Due Diligence in Business Acquisitions: What to Investigate and When
Due diligence is the formal period of investigation that follows a signed Letter of Intent (LOI). The buyer examines every material aspect of the business — financials, legal matters, operations, customers, employees — to verify that what the seller represented is actually true, and to surface any risks that weren't disclosed.
The goal is not to find reasons to walk away. It's to close with accurate information and appropriate protections. Most deal-killers discovered in diligence are either negotiated into price/terms adjustments or addressed with reps and warranties rather than killing the transaction.
Typical Due Diligence Timeline
For small business acquisitions under $5M, due diligence typically runs 30 to 60 days from LOI signing. SBA-financed deals run closer to 60–90 days due to lender requirements. The period is defined in the LOI and gives the buyer a right to terminate without penalty if they find material issues.
Financial Due Diligence
This is where most deals are verified or unraveled:
- Three years of federal income tax returns (business and sometimes personal)
- Three years of profit-and-loss statements reconciled against tax returns
- Bank statements for the past 12–24 months
- Accounts receivable aging report
- Accounts payable aging report
- Verification of all add-backs with documentation
- Payroll records and employee compensation
- Outstanding liabilities: loans, leases, obligations
- Sales by customer to identify customer concentration
The test is whether reported earnings are consistent with bank deposits. If a business claims $400K in revenue but deposits don't support it, that's a red flag regardless of what the P&L says.
Legal Due Diligence
- Entity structure and formation documents (articles, operating agreement)
- Any pending or threatened litigation
- Contracts: leases, customer contracts, supplier agreements, employment agreements
- UCC lien search — any encumbrances on assets being purchased
- Intellectual property: trademarks, domain ownership, software licenses
- Permits, licenses, and regulatory compliance
- Insurance policies and claims history
Operational Due Diligence
- Facility visit — condition of equipment, organization of operations
- Employee interviews (carefully staged, as sellers may not want employees to know during diligence)
- Supplier relationships and terms
- Technology systems and dependencies
- Assessment of key man risk — what happens if the owner leaves day one
- Process documentation: is the operation scalable without the seller?
Common Red Flags
- Tax returns and P&Ls that don't reconcile to bank statements
- Revenue concentrated in 1–2 customers who aren't under contract
- Undisclosed lawsuits, environmental issues, or regulatory violations
- Equipment in poor condition that will require capital investment immediately
- Verbal or undocumented customer relationships that depend entirely on the owner
- Large unexplained deposits or withdrawals in bank statements
- Seller who becomes defensive or slow-walks document delivery
How Due Diligence Affects the Deal
Findings in due diligence typically result in one of four outcomes: price reduction, escrow holdback, additional representations and warranties coverage, or deal termination. Buyers should enter diligence with a clear understanding of what issues are deal-killers versus what issues are negotiation leverage.
Related Terms
- Add-backs — key financial verification item during diligence
- Reps and warranties — seller's factual disclosures that arise from diligence findings
- Customer concentration — key operational risk assessed during diligence
- Key man risk — assessed during operational diligence
- UCC filing — lien search done during legal diligence