Due Diligence Checklist: Everything You Need to Know
A due diligence checklist is an organized way to analyze a company that you are acquiring through sale, merger, or another method. 12 min read
What Is a Due Diligence Checklist?
A due diligence checklist is an organized way to analyze a company that you are acquiring through sale, merger, or another method. By following this checklist, you can learn about a company's assets, liabilities, contracts, benefits, and potential problems. Due diligence checklists are usually arranged in a basic format. However, they can be changed to fit different industries.
A due diligence checklist is also used for:
- Preparing an audited financial statement or annual report
- A public or private financing transaction
- Major bank financing
- A joint venture
- An initial public offering (IPO)
- General risk management
Why Is a Due Diligence Checklist Important?
The main reason you need a due diligence checklist is to make sure you don't overlook anything when acquiring a business. Having a due diligence checklist allows you to see what obligations, liabilities, problematic contracts, intellectual property issues, and litigation risks you're assuming. Most of the documents and information on your due diligence checklist is available on request. Once you have the information, it's up to you to analyze it and decide whether it's a good investment.
Another reason a due diligence checklist is important is that the buyer needs to know if the company is a good fit for its business. If the selling company provides a service the buyer doesn't, it becomes beneficial. It also provides a way to measure the length and cost of integration, as well as potential revenue.
Company sales, mergers, and acquisitions should all follow the same checklist to avoid unforeseen issues. Sellers might also create a reverse diligence checklist to analyze the buyer.
What Should I Have in My Due Diligence Checklist?
Most due diligence checklists involve 19 categories about a company:
- Antitrust and Regulatory Issues
- Any potential antitrust issues as a result of the purchase.
- A list of any prior regulatory or antitrust issues.
- Issues involved in a Hart-Scott-Rodino filing with the Federal Trade Commission.
- Any Exon-Florio issues for national security and foreign investment.
- A list of Department of Commerce filings.
- Information Technology Concerns
- A list of software used by the company.
- A list of software licenses bought to analyze other companies.
- The current system usage and age of equipment.
- Outsourcing agreements with IT companies.
- The software's level of customization.
- A list of interfaces that link systems together.
- An analysis of the system. Legacy systems often need maintenance. From this analysis, you can choose to keep the current system or replace it.
- An outline of a disaster recovery plan should systems crash or become damaged.
- Articles and press releases about the company within the last three years.
- Outsourced Professionals
- A list of all independent professionals that have worked with the company within the past five years. This includes accountants, lawyers, and consultants.
- Insurance Coverage
- A copy of insurance claims over the past three years.
- A schedule and copy of the company's insurance coverage, such as:
- Worker's compensation
- General liability
- Personal and property
- Directors and officers
- Errors and omissions
- Product Liability
- Intellectual Property
- A list of all pending litigation.
- Descriptions of threatened litigation.
- A list of unsatisfied judgments.
- Documents about injunctions or settlements.
- Copies of insurance policies that protect against litigation.
- History of problems with regulatory bodies such as the SEC or IRS.
- A review of all board minutes, shareholder minutes, and audit minutes.
- Product and Services
- Lists of products and services offered.
- Lists of products and services in development.
- Correspondence and documents related to regulatory approval of product line.
- Summary of complaints.
- Summary of warranty claims.
- Tests, evaluations, studies, and surveys about products or services under development.
- A list of major customers and product applications.
- Current market share values.
- Profitability and cost structure, including:
- Expense trends over the past five years.
- Questionable expenses that you can cut.
- Employee loans. This might include pay advances or long-term loans.
- Fixed assets.
- If a company owns many fixed assets, it could show a reactive approach to market trends.
- Valuation, inspection, maintenance, utilization, and replacement rate are all topics to know about fixed assets.
- Speed and nature of change within the industry.
- Customer Information
- List and description of competitors, including strengths, weaknesses, market position, and basis of competition.
- Current ad programs, marketing budgets, and printed marketing materials.
- Research on ways to get new business.
- A list of distribution channels, marketing opportunities, and marketing risks.
- Surveys and market research on company products.
- A comparative analysis.
- This shows how the company's marketing efforts stack up against competitors.
- It should also show the company's dedication to creating a brand.
- A list of coordination protocols between the sales and marketing departments.
- A schedule of the company's 12 to 20 largest customers, as well as sales within the last two years for each.
- Issues about keeping customers after the sale.
- A description of the company's credit policies.
- A description of the company's purchasing policies.
- Supply and service agreements.
- A schedule of unfilled orders.
