M&A Due Diligence: What Buyers Should Investigate—and What Sellers Should Prepare

Then the document requests arrive.

Tax returns. Monthly financial statements. Customer contracts. Payroll records. Equipment lists. Leases. Employee agreements. Permits. More questions about documents the seller thought had already been explained.

For a seller who has spent years building a successful company, the process can feel intrusive. For a buyer committing savings, borrowing money, and possibly signing personal guarantees, the same requests can feel essential.

Both perspectives are understandable. M&A due diligence is how the parties test whether the business being transferred supports the deal they have negotiated—and identify what must happen before the buyer can operate it successfully.

A useful process connects the information to decisions: whether to proceed, what needs to be fixed, which terms need to change, and which risks each party will accept.

What Is Due Diligence When Buying a Business?

Due diligence is the investigation of a business before an acquisition. The buyer and its advisors review financial, tax, legal, commercial, and operational information to evaluate what the buyer is acquiring, whether the transaction assumptions hold up, and what liabilities or practical obstacles need attention.

For a privately held business acquisition, the core questions are straightforward:

• Do the reported earnings fairly reflect the business’s ongoing performance?
• Does the seller own what it proposes to sell?
• Can the buyer continue using the location, contracts, licenses, systems, and workforce that make the business valuable?
• What obligations, expenses, or disputes could affect the economics after closing?

The scope should fit the business. A local service company, a software business, and a regulated healthcare practice raise different questions. Deal size matters, but a relatively small acquisition can still depend on one difficult lease, one important license, or one customer relationship.

When Does M&A Due Diligence Begin?

Preliminary review often starts before an LOI, using limited financial information and discussions with the seller or broker. More detailed investigation commonly follows the LOI and a confidentiality agreement, when the parties establish access rules and begin exchanging sensitive records.

The LOI should address the anticipated diligence period, access to information, exclusivity, and the relationship between diligence and the proposed closing schedule. Our article on what to negotiate before signing a letter of intent explains how those early decisions shape the transaction.

The relevant deadlines may appear in different documents. An exclusivity period restricts the seller’s ability to pursue competing transactions under its terms. It does not, by itself, give the buyer an unlimited right to terminate a subsequently signed purchase agreement. Counsel should coordinate the LOI, definitive agreement, financing conditions, and actual diligence timeline.

Financial Due Diligence: Do the Numbers Support the Price?

The buyer needs to understand how the company earns money, how much of that performance is repeatable, and how much cash the business requires to operate.

The initial review commonly includes several years of tax returns and financial statements, current year-to-date results, monthly performance, bank records, accounts receivable and payable aging, debt, inventory, and supporting records for significant adjustments.

The comparison matters as much as the individual documents. If the tax returns, accounting reports, and bank activity tell different stories, the buyer needs a supported explanation. Differences may reflect timing or accounting methods. Unexplained differences deserve investigation.

Evaluate Add-Backs and Owner Compensation

Small businesses are often marketed using seller’s discretionary earnings or adjusted EBITDA. Those measures may add back owner compensation, personal expenses, unusual costs, or other items. Each adjustment should have a defensible basis.

Add-back example: Suppose the seller manages operations and takes $180,000 in annual compensation. If the buyer will need to hire a replacement manager for $120,000, adding back the entire $180,000 without accounting for that replacement cost can overstate the earnings available under the buyer’s operating model.

A one-time legal expense might be a reasonable adjustment. Labeling ordinary annual repairs “nonrecurring” requires closer scrutiny. The buyer should distinguish a seller’s historical earnings presentation from the cash flow the buyer can reasonably expect after closing, including debt service and necessary investment.

For context on how earnings and risk affect value, see our practical guide to small business valuation.

Look Beyond Revenue and Reported Profit

Revenue can grow while collections deteriorate. A profitable company may require substantial cash for inventory, payroll, or customer projects before receiving payment.

Review customer concentration, overdue receivables, disputed invoices, seasonal patterns, supplier payment practices, inventory obsolescence, and deferred equipment replacement. A seller who has delayed paying vendors or replacing worn equipment may be presenting a business with near-term cash needs the buyer has not priced into the offer.

