Due diligence, step by step

10 min read · Updated

Due diligence is the window between the signed letter of intent and closing, usually under exclusivity, when you check everything the seller has told you. It is where most deals end, and where they should end if the numbers don't hold. Do the checks in this order: each one is cheaper than the next, and the early ones end the most deals.

The numbers

  1. Get the documents

    When
    As soon as the letter of intent is signed
    Who decides
    The seller or their broker

    Ask for the full set at once: several years of P&Ls and business tax returns, balance sheets, bank statements, the lease, and the main contracts. Which documents to request from a seller explains why each one matters, and why a P&L on its own can't be verified.

  2. Rebuild the earnings from the tax return

    When
    First, before anything else
    Who decides
    You and your accountant

    Start from the tax return, not the P&L. Reconcile the P&L to it, then both to the bank deposits. Where they disagree, the tax return is the figure the seller signed. How to verify a seller's reported earnings walks the checks in the order that finds the most.

    The seller can get the business's tax transcripts from their IRS business tax account, by mail with Form 4506-T, or by calling the IRS business and specialty tax line.

    From IRS — Get a business tax transcript, read

  3. Test every add-back

    When
    Once the earnings are rebuilt
    Who decides
    You and your accountant

    Add-backs are the costs a seller says a new owner wouldn't have. Owner pay and documented one-off costs usually are; recurring "one-time" costs and cut marketing usually aren't. Add-backs: which ones are legitimate gives the test for each.

  1. Search for liens

    When
    Before you agree the final price
    Who decides
    The state's filing office

    A lien gives a lender a claim on the business's assets — and if it isn't released at closing, it can come with them.

    In California, the Secretary of State is the central filing office for financing statements and other lien documents under the Uniform Commercial Code, and handles UCC inquiries and debtor searches online through UCC Connect.

    From California Secretary of State — Uniform Commercial Code, read

    Every state keeps its own filings. Search the state where the business is organised and the states where it holds assets, under every name it has used.

  2. Search for lawsuits

    When
    Before you agree the final price
    Who decides
    The courts

    PACER gives public access to federal court records. It charges $0.10 a page, capped at $3 per document, and waives fees for anyone who spends $30 or less in a quarter.

    From PACER (U.S. Courts) — PACER pricing: how fees work, read

    PACER covers federal courts only. Most disputes a small business has — with customers, landlords, employees — are in state courts, which keep their own records. Search those too, in each county where the business operates.

  3. Check the licenses and permits

    When
    Before the purchase agreement
    Who decides
    The licensing agencies

    You'll need any licenses and permits the business requires — from the current owner, or by applying for them yourself.

    From SBA — Plan your business: buy an existing business or franchise, read

    List every license the business operates under, who issued it, and whether it can move to a new owner. A license you can't get in time can delay closing; one you can't get at all can end the deal.

  4. Read the lease

    When
    Before the purchase agreement
    Who decides
    The landlord

    For most physical businesses the lease is the most valuable contract. Check how long is left, whether it can be assigned to you, whether the landlord has to consent, and whether the rent changes on assignment. A business with a great location and a lease that ends next year is a different business.

Online businesses

  1. Online business only

    Verify the traffic and revenue at the source

    When
    Early in diligence
    Who decides
    The seller

    Log in to the analytics, the payment processor and the store or ad accounts yourself, rather than reading exported reports. Match the processor's deposits to the P&L month by month, and check where the traffic comes from — a business whose visitors arrive from one search ranking or one ad account can lose them overnight.

  2. Online business only

    Check the domain can move cleanly

    When
    Before closing
    Who decides
    The domain registrar

    After a change of registrant, the registrar must lock the domain against transfer to another registrar for 60 days — unless the registrant opted out before the change was requested.

    From ICANN — Transfer Policy, read

    Confirm the seller is the domain's registrant, not an agency or a former partner, before you agree a closing date.

The people

  1. Find out who the business depends on

    When
    Late in diligence, with the seller's agreement
    Who decides
    You

    Ask which customers make up the largest share of revenue, which suppliers would be hard to replace, and which employees know things nobody else does. Then ask how each of those relationships would survive the seller leaving. The answer is part of the price.

Next guide: Closing, and your first months as owner

This guide is general information, not legal, tax or financial advice. Each rule above links to the official page it came from and the date we read it.