The role of due diligence in the sale or purchase of a business

In the context of the sale and purchase of a business, due diligence simply means obtaining the information necessary in order to properly evaluate the Vendor’s business. In some situations, simple enquiries may suffice while other transactions might call for a thorough investigation.

Due diligence is a critical element in any risk minimisation strategy for both the vendors and purchasers, although each party will have different objectives. It typically includes a legal, financial and physical (eg building and environmental) investigation.  It may require the assistance of accountants, lawyers and other experts to produce the necessary information. 

Among other things, due diligence will impact the following two critical aspects of any business sale.    

1. The decision to sell or buy

Both the vendor’s decision to sell and the purchaser’s decision to buy is ultimately the choice of any vendor or purchaser based on a range of factors, however, due diligence will assist both parties to make informed decisions about whether to transact at all.    

For a vendor, this may include seeking advice from your accountant and lawyer about the tax implications of any capital gain and your obligations to any current employees. Seeking advice on such issues at the outset might impact the sale price you are willing to settle on. 

For a purchaser, obtaining the necessary financial information and business advice to be comfortable with the financial viability of the business will be critical, particularly if you are seeking to acquire bank finance using your personal assets as security.  

If the vendor has not kept adequate financial records, there is a risk that the purchaser will not have sufficient comfort in the performance of the business and may withdraw from any negotiations altogether. 

2. The terms of the contract(s)

Due diligence will impact (and efficiently identify) the terms that need to be negotiated and set out in any contract(s).  

One of the many advantages of undertaking a thorough due diligence process is that it provides both the vendor and purchaser with the ability to deal with potential issues at the outset. This means that a number of potential risks can be mitigated, if not, eliminated entirely.

Due diligence enquiries will help to determine the following common issues:

  • Who are the required parties to the transaction.  It is common for family businesses to own some of the business assets in a mix of companies, trusts and the names of individuals.  Due diligence will identify the relevant owners of the business assets and the contractual documentation should accurately reflect this. 
  • If the business assets are held in a company, the purchaser may wish to buy all the company shares, rather than the assets themselves.  Due diligence may identify tax or stamp duty benefits in doing so.
  • The structure the purchaser may want to buy the business in.  Some business assets may be required to be held in the purchaser’s personal name(s) due to legislative or lender’s arrangements, while others may require more protective ways of holding the asset.    
  • Any preconditions the sale of the business may be subject to.  For example, what licences, permits and statutory consents are required to operate the business.  There may also be other requirements that a purchaser must satisfy under competition and consumer laws, stock exchange rules, foreign acquisitions and take over laws, depending on the nature of the business and the parties involved.
  • Identifying matters which should be “tidied up” prior to or at settlement, such as securities held on the business assets that the vendor may need to discharge (eg mortgages on business land or securities on personal property registered on the PPSR).  It may also be the case that the vendor has not fully documented its leases, licences, supply or employment contracts and other agreements, which should all be put into writing prior to settlement.   

Practicalities and costs

It is common for a due diligence period to be included in a business sale contract(s). These often allow a purchaser to terminate any purchase if their enquiry is unsatisfactory.  Alternatively, a vendor and purchaser may enter into separate due diligence agreements before entering any business sale contract(s).  Often the Vendor will require a timeframe for completion of the enquiry and confidentiality provisions. 

Due diligence may be an additional cost, as it does involve engaging financial, legal and technical expertise.  Understandably, the less the purchase price or value of the business, the less the level of due diligence enquiry and costs a Vendor or Purchaser will want to spend. 

However, identifying and dealing with critical issues at the outset before a binding contract is entered into is often far cheaper with better prospects of an outcome, compared to commencing court proceedings or other forms of dispute resolution to enforce rights.  Vendors and purchasers should at least identify their due diligence plan (even if it is limited to some basics) and a budget for executing it. An experienced lawyer and accountant can advise you on the specifics you should take into account based on your individual circumstances.

This article was written by Solicitor, Jonathan Elford.

Practice Area: Corporate, Commercial & Business

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