Due Diligence: What Buyers Ask For and How to Get Through It

The document request

It arrives as a list, often a hundred items or more, organized by category. The core of it is the same on almost every deal.

Financial. Three years of tax returns, annual and monthly financial statements, general ledger, bank statements, merchant statements, accounts receivable and payable aging, the add-back schedule with support, budgets or projections if they exist, and a reconciliation of the P&L to the tax returns.

Legal. Entity documents and good standing, ownership records, minutes, any pending or threatened litigation, judgments, liens, and regulatory correspondence.

Contracts. Customer agreements, vendor agreements, the lease, equipment leases and loans, service contracts, software licenses, and anything with a change of control or assignment clause.

Employees. Roster with title, hire date, compensation, and benefits, employment agreements, handbook, independent contractor agreements, payroll tax filings, workers compensation records, and any claims or complaints.

Operations. Equipment list with condition and ownership, vehicles and titles, inventory records, licenses and permits, insurance policies and claims history, environmental reports if the property or use requires them, and the operations manual if there is one.

Customers and sales. Revenue by customer for three years, top customer contracts, retention data, pipeline, pricing, and marketing spend and results.

Tax. Sales tax returns, payroll tax returns, property tax, any audits or notices, and in California the status of accounts with the CDTFA, EDD, and Franchise Tax Board, since clearance certificates will be needed at closing.

What they are checking

That the earnings are what the offering memorandum said. The buyer's accountant rebuilds SDE from the source documents. Every add-back is traced. Revenue is tied to bank deposits. If the memorandum said $500,000 and the rebuild says $440,000, the buyer will ask for a price reduction proportional to the difference, and they will usually get it.

That the earnings will continue. Customer concentration, contract terms, key employee stability, competitive changes, and anything in the trailing months that suggests a trend.

That there are no liabilities they are not being told about. Litigation, tax problems, employee claims, environmental issues, warranty exposure, and anything that would follow the assets.

That the business can be transferred. Lease assignment, license transfers, contract consents, and the seller's transition commitment.

Where deals get renegotiated

Add-backs that do not hold up. The single most common cause. An add-back schedule built for the sale that the buyer's accountant cuts by a third.

A soft trailing period. Revenue or margin that declined between the LOI and the end of diligence. Buyers look at the most recent months closely, and a dip gives them a reason.

Undisclosed problems. A lawsuit, a tax notice, a customer who is leaving, a key employee who has given notice. Anything the seller knew and did not say. The price reduction that follows is partly about the problem and partly about trust.

Working capital surprises. A buyer who expected the business to come with normal levels of inventory and receivables and finds them depleted.

Lease and landlord problems. Covered elsewhere and still the most frequent deal killer at this stage.

How a prepared seller gets through it

The data room is built before the listing. Every document on the standard request list is already organized in the ten sections a buyer expects. When the request arrives, most of it is answered the same day.

The add-back schedule was built to lender standards, so the accountant's rebuild matches.

The problems are already disclosed. A seller who wrote in the memorandum that there is a pending claim, what it is about, and what the expected outcome is, does not get retraded over it. A seller who hoped the buyer would not find it does.

The business is run hard through diligence. The owner is present, the numbers hold, and the buyer sees a company that is performing.

Responses are fast. A buyer who waits a week for each document starts to wonder what is being hidden and starts to lose patience with the deal. A buyer who gets answers in a day stays engaged.

What the seller should be doing in return

Diligence goes both ways. The seller should be verifying the buyer's financing, confirming the lender is on schedule, checking that the buyer's attorney is drafting the purchase agreement rather than waiting until diligence ends, and reading the buyer's draft carefully when it arrives. If there is a seller note, the seller underwrites the buyer. If there is an earnout, the seller needs to understand the buyer's plans for the business.

The request list, in practice

Buyers send the list in one document, but it arrives in the data room in the same ten sections a prepared seller has already built: business information, financial, clients and contracts, products and services, sales and marketing, team and people, operations, intellectual property and technology, legal and tax, vendors and suppliers. When the data room mirrors the request, the response is mostly a matter of pointing to what is already there.

A typical financial request from a buyer's accountant on a $1.5 million deal has thirty to forty items. A prepared seller answers thirty of them on day one from the data room and produces the rest, usually current-month items, within a week. An unprepared seller answers five on day one and spends the next six weeks on the rest, while the buyer's accountant bills hours and the lender waits.

A retrade, and how it was avoided

A distribution business went under LOI at $2.1 million on $650,000 in SDE. The buyer's accountant rebuilt SDE from the general ledger and found that $40,000 in "one-time" consulting fees had appeared in each of the last three years. The seller's advisor had flagged the same item during preparation, and the memorandum had already excluded it, showing SDE of $610,000 with a note explaining the consulting fees were recurring. The accountant's rebuild matched the memorandum. There was nothing to retrade.

Had the memorandum shown $650,000, the accountant would have found the $40,000, the buyer would have asked for a $120,000 price reduction at a 3 multiple, and the seller would have been negotiating from a bad position with the other buyers gone. The item was worth more disclosed than claimed.

Reverse diligence

While the buyer is verifying the business, the seller should be verifying the buyer. Has the lender issued a term sheet or a commitment. Is the buyer's equity injection in an account the lender has verified. Has the buyer's attorney started the purchase agreement. Is the buyer asking questions that suggest they are still deciding whether to buy, or questions that suggest they are planning how to run it. A buyer whose lender has gone quiet, or whose attorney has not produced a draft three weeks into diligence, may be looking at other deals. It is fair to ask, and the answer tells the seller whether to keep the other buyers warm.

The time it should take

With a complete data room and a documented add-back schedule, financial diligence takes two to three weeks and legal diligence runs in parallel. The lender's underwriting runs alongside and is usually the long pole. Four to six weeks from LOI to a final purchase agreement is a good outcome. Two to three months means something was not ready.

We build the data room and the add-back schedule before a business goes to market.