- A list and explanation of any major customers lost within the past two years.
- A list of strategic relationships or partnerships.
- Revenue listed by customer
- A list of the top 10 suppliers, as well as business deals within the past two years.
- A sales force productivity model that outlines:
- Plans for new hires
- Quota average
- Sales cycle
- Compensation and commission
- Skills match
- Tax Information
- Federal, state, local, and foreign tax returns for the past three years, including net loss or profit.
- A list of any tax liens.
- IRS Form 5500 for 401(k) plans.
- State sales tax returns for the last three years.
- Excise tax filings for three years.
- Audit reports.
- Employment tax filings for past three years.
- This shows if the company pays a lump sum or quarterly taxes.
- You can also see if the company is paying the correct amount in taxes.
- Tax settlement documents over the past three years.
- Detailed explanations of general accounting principles.
- A schedule of financing for debt and equity.
- A list of undisclosed tax liabilities.
- Materials Contracts
- Monthly manufacturing yields.
- Agreements and relationships with any subsidiaries, partnerships, or joint ventures.
- Copies of contracts between the company and directors, officers, affiliates, and minimum 5 percent shareholders.
- Loan agreements including promissory notes, financing details, and lines of credit.
- All nondisclosure and noncompete agreements.
- A list of mortgages, collateral pledges, indentures, and security agreements.
- Installment sales agreements.
- Guarantees involving the company on any level.
- Copies of quote, invoice, purchase, and warranty forms.
- Distribution, sales, marketing, and supply agreements.
- Contracts, transcripts, or letters of divestitures from any merger or acquisition within the past five years.
- Options and stock purchase agreements affecting company operations.
- Off-balance sheet liabilities.
- Explanation of supply chain and supply restrictions.
- Transportation costs.
- A list of inventory systems to track incoming and outgoing goods and find obsolete goods.
- Power of attorney agreements.
- Exclusivity agreements.
- Franchise agreements.
- Indemnification agreements.
- Licenses and Permits
- Copies of federal, state, and local licenses, permits, and consent forms.
- Any documents about proceedings with a regulatory agency.
- Environmental Issues
- A list describing or identifying any environmental liabilities or contingencies.
- A list of hazardous materials used in production.
- A list of any superfund exposure.
- Copies of notices and filings with the Environmental Protection Agency (EPA).
- A list of all environmental investigations and pending litigation.
- Environmental audits for each company property.
- A description of company disposal methods for hazardous materials, recyclables, etc.
- A list of terminated licenses or permits.
- Costs for environmental compliance.
- Real Estate
- Listings of all owned or leased property and locations.
- Copies of deeds, mortgages, real estate leases, title policies, and zoning approvals.
- Physical Assets
- A list of Uniform Commercial Code (UCC) filings.
- A list of leased equipment.
- A list of major equipment sales and purchases over the past three years.
- A schedule of fixed assets with locations.
- Intellectual Property (Trade Secrets, Copyrights, Patents, Trademarks)
- A list of foreign and domestic patent applications.
- A list of copyrights.
- A list of trademarks and trade names both domestic and abroad.
- A description of methods used to protect trade secrets.
- Descriptions of all technical information within the company.
- Patent clearance documents.
- Work-for-hire agreements.
- Summary of claims or threatened claims on intellectual property.
- Copies of all consulting agreements, invention agreements, and licenses of intellectual property to and from the company.
- A list of all licensing revenue and expenses.
- Employees and Benefits
- Copies of stock purchase and stock option benefits for employees.
- Worker's compensation claims history.
- Unemployment claims history.
- List of employees and their positions, current salaries, years of service, and total compensation over the past three years.
- An explanation of the company's salary philosophy.
- Pay history and pay freeze information, which helps you decide if current employees will expect a raise soon.
- All nondisclosure, noncompete, and nonsolicitation agreements between employees and company.
- Resumes, history, and experience of key employees such as senior level management.
- A list of union affiliations and contracts.
- List and description of all employee health and welfare insurance policies.
- Descriptions of any labor disputes, arbitration, or grievances settled or outstanding over the past three years.
- Copies of collective bargaining agreements.
- Evidence of compliance with IRS Section 409A in regards to stock options.
- Evidence of compliance with IRS Section 280G in connection with the purchase.
- A list of any officers in criminal or civil litigation.
- Actuarial reports for the past three years.
- Layoff and severance package information.
- A list of harassment, wrongful termination, and discrimination disputes within the past three years.
