Kingswell Strategic Ventures is the holding and venture company behind several independent brands, including Paxton-Digital. Holding companies, entrepreneurs and individual buyers who consider acquiring a small business share a common challenge: confirming that what they are buying is what it appears to be. That process is called due diligence. This article explains the basics in plain language. It is general educational information, not legal, tax or financial advice. Anyone considering an acquisition should work with qualified attorneys, accountants and other advisors.
What Due Diligence Is
Due diligence is the investigation a buyer conducts before completing a purchase. Its purpose is to verify the seller’s claims, uncover risks, understand what is being acquired and inform the price and terms of the deal. In a small acquisition, it might take a few weeks; in a complex one, it can take months.
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Due diligence usually begins after the buyer and seller agree on basic terms, often recorded in a letter of intent. That document typically includes a confidentiality agreement and sometimes an exclusivity period during which the seller agrees not to negotiate with other buyers.
Asset Purchase or Stock Purchase?
Small acquisitions are often structured in one of two ways. In an asset purchase, the buyer acquires specific assets, such as equipment, inventory, customer lists, intellectual property and contracts, and usually leaves many liabilities with the seller. In a stock or equity purchase, the buyer acquires ownership of the company itself, including its liabilities. The structure affects taxes, liability and what due diligence needs to cover, and it is an area where professional advice is essential.
1. Financial Review
Financial due diligence examines whether the business earns what the seller says it earns and whether those earnings are likely to continue. Common steps include:
- Reviewing several years of financial statements and tax returns.
- Comparing reported revenue with bank statements and payment processor records.
- Examining profit margins, expenses and how they have changed over time.
- Understanding any adjustments the seller proposes, such as removing the owner’s personal expenses from the accounts.
- Reviewing accounts receivable, accounts payable, debt and inventory.
- Assessing seasonality and the impact of one-time events.
A quality of earnings review, often performed by an independent accountant, can help assess whether reported profits are sustainable.
2. Customers and Revenue Concentration
Buyers want to know who the customers are and how dependent the business is on a few of them. If one customer accounts for a large share of revenue, losing that customer after the acquisition could be a serious problem. Questions include how long customers have stayed, whether they have contracts, how they were acquired and whether relationships depend on the current owner personally.
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3. Contracts and Commitments
A business is bound by its agreements. Buyers typically review:
- Customer and supplier contracts, including terms, renewals and termination rights.
- Leases for office, retail or warehouse space.
- Loans, guarantees and liens on assets.
- Licenses and software subscriptions essential to operations.
- Agreements with contractors, agencies and partners.
Some contracts include change-of-control clauses that allow the other party to terminate or renegotiate if the business is sold. Identifying these early prevents surprises.
4. Legal and Regulatory Matters
Legal due diligence, conducted with an attorney, looks for risks such as pending or threatened lawsuits, regulatory violations, required permits and licenses, and compliance with employment, privacy and consumer protection laws. For businesses in regulated industries, such as health care, finance or government contracting, specific rules may apply to ownership changes.
5. Intellectual Property and Digital Assets
For brands and online businesses, intangible assets can be the most valuable part of the deal. Buyers should confirm:
- Ownership of trademarks, copyrights, domain names and any patents.
- That logos, content and software were created by employees or contractors who assigned the rights to the business.
- Control of websites, hosting accounts, social media accounts, email lists and analytics.
- Compliance with privacy laws for any customer data being transferred.
An asset that the seller does not clearly own, such as a domain registered in an employee’s personal name, can create complications.
6. Operations
Operational due diligence asks how the business actually runs. Who does what? Which processes are documented, and which exist only in the owner’s head? What systems and suppliers does it depend on? Are there quality, safety or capacity problems? Visiting the business, observing operations and speaking with key staff, with the seller’s permission, can reveal much more than documents alone.
7. People
Small businesses often depend heavily on a few people, especially the owner. Buyers should understand the roles of key employees, their compensation and their likelihood of staying. Transition plans matter: will the seller stay on for a period to help with the handover? Are there non-compete or non-solicitation agreements, where legally permitted? Cultural fit between the buyer and the business can be as important as the numbers.
8. Taxes
Unpaid taxes can follow a business, particularly in stock purchases. Buyers typically review tax filings and payments for income, payroll and sales taxes. Tax structure also affects the deal’s economics, which is another reason to involve an accountant early.
Red Flags
Some warning signs warrant closer attention:
- Financial records that are incomplete or inconsistent with bank records.
- Reluctance to share information or allow verification.
- Heavy dependence on one customer, supplier or platform.
- Recent sharp changes in revenue without a clear explanation.
- Unresolved legal disputes or regulatory issues.
- Key assets held in someone’s personal name.
Red flags do not always end a deal, but they may change the price, structure or protections the buyer requires.
Using What You Learn
Due diligence findings feed into the final purchase agreement. Buyers and their advisors may negotiate price adjustments, representations and warranties from the seller, indemnification provisions, escrow or holdback of part of the purchase price, or conditions that must be met before closing. Sometimes the right decision is to walk away.
The Takeaway
Due diligence is about replacing assumptions with verified facts. A structured review of finances, customers, contracts, legal issues, intellectual property, operations, people and taxes, guided by qualified professionals, helps buyers understand what they are acquiring and make sound decisions.
Quick check: Why do buyers check for change-of-control clauses in contracts?
- They set the purchase price
- They may let the other party end or renegotiate a contract after a sale
- They determine the tax rate
Show answer
B. Change-of-control clauses can allow customers, suppliers or landlords to terminate or renegotiate when ownership changes.