A quality-of-earnings review can help evaluate earnings sustainability and adjustments. Its scope should be agreed with the financial advisor; it should not be assumed to provide the same assurance as an audit or to replace legal and tax diligence. Whether a full report or a more limited review is appropriate depends on the transaction and financing requirements.

Working Capital, Customer Deposits, and Unfinished Work

Agreeing on a purchase price does not answer how much operating capital the buyer will receive.

The parties should identify which receivables, inventory, payables, accrued expenses, customer deposits, and other balances will transfer, and how those items fit the purchase-price calculation. They should also test whether the proposed working-capital target reflects the company’s actual operating cycle and seasonality.

Customer deposit example: Suppose a contractor has collected $100,000 in customer deposits for projects the buyer must complete after closing. The buyer needs to understand the remaining labor and material costs, what cash or other assets accompany the obligations, and how the agreement accounts for them. Neither transferring the full deposit balance nor treating the entire balance as an additional price deduction is automatically the correct answer.

The parties must coordinate their treatment of deposits, deferred revenue, debt-like items, and working capital so the same obligation is not counted twice. Our guide to working capital adjustments in business sales explains the adjustment framework in more detail.

Legal Due Diligence: Ownership, Authority, and Liabilities

Legal due diligence begins with identifying the seller, the assets or ownership interests being transferred, and the approvals required to complete the transaction.

The review may include formation documents, operating or shareholder agreements, ownership records, prior equity transfers, options, buy-sell rights, and required member, shareholder, or board approvals. A company’s good-standing certificate does not, by itself, establish who owns every interest or whether a particular sale has been properly authorized.

Counsel should also investigate material disputes, threatened claims, judgments, loan documents, guarantees, security interests, and restrictions affecting the proposed transfer. Appropriate lien and public-record searches should be coordinated with the transaction structure and the seller’s history.

If a lender holds a lien on the assets, the closing process needs more than a general promise that the seller will pay its debts. The parties should arrange payoff documentation, payment mechanics, and the releases or termination filings needed to deliver the agreed title.

Does an Asset Purchase Eliminate Historical Liabilities?

An asset purchase allows the parties to specify the assets acquired and liabilities assumed. It does not guarantee that a buyer has no exposure to historical obligations. Applicable successor-liability rules, taxes, liens, employment matters, environmental issues, and other legal requirements can affect that analysis.

In an equity purchase, the buyer acquires interests in the entity, which generally continues to hold its assets and liabilities. That makes investigation of the entity’s history particularly important.

Our article on asset purchase agreements versus stock purchase agreements discusses how structure changes the transaction. Diligence remains necessary under either approach.

Contracts, Leases, and Third-Party Consents

Some of the most consequential diligence findings involve agreements the company relies on every day.

A customer contract may prohibit assignment. A commercial lease may require landlord approval. A software license may be tied to the seller’s entity. A franchise agreement may require approval of the buyer and completion of training.

Review material agreements for assignment restrictions, change-of-control clauses, termination rights, renewal dates, pricing commitments, minimum purchases, guarantees, and defaults. An equity purchase does not automatically avoid consent requirements; a change-of-control provision may apply even when the contracting entity remains the same.

For the lease, the buyer should evaluate the remaining term and available renewal rights alongside expected financing and operational needs. A business can be financially attractive and still be unsuitable for the buyer if it cannot remain at its essential location on workable terms.

Consent requests also require a communication plan. The parties should agree on who contacts landlords, customers, vendors, and employees, when those contacts occur, and what can be disclosed. Uncoordinated outreach can damage a relationship or reveal a proposed sale prematurely.

Tax Due Diligence and Transaction Requirements

Tax diligence should examine filed returns, payment history, audits, notices, payroll withholding, sales and use taxes, and other obligations relevant to the business and the jurisdictions where it operates. Copies of filed returns alone do not establish that all taxes were paid or that the correct treatment was used.

The tax advisor should evaluate both historical exposure and the proposed sale structure, including allocation of purchase price, asset tax basis, and any contemplated elections. Counsel and the tax advisor should coordinate required notices, releases, escrows, and closing conditions.

New York bulk-sale warning: New York provides a practical example. A qualifying bulk sale can trigger purchaser notification and related sales-tax procedures. Failure to follow the applicable process can expose the purchaser to the seller’s unpaid sales and use taxes. Those requirements should be evaluated early enough to meet the required timetable, rather than discovered immediately before funds are released. The New York Department of Taxation and Finance’s bulk-sales guidance explains the process.

Other states have their own requirements. The business’s operations and asset locations matter; the state where the entity was formed is only part of the analysis.

Employees, Contractors, and Owner Dependence

For many small businesses, the people are central to the purchase. The buyer needs to understand who performs the work, who manages customers, and which relationships depend on the departing owner.

Review compensation, commissions, accrued leave, benefits, employment agreements, contractor arrangements, classification practices, and material employment disputes. Identify key employees and determine whether retention incentives, new employment agreements, or transition arrangements are needed.

The treatment of employees and benefits depends on deal structure and applicable law. Buyers should not assume that all employment arrangements transfer unchanged, and sellers should not promise that every employee will retain the same role or benefits without confirming the buyer’s plan.

Owner dependence also affects the economics. If the seller personally handles estimating, sales, customer retention, and technical supervision, a brief introduction after closing may not provide a workable transition. The purchase documents should address the services, duration, availability, and compensation the parties actually expect.

Intellectual Property, Technology, and Data

A business may rely on its name, website, software, designs, customer data, or proprietary processes without having clear ownership or transfer rights.

The buyer should review relevant employee, contractor, and agency agreements; IP assignments; registrations; licenses; and restrictions affecting the technology used in the business. Paying a developer or designer does not necessarily establish ownership of the resulting work. Our article on IP ownership and assignments from contractors, employees, and agencies explains common gaps.

Practical control matters too. Determine who holds the domain registration, administrator access, cloud accounts, source-code repositories, and other essential credentials. Identify subscriptions or platform accounts that require a new agreement or approval to transfer.

Data review should address collection and sharing practices, security incidents, contractual commitments, and applicable privacy obligations. A buyer should assess whether customer information can lawfully be transferred and used as intended. The ability to download a database does not resolve those questions.

Licenses, Compliance, Facilities, and Insurance

Confirm which licenses, permits, professional qualifications, and approvals the business needs to operate. Determine whether they remain effective after the transaction, transfer to the buyer, require a new application, or depend on a particular individual.

The necessary investigation varies by industry. Healthcare, food service, alcohol sales, transportation, construction, and other regulated activities may require specialized review. Property use, equipment condition, safety, and environmental concerns can also warrant inspections or specialist advice.

Insurance diligence should consider existing policies, claims history, and the buyer’s coverage from closing onward. Some policies may require attention to reporting periods, retroactive dates, or tail coverage. A certificate of insurance is not a substitute for understanding the relevant policy terms.

What Should Sellers Prepare for Due Diligence?

Sellers benefit from organizing records before the buyer begins asking for them. A secure, indexed electronic data room can make the process easier to manage.

A practical starting checklist includes:

• Formation, ownership, governance, and approval records.
• Historical and current financial statements, tax returns, and support for proposed add-backs.
• Receivables, payables, inventory, deposits, debt, and fixed-asset schedules.
• Material customer, supplier, lease, financing, and other contracts, including amendments.
• Employee, contractor, compensation, benefits, and IP documentation.
• Licenses, insurance information, and records of material disputes, claims, and regulatory matters.

Use consistent file names and identify the period each report covers. If a request does not apply, say so. If a document cannot be found, identify the gap and discuss how to address it with counsel. Repeatedly uploading partial versions without explanation tends to generate more questions.

Sellers should investigate known problems early: unsigned agreements, inconsistent ownership records, undocumented loans, missing assignments, or unresolved tax notices. A buyer discovering an issue late may have less confidence in the explanation and less time to evaluate a solution.

How Should Confidential Information Be Shared?

A confidentiality agreement is an important starting point, but the parties also need practical access controls. Use secure sharing, limit access to appropriate recipients, and consider redaction or staged disclosure for personal information and commercially sensitive records. Obtain legal advice before sharing privileged communications; a confidentiality agreement alone may not preserve privilege.

When the buyer is a competitor, current pricing, customer-level information, and future strategy may require stronger safeguards, including a restricted “clean team” of approved reviewers. The parties should continue operating independently before closing.

Sellers financing part of the price or accepting an earnout should also investigate the buyer’s financial capacity, proposed security, and ability to perform post-closing obligations. Risk review can run in both directions.

How Long Does M&A Due Diligence Take?

There is no single timetable. For planning purposes, a privately held acquisition may contemplate a review period of roughly 30 to 90 days, but that is a negotiated assumption, not a rule or promised completion time. Complexity, record quality, financing, regulatory requirements, and third-party cooperation can materially change the schedule.

The diligence period and the total time from LOI to closing are also different. Reviewing records may expose issues that require a landlord’s consent, a corrected tax filing, a lender’s approval, or a missing assignment. Resolving those issues can outlast the initial review.

Due diligence often proceeds in rounds because one answer raises another question. A large balance labeled “customer advances” may require a project schedule, which then reveals unfinished work with low margins. Uploading the balance sheet completes the initial request; it does not complete the analysis.

The most useful way to maintain momentum is to identify critical items early, assign responsibility, and maintain a shared list of open questions and decisions. Buyers should prioritize information that could change the acquisition decision, while sellers continue running the business and keeping financial information current.

What Happens When Due Diligence Finds a Problem?

A finding should lead to a decision proportionate to its significance. Possible responses include correcting the issue before closing, obtaining consent or a release, changing the price, negotiating a specific indemnity, holding funds in escrow, accepting a manageable operating risk, or declining to proceed when the applicable agreements permit it.

Consider a hypothetical $2 million acquisition of a service business. Review shows that its largest customer represents 35% of revenue and can terminate on short notice, while a contractor never signed an assignment covering software used to deliver the service.

Those findings raise different problems. The software issue may be addressed through an appropriate assignment before closing. Customer concentration cannot be eliminated by adding a representation that the seller has supplied all contracts. The buyer must evaluate the durability of that relationship and whether the price and structure still make sense.

An indemnity may help allocate financial responsibility for a covered loss. Its value depends on the wording, limits, available security, and the responsible party’s ability to pay. It cannot ensure that a customer stays or that a missing operational capability exists.

Diligence findings must also be coordinated with the purchase agreement and disclosure schedules—the seller’s disclosures qualifying particular representations. Uploading a document to the data room should not be assumed to satisfy a contractual disclosure obligation. The agreement determines what disclosures count and how a buyer’s knowledge affects available remedies.

Who Handles Due Diligence in a Business Acquisition?

The buyer owns the investment decision. Its attorney evaluates legal risks and transaction documents; its CPA or financial advisor investigates financial and tax issues within the agreed scope; and industry, technology, environmental, insurance, or other specialists address areas requiring their expertise.

The lender conducts its own underwriting. That review serves the lender’s requirements and does not replace the buyer’s investigation. Buyers using acquisition financing should coordinate both workstreams; our discussion of legal issues in SBA-financed business acquisitions addresses related closing concerns.

Each side should identify a person who coordinates requests and decisions. Clear responsibility helps prevent a material issue from being overlooked because everyone assumed someone else was handling it.

Preparing for the Business You Will Own After Closing

A sound diligence process gives the buyer a more reliable understanding of the business and gives the seller a clearer path to delivering what was promised.

Some findings belong in the purchase agreement. Others belong in a closing checklist or a plan for the first months of ownership. The important step is connecting each material finding to someone responsible for addressing it.

If you are preparing to buy or sell a privately held business, Auxo Law PLLC provides due diligence support, purchase-agreement negotiation, and related transaction counsel for clients throughout New York and Colorado. Contact Auxo Law to discuss the proposed transaction and the issues to address before closing.

This article provides general information and does not constitute legal or tax advice. Requirements and outcomes depend on the transaction, industry, governing documents, and applicable law. Contacting Auxo Law does not establish an attorney-client relationship.