Due diligence when buying a business: what to check and what lenders need

Due diligence when buying a business is the structured investigation a buyer carries out before completion to confirm that the profits, assets, contracts and liabilities are what the seller says they are. It normally covers financial, tax, legal, commercial, operational and regulatory areas, and lenders will usually want to see its findings before they release acquisition funds. This guide is for first-time and experienced buyers of UK private companies, practices and trading businesses. Smart Funding Solutions is a broker, not a lender. We arrange acquisition finance from around £10,000 to £500,000+, with larger facilities available in suitable cases, and well-run diligence is one of the things that makes a funding case straightforward.

01Why due diligence matters

Due diligence matters because it is the buyer's only real chance to find problems before the money is paid, and it directly affects the price, the structure and the protections in the sale agreement. A seller knows the business far better than you do. Diligence narrows that gap. Its findings feed into three decisions: whether to proceed at all, whether to renegotiate the price or move some of it into deferred payments, and which specific warranties and indemnities you need.

Diligence and contractual protection work together. Warranties are statements of fact the seller makes in the sale agreement, and indemnities are promises to reimburse specific losses, such as a known tax exposure. They give you a route to claim if something turns out to be wrong, but a claim against a seller who has spent the proceeds is hard to recover, which is why buyers often link protection to deferred consideration held back from completion. Neither replaces finding the problem in the first place.

02Financial due diligence

Financial due diligence tests whether the business really earns what its accounts suggest and whether that profit will continue under new ownership. It is usually carried out by an accountant with transaction experience and is the area lenders focus on most.

• Quality of earnings. Reconciling filed accounts to management accounts and bank statements, scrutinising the seller's add-backs and arriving at a maintainable profit figure. This is the number that drives both the price and the debt, as explained in our guide to how to value a business.
• Working capital. Understanding the normal level of debtors, stock and creditors through the year, so that the sale agreement can set a working capital target and the business is not handed over drained of cash.
• Debt and debt-like items. Identifying loans, overdrafts, asset finance, invoice finance, director's loans, deferred tax, unpaid bonuses and other items that reduce what the buyer should pay for the shares.
• Forecasts. Testing the current year's trading and the assumptions behind any forecast the seller has provided.
• Revenue recognition. Checking that income is recorded in the right period, particularly in project, subscription and work-in-progress businesses.

03Tax due diligence

Tax due diligence looks for unpaid or disputed tax that a buyer of shares would inherit along with the company. Reviewers check corporation tax, VAT, PAYE and National Insurance compliance, any open HMRC enquiries or Time to Pay arrangements, the treatment of contractors and employment status, and any past restructuring or share schemes. On a share purchase, historic liabilities stay with the company, so a tax indemnity from the seller is standard. On an asset purchase, most historic tax stays with the seller, although VAT treatment of the transfer still needs advice.

Financial due diligence tests whether the business really earns what its accounts suggest and whether that profit will continue under new ownership.

04Legal due diligence

Legal due diligence confirms what you are buying and identifies obligations and disputes that come with it. It is usually run by your solicitor through a questionnaire, a review of documents in a data room and searches of public registers.

• Title and corporate records. Who owns the shares or assets, whether there are options or charges over them, and whether statutory books are in order. Existing charges registered at Companies House must be released at completion.
• Contracts. Key customer and supplier contracts, including change of control clauses that allow the other party to terminate when ownership changes, exclusivity and onerous terms.
• Property. Leases, rent reviews, break clauses, dilapidations and title to any freehold.
• Employment. Contracts and terms for key staff, restrictive covenants, disputes and pension arrangements. On an asset purchase, employees generally transfer to the buyer on their existing terms under the TUPE rules on business transfers, so their terms need checking either way.
• Intellectual property. Ownership of trade marks, domain names, software and designs, and whether anything critical is owned personally by the seller or licensed.
• Litigation. Current, threatened and recent claims, and any regulatory action.

05Commercial due diligence

Commercial due diligence asks whether the business's market position and customer relationships will hold up after the sale. It covers customer concentration and retention, pricing power, the reasons customers buy, supplier dependence and alternative sources, competitors and market trends. Buyers often do much of this themselves, through customer calls arranged with the seller's agreement late in the process, sector research and their own industry knowledge. Larger deals may use a specialist adviser.

06Operational and regulatory due diligence

Operational and regulatory diligence checks that the business can keep running safely and lawfully once the seller steps back. Operationally, that means systems and data, key-person dependence, the condition of equipment and premises, health and safety, insurance cover and claims history. Regulatory diligence depends on the sector: care, healthcare, pharmacy, financial services, legal and environmental businesses all have licences, registrations or inspection regimes that must transfer or be renewed. Practices also need to check professional indemnity history and client engagement terms, which is covered further on our practice acquisition finance page.

£137,500A transaction we arranged£137.5K to fund an accountancy practice acquisition.An established firm had an acquisition agreed. We structured the funding around the transaction and got it completed.

07What lenders require before drawdown

Lenders usually make satisfactory due diligence a condition of the facility, and they will not release funds until those conditions are met. The exact list depends on the lender, the deal size and the sector, but commonly includes:

• A financial due diligence report, or at least an accountant's review of quality of earnings, for anything beyond a small or simple deal
• Confirmation from the buyer's solicitor that legal diligence is complete and no material issues are outstanding
• The agreed sale and purchase agreement, disclosure letter and any deferred consideration terms, with the seller's debt subordinated where relevant
• Evidence of the buyer's own contribution and where it came from
• Release of existing charges and repayment of the seller's borrowing at completion
• Insurance with the lender's interest noted and, where relevant, key-person cover
• Security documents, such as a debenture and any personal guarantees, signed and ready to register

Some lenders ask to rely on the diligence reports directly, which means the adviser must agree to give the lender a reliance letter. Raise this early, because it can affect the adviser's fee and timetable.

08Typical sequence and who does what

Diligence usually starts after heads of terms are agreed and runs alongside the drafting of the sale agreement and the lender's underwriting. A typical order is set out below, although timescales vary widely with the size and complexity of the business and how organised the seller is.

Stage	What happens	Who usually leads
Heads of terms	Price, structure, exclusivity and timetable agreed in principle	Buyer and seller, with advisers
Funding in principle	Lenders assess the outline case and indicate terms	Buyer and broker
Information request	Questionnaires issued; seller populates a data room	Buyer's solicitor and accountant
Financial and tax review	Quality of earnings, working capital, debt and tax exposure	Accountant with transaction experience
Legal review	Title, contracts, property, employment, IP, litigation	Buyer's solicitor
Commercial, operational and specialist	Customers, market, systems; property, environmental or regulatory reports if needed	Buyer, with surveyors or sector specialists
Findings and negotiation	Price adjustments, specific indemnities, retentions or deferrals agreed	Buyer, solicitor, accountant
Lender conditions satisfied	Reports, documents and security delivered	Solicitors for buyer and lender
Completion	Sale agreement signed, funds drawn, charges released	All parties

09Red flags to watch for

Red flags are findings that suggest the profit, assets or risk are different from what the price assumes, and each should lead to a question, a price change or a contractual protection. Common examples include:

• Management accounts that do not reconcile to filed accounts or bank statements
• Add-backs that cannot be evidenced, or a profit spike in the final year before sale
• One customer, supplier or contract carrying a large share of the business
• Change of control clauses in key contracts
• HMRC arrears, a Time to Pay arrangement or an open enquiry
• Rising debtor days, old stock or creditors stretched beyond normal terms
• Key staff without contracts or restrictive covenants, or about to leave
• A short remaining lease term or an imminent rent review
• Regulatory warnings, licence conditions or recent poor inspections
• Reluctance to provide information or allow customer conversations

10Due diligence checklist

This checklist summarises what to request and why. It is a starting point for your advisers, not a substitute for their scope.

Area	Key documents and questions	Why it matters
Financial	Three years of accounts, monthly management accounts, bank statements, add-back schedule, aged debtors and creditors	Confirms maintainable profit and working capital
Debt	Loan, asset finance and invoice finance agreements; director's loan account; charges register	Sets the cash-free, debt-free price and completion repayments
Tax	Corporation tax, VAT and PAYE returns; HMRC correspondence; any Time to Pay	Identifies inherited liabilities and indemnities needed
Legal	Statutory books, share register, customer and supplier contracts, leases, IP registrations, litigation list	Confirms title and obligations
People	Staff list, contracts, pay and benefits, pensions, disputes	Costs and transfer of the workforce
Commercial	Sales by customer, retention data, pricing history, supplier terms, market overview	Tests durability of income
Operational	Systems, asset register, insurance schedule and claims, health and safety records	Shows what it takes to keep trading
Regulatory	Licences, registrations, inspection reports, complaints	Confirms the right to operate continues

11Diligence in practice purchases

When buying a professional practice, diligence concentrates on the client bank: fee history by client, retention, the age profile of clients, engagement letters and how dependent relationships are on the outgoing partner. In one completed case, we arranged a £137,500 acquisition facility for an established accountancy firm buying another practice, presented on agreed heads of terms and a clear acquisition rationale; see the accountancy practice acquisition case study.

12How Smart Funding Solutions can help