4 Types of Due Diligence

Due diligence is conducted primarily in four areas – financial, operations, legal, and HR.

Financial Due Diligence

In most transactions, the review of the financial statements is the most important part of due diligence. Before the buyer conducts due diligence, they may have already seen summary or normalized P&L and balance sheet statements. After you accept an offer, the buyer will finally get to see beyond these summaries to the financial details of your business. 

The importance of financial diligence depends on the legal form of the transaction and whether it’s structured as an asset or stock sale. In a stock sale, more emphasis will be placed on examining the debts and liabilities of your company because these will be assumed by the buyer. In an asset sale, less emphasis will be placed on the balance sheet.

The purpose of financial due diligence varies from buyer to buyer. Some buyers primarily use financial due diligence to value the business. Others simply want to verify that the numbers presented to them are accurate. The extent to which either is the case depends on the buyer’s purpose for making the acquisition. In industries where valuations are fairly stable, and the buyer is purchasing a book of business, the potential range of values is more narrow, and they may simply be seeking to verify the numbers. In high-growth industries, such as software, the buyer may use the due diligence process to value the business to help determine if the price they’re offering is reasonable.

Here’s a general description of some of the primary objectives of financial due diligence:

  • Financial Controls: Assess the strength of your company’s financial controls. The stronger your financial controls, the more trust the buyer will place in your financial statements.
  • Financial Statements: Determine the extent to which your financial statements comply with generally accepted accounting principles (GAAP). If the LOI contains language that specifies that your financial statements comply with GAAP, this can become a pitfall for you if your financial statements don’t comply.
  • Working Capital: Examine the level of working capital to determine if it’s sufficient. The buyer will estimate the amount of working capital required to operate your business, and then this number will be verified sometime after the closing, typically 90 to 120 days following the closing. 
  • EBITDA: Ensure the stated EBITDA is accurate. Many buyers will place a heavy emphasis on this verification. They’ll also spend time ensuring any adjustments to the financial statements are accurate.
  • Financial Ratios: Compare your company to others in your industry by examining industry benchmarks to ensure financial ratios are reasonable. The buyer will pay particular attention to any ratios that have improved in recent years, such as gross profit margins, to ensure that no financial gimmicks were employed to massage the numbers.
  • Due Diligence: The buyer will also be on the lookout for any of the following:
    • Inflating revenue or hiding or deferring expenses.
    • Timing of inventory purchases, which will affect the cost of goods and the gross profit.
    • Any indication that revenue may have been booked early.
    • Significant changes in the balance sheet trends from year to year, such as an increase in accounts receivable.
    • The extent to which your accounting policies differ from industry norms.

The following is a list of financial documents commonly requested during due diligence:

  • Accounts payable schedule
  • Accounts receivable aging schedule
  • Annual personal property tax certificate
  • Backup data of adjustments to financials
  • Bank statements
  • Breakdown of sales by customer
  • Breakdown of sales by product type
  • Copies of existing loan or financing agreements
  • Customer or client agreements
  • Documentation for add-backs to financial statements
  • Federal income tax returns
  • Financial budgets and projections
  • Full QuickBooks or accounting software files
  • General ledger or detailed list of all transactions and expenses
  • List of monthly sales since inception
  • Merchant account statements
  • Payroll tax reports
  • Profit and loss statements
  • Sales and use tax reports
  • Utility bills

Operations Due Diligence

The buyer must understand your business’s operations as a whole to make sense of its parts. By understanding how your business operates at a fundamental level, they will be better equipped to comprehend the other areas of due diligence, including legal, financial, tech, and HR. Operations due diligence may be further broken down into the following categories, depending on the industry:

  • Financial Services and Healthcare: Financial services and healthcare are highly regulated, and much of due diligence will be focused on compliance with existing laws.
  • Professional Services: Professional services are relatively low risk, and one of the primary concerns will be customer retention.
  • Manufacturing: Manufacturing is considered medium to high risk with common issues related to staff experience and adequacy, ownership of intellectual property, and product liability.
  • Tech: Tech is considered medium risk with issues related to ownership of intellectual property and new competitive threats.
  • Retail and Wholesale: Retail and wholesale are considered low to medium risk with threats from mismanagement of costs.
  • Construction: Construction is considered medium risk with potential threats related to compliance with regulations and issues with contracts and work in progress.

Face-to-face interviews are common when assessing the operations – they may be used to corroborate what’s in writing, fill in knowledge gaps, or uncover new areas of risk not previously identified. The interviews may be with third parties, customers, suppliers, or key employees. Many private equity firms also employ the use of experts, especially in highly specialized industries. 

Here’s a summary of common topics covered during operational due diligence:

  • Operations
    • Strength and adequacy of internal controls
    • Efficiency of operations
    • Capabilities of the management team
    • Potential issues related to integration 
    • Adequacy of the facilities, and condition and age of your equipment
    • Current lease terms and degree to which these align with present-day market conditions
    • Your company’s reputation in the marketplace
    • Performance or operational standards
    • Product or service methods of operations
    • Revenue projections and assumptions
    • Warranty claims
    • Capital expenditures
    • Revenue trends
    • Supply chain dependencies
    • Cost of goods trends
    • Seasonality trends
    • Variations in revenue or income
    • Industry trends
    • IT due diligence, including an analysis of current software and integration
  • Marketing Due Diligence
    • Analysis of any marketing and advertising methods 
    • Advertising and marketing concentration issues, such as salespeople or marketing concentration
    • Competition, leadership, and position in the market
  • Cultural Due Diligence
    • Issues with integration
    • Attitudes, norms, hierarchy, how decisions are made, and ethics
    • Corporate communication styles and preferences
  • Threats
    • Competition, whether direct and indirect, or from new products, or new competitors
    • Raw material and labor shortages
    • New or proposed regulation changes
    • Changes in economic conditions, such as an increase in interest rates
    • Lawsuits, typically from customers, employees, competitors, or suppliers
  • Environmental: Environmental laws consist of a patchwork of federal and state regulations that cover the land, water, and air and are enforced by numerous agencies. The two primary agencies are the U.S. Environmental Protection Agency (EPA) and the U.S. Occupational Safety and Health Administration (OSHA). There are two main concerns – ongoing environmental compliance and cleanup that may be required. In most cases, a preliminary assessment will first be conducted. A full site investigation will be conducted only if necessary. Problems can stem from ongoing compliance or from violations committed in the past, which can lead to successor liability.
    • The cost of cleanup is expensive. As a result, environmental due diligence can be thorough for any businesses that handle materials that may lead to environmental violations. Officers, directors, and stockholders can also be held personally liable. The U.S. Federal Superfund Law can pierce the corporate veil, and as a result, cleanup costs can be enormous. The extent of liability depends on the legal form of the transaction and the extent to which the seller provides reps and warranties to the buyer. Any environmental concerns will require significant indemnification, and reps and warranties may survive a long time or even indefinitely, in some cases.

Legal Due Diligence

Legal due diligence is normally conducted by the buyer’s legal team.

The form of the transaction – asset vs. stock sale – will greatly impact the level of legal due diligence conducted. In a stock sale, the buyer will assume your liabilities and must make sure your company is free from all illegal activity. The reverse may also be true – legal due diligence may determine the form of the transaction. If significant liabilities are discovered, the buyer may elect to structure the transaction as a stock sale instead of an asset sale.

One of the most common issues is pending, threatened, or potential litigation. The buyer will research litigation trends in your industry to determine points of potential risk. The buyer will also examine any existing claims to determine the extent to which they may be valid and their potential impact. Note that immaterial litigation can start with a small claim that can roil the industry. For example, the asbestos debacle began with one small claim. Industries with the highest average number of proceedings are health care, manufacturing, and energy. As a result, you can expect businesses in these industries to be subject to greater legal due diligence requirements. 

If you’re involved in litigation, you should consider expediting it by settling out of court or through an alternative dispute resolution. The buyer may also examine litigation involving other companies since litigation within your industry could pose a potential source of risk through changes to industry structure and practices. Anyone can file a lawsuit – employees, unions, shareholders, customers, suppliers, competitors, contractors, governmental agencies – so the buyer must often cover a lot of ground to discover potential risks.

The findings will also impact the strength of the reps and warranties proposed in the purchase agreement. The purchase agreement can also state that the risk of undisclosed liabilities will remain with you after the closing.

Here’s a summary of the major areas addressed by legal due diligence:

  • General legal compliance
  • Agreements with customers, suppliers, landlords, lenders, taxing authorities, employees, subcontractors, and others
  • Insurance coverage – including issues such as deductibles, adequacy of coverage, if premiums will rise when claims are made, and more. It should also address whether the policy is claims-incurred, such as coverage that continues after termination, or claims-made, like covering claims made during the term of the policy. If you have a claims-made policy, you should purchase a tail to ensure you’re protected after the closing.
  • Intellectual property ownership and protection – for example, checking actual ownership and infringement
  • Confirmation of the legal formation and existence of the corporation, including a review of the articles, amendments, bylaws, and minutes
  • Qualifications to do business in all jurisdictions the business operates in
  • Tax certificates
  • Liens on assets
  • Title to all assets
  • Potential successor liability, which can arise from unpaid taxes, environmental violations, or product liability claims
  • Copies of correspondence with all governmental agencies 
  • Debts and liabilities – the buyer will generally not be liable if the transaction is structured as an asset sale
  • Collective bargaining agreements and unions – the buyer will generally be required to recognize unions
The form of the transaction – asset vs. stock sale – will greatly impact the level of legal due diligence conducted. 

HR Due Diligence

Employees are one of a business’s most valuable assets. They’re also one of the biggest sources of liability. Issues with employees are a common source of litigation. Employment law is complex and consists of thousands of federal and state laws, administrative regulations, and judicial decisions. The statute of limitations isn’t always clear when it comes to employee liability – there are no clear rules on when liability may start and stop. The result is that buyers spend a significant amount of time and effort ensuring your business is in compliance with all employment laws.

Common issues related to compliance with employment laws include:

  • Equal Opportunity: This will cover potential discrimination issues such as race, disability, age, gender, religion, drug use, sexual harassment, and other topics. 
  • Health and Safety: OSHA
  • Wages and Hours: This includes minimum wage, family or medical leave, workers’ compensation, unemployment insurance, health insurance, overtime pay, ERISA (pensions), and more, including:
    • The buyer will also determine whether the plan is underfunded, whether to terminate or merge plans, and the impact of severance agreements.
    • Treatment of pensioners when a business is sold is a common area of litigation.
    • Merging of plans is best handled on a case-by-case basis.
  • Collective Bargaining (Unions): The buyer will check if you’re in compliance with collective bargaining regulations, which is a source of potential successor liability.
  • Workforce Reduction: Considerations include layoffs, avoidance of discrimination in layoffs, and the WARN Act, which applies to companies with 100 or more employees to provide 60 days of advance notice of a plant closing.
  • Illegal Aliens (Non-Citizen): Companies may not employ non-U.S. citizens. 

Here’s a summary of the major areas reviewed during HR due diligence:

  • Organization chart, including lines of reporting and authority
  • Recruiting practices
  • Retention, including average tenure and attrition rates
  • Performance awards
  • Benefits
  • Whether salaries are in line with the current market
  • HR policies
  • Workers’ compensation claims