial websites
  • trade journals and industry magazines
  • advertisements for businesses for sale in the area or region that interests you through online searches.

To understand your needs and how to conduct due diligence, see the following areas of research and what to investigate.

Putting together a due diligence team

Having a team to help with due diligence will make the decision-making process easier and better managed.

Your team could include:

  • accountants
  • financial advisers
  • lawyers
  • business mentors.

The role of advisers is to:

  • review the business reports
  • advise you on the business's performance and viability
  • advise you about risks and liabilities.

Getting advice from the team will give you a better understanding of the areas that are not your expertise. The team will be able to identify risks and issues you may not have considered.

Early warning signs

Through your research and investigations, you may find early warning signs of challenges you might face when purchasing the business.

For example:

  • if the work equipment looks old and poorly maintained this could indicate extra expenses may be needed soon to replace it
  • if there are poor customer reviews, extra resources may be needed to turn the business's reputation around.

Identifying warning signs and potential disadvantages is also part of due diligence when purchasing a particular business.

Gathering documents and information

During the due diligence process, it is important to gather documents and information to get a clear picture of the business. The seller may ask you to sign a non-disclosure agreement prior to accessing the documents and information if any of it is sensitive or protected.

Before signing the sale contract, you should get specific warranties and indemnities from the seller to protect you from any potential issues throughout and after the sale. For example:

  • underpaid wages or unpaid superannuation
  • disputes with manufacturers or other creditors over unpaid invoices.

Once you and your advisers have reviewed the necessary documents, the RFI can be prepared to look more closely into the potential purchase and the business.

Example of decisions affected by due diligence

The potential buyer knew from industry research that new compliance systems would be mandated within months of purchasing a business. The document check revealed the software currently used in the business was non-compliant. This indicated a large investment in both software and staff training would be required before the buyer could trade.

The RFI asked if the software would be purchased and implemented prior to the sale. The seller declined and the buyer decided the expense, time and risk was too high and did not proceed with the purchase.

Types of information for due diligence

The following is a list of documents and information you and your advisers will assess to determine if a business is a good investment.

    • Income statement
    • Balance sheet
    • Accounts receivable and payable
    • Goods and services tax (GST)
    • Tax returns (minimum 3 years previous)
    • Profit and loss statement (3 years or longer to determine market variations)
    • Bank loans, line of credit, overdraft, debtor finance facilities
    • Leases, including terms and conditions (e.g. recent landlord changes and potential rate rises; permitted uses in case you wish to change use; guarantors)
    • EFTPOS terminals and facilities
    • Payroll, pay as you go (PAYG), superannuation guarantee
    • Australian Taxation Office (ATO) compliance software
    • Audit reports (if available)
    • Credit history check (your advisers can obtain this)
    • Plant, equipment, vehicles
    • Maintenance records and leases
    • Other assets owned or leased by the business
    • Outstanding debt or title
    • Stock, including stock not fully paid for
    • Australian Securities and Investments Commission check (your advisers can do this)
    • Legal details and agreements for directors, partners and shareholders
    • WorkCover
    • Other insurances
    • Any legal proceedings (e.g. work health and safety, environmental)
    • Any regulations or issues under investigation (e.g. by Australian Competition and Consumer Commission)
    • Privacy requirements (e.g. small businesses in the health industry)
    • Mandatory codes of practice
    • Business processes, procedures and standards
    • Contracts with suppliers—liability exclusions (e.g. can the seller transfer the contract to you without the supplier's consent and privacy requirements?)
    • Staff and contractor contracts
    • Staff awards (entitlements and conditions) (e.g. modern awards or other)
    • Induction and training records
    • Licences and qualifications
    • Utilities
    • Vehicles
    • Accounting
    • Trademarks
    • Patents
    • Copyright
    • Registered designs
    • Business registration
    • Licences and contracts
    • Policies and procedures
    • Systems
    • Voluntary codes of conduct
    • Minutes of management meetings

Draft contracts

A draft contract will provide information about:

  • assets and liabilities you are purchasing, and if you are paying book value, market value or the replacement value for them
  • date and time you would take over
  • trial period, if applicable.

The RFI questions should assist in preparing the draft contract, including the following:

  • Will you have total control over recording cash sales and banking during the trial period?
  • Are there any limits around partnerships (e.g. if one partner can commit to anything without the other partner(s))?
  • Will you be purchasing the accounts receivable?
  • What standards are set for sales, warranties and refunds?
  • Is the seller prepared to sign an agreement to not compete with you?
  • Will the seller provide training after the purchase, and if so, for how long?
  • Could you spend time working in the business prior to the sale?
  • What is the seller's job role in the business and will you need to match this to be successful?
  • Is there any work in progress you may need to complete or any inventory you will need to buy?
  • Are there any other expenses (e.g. body corporate)?
  • Are there any unwritten agreements with suppliers?
  • When are staff expecting a wage rise?
  • Does the business have any assets, such as databases, and exclusive rights?

Preparing for the unexpected

Even though you have gathered all relevant information, you should still prepare for the unexpected, including the following.

  • Expenses may have been delayed and you have immediate equipment, maintenance or wages to fund.
  • Sales figures and cash flow may be inflated, and you will need some extra cash to overcome a financial shortfall.
  • Figures may not be in line with current industry benchmarks.
  • Risks result from the seller's earlier actions that you are not aware of and you have no indemnities in the contract.
  • The personality of the seller may be the success story and you may need time to be accepted by customers and achieve your own success.

Having a contingency plan in place can prepare you for problems when they arise.

Example of an unexpected issue when purchasing a business

The buyer bought a business that they considered to be a going concern. They discovered the supplier rates had been kept low due to the relationship with the previous owner and the supplier immediately lifted their rates with the new owner.

They will now have to increase the price of their goods, which then affects the business's competitiveness and reputation with customers.

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