Due diligence for a first acquisition: the short list that catches most problems

Due diligence is the period between agreeing a price in principle and signing. The seller opens the books. You find out whether the business you were described is the business that exists.

First-time buyers make one of two mistakes. They check almost nothing because they like the seller, or they ask for everything and drown. The answer is to work in order of what kills deals.

1. Is the profit real?

Start here, because everything else depends on it.

• Three years of filed accounts, and management accounts for the months since.
• Bank statements for the same period. Revenue in the accounts should match money arriving in the bank.
• Tax returns and proof they were paid. In the UK that includes VAT and PAYE.
• The schedule of add-backs, with an invoice or payslip behind each one.

If cash in the bank does not support the profit claimed, stop and ask why. There are sometimes good answers. You need to hear one.

2. Will the revenue stay?

Profit last year only matters if it continues under you.

• Revenue by customer for three years. Look for one customer growing into a dependency, or a large one that has gone quiet.
• Contracts with the biggest customers: length, notice period, and any clause that lets them leave if the business changes hands.
• Where new work comes from. If the answer is the owner's phone, plan the handover carefully.
• Anything seasonal or one-off that flattered the last year.

3. What are you taking on?

In a share purchase you buy the company and its history, including debts you have not been told about. In an asset purchase you buy the trade and chosen assets, and leave most of the history behind. Which one you are doing changes how deep this section goes. Your solicitor will advise on the structure.

Either way, ask for:

• All loans, finance agreements, leases and guarantees.
• Money owed to suppliers and how old it is.
• Any dispute, claim or complaint, current or threatened.
• Tax: enquiries open, payment plans in place, anything overdue.

4. Who are the people?

A small business is its staff.

• A list of employees with role, pay, start date and notice period.
• Who holds the knowledge. If one person leaving would stop the business, speak to them before completion, with the seller's agreement.
• Contracts, and whether key people are bound by sensible restrictions.
• Subcontractors: are they genuinely self-employed, or employees in all but name?

5. Does the business own what it uses?

• Premises: the lease, how long is left, the rent review dates and whether the landlord must consent to a change of ownership.
• Equipment and vehicles: owned or financed, and in what condition.
• The name, website, phone numbers, software accounts and customer list. It is surprisingly common for these to be registered to the owner personally.
• Licences, accreditations and insurance, and whether they transfer.

6. See it working

Paper tells you what happened. A visit tells you how.

Spend a day in the business if the seller allows it. Watch how an enquiry becomes a job and a job becomes an invoice. Ask the same question of two different people. You will learn more than from a week of documents.

What to do with what you find

Every business has problems. Finding them is the point. Each one leads to one of four outcomes:

Walking away is the outcome first-time buyers resist, because by then they have spent money and imagined themselves as the owner. The fees you have paid are the price of finding out. They are far smaller than the price of buying the wrong business.

Use professionals, and use them well

An accountant should test the numbers and a solicitor should handle the contract. Neither will judge the business for you. Go to them with your own list of concerns, in order, and they will spend your money where it counts.

It also helps to have people who have done this before read the deal with you. That is a large part of what a community of investors is for.