- A copy of the employee handbook including policies on vacation, sick days, benefits, holidays, and paid leave. This allows you to compare your current situation with others in the industry.
- Turnover data for the past two years.
- Documents on pension plan funding and distributions.
- Copies of all Occupational Safety and Health Administration (OSHA) examinations.
- The results of formal and informal employee surveys.
- Organization and Good Standing of Company
- The Articles of Incorporation and any amendments.
- A list of company bylaws and amendments.
- A list of company assumed names.
- A list of all states or countries where the company does business, has employees, or owns/leases an asset.
- Annual reports for the last three years.
- A copy of the company's minute book.
- An organizational chart.
- A list of all shareholders and percentages owned.
- A Certificate of Good Standing from each Secretary of State where the company does business.
- Active status reports in the state of incorporation over the past three years.
- Agreements on voting trusts, subscriptions, puts, calls, options, and convertible securities.
- Financial Information
- Audited financial statements (cash flow, balance sheet, income statement, footnotes) for the last three years, including an auditor's report and quarterly and annual statements.
- Auditor's correspondence for the past five years. These are letters sent to management that outline areas to improve profits and efficiency.
- Unaudited financial statements for comparison.
- Company credit report.
- A schedule of accounts receivable
- A schedule of accounts payable. Check these for any overdue or unpaid accounts that might impact profit.
- An aging schedule of accounts payable and accounts receivable.
- A list of outstanding debt.
- Search for any clauses that increase debt if a company is sold.
- Scan for any related parties that have loaned money to the company. This includes manager, investors, and shareholders.
- A list of unrecorded liabilities, which you usually find when interviewing the seller or employees.
- A list of collateral for debt.
- A schedule of depreciation and amortization methods over the past five years.
- Analysis of gross margins.
- Analysis of fixed and variable expenses.
- A list of the company's internal control procedures.
- A list of assets and liabilities.
- A schedule of inventory.
- Projections, capital budgets, and strategic plans.
- Projections should include revenue by product type, customer, and channel.
- Projections should also include all financial statements such as a balance sheet, cash flow statement, and cash-on-hand.
- A list of growth drivers and possible clients and customers.
- Industry and company pricing plans.
- Analysis of projected expenditures and depreciation.
- Any perceived risk in foreign markets such as inflation, political strife, and exchange rates.
- The general ledger.
- Analyst reports.
- Breakdown of sales and gross profits by geography, channel, and product type
- Planned projection vs. actual sales chart.
- Capital structure.
- Current shares outstanding.
- A list of all stockholders with options, warrants, and notes.
- A list of non-operational expenses. Many companies put operating expenses in this category to pad their earnings.
- Public filings. If the company is publicly traded, it must file a Form 10-K annual report, Form 10-Q quarterly report, and other issues on the Form 8-K. You can get these from the Securities and Exchange Commission (SEC) website.
- Revenue Streams
- Recurring revenue stream. This is a key value driver from the company. It shows loyal customers and how much they bring to the business.
- Backlog. Creating a monthly backlog of the past year shows true revenue. It also shows decreasing or increasing revenue trends.
- Pricing philosophy. This lets you know how the company prices its goods or services.
- Estimating philosophy. If the company has a special order, it should have an estimate department. Analyzing this provides you with a detailed list of profit or loss.
With this comprehensive list, you leave nothing to chance. It covers all the company's major operations, leaving you with detailed, unbiased information.
After Compiling Your Due Diligence Checklist
Once you have all the information, you must analyze it thoroughly to see the potential for:
- Profit Margins
- Operational efficiency upgrades
- Market competition and market review
- Monitoring trends in the market
- Examining the impact of new technology
After reviewing your due diligence checklist, you have the option to buy all the shares or assets.
Advantages of buying shares:
- No need to transfer titles or property.
- Taking advantage of existing government licenses.
- Taking over all contracts without need for assignments.
- Receive all employees without entering into new contracts.
Things to consider when buying shares:
- Their price.
- Examining the Articles of Incorporation about the sale of shares.
- Share transfer forms and share certificates.
- Any changes in the board of directors.
- Changing the auditors or secretaries.
- Bank accounts.
- Procuring transfer forms with secretary's signature.
Advantages of buying assets:
- No need to take over debts and liabilities.
- No need to take over contracts or obligations.
- No need to continue employing any worker you don't want.
Things to consider when buying assets:
- Identifying assets.
- Pricing assets.
- Procuring all licenses and permits from various parties.
- Considering restrictive covenants.
- Choosing which employees to keep.
- Making arrangements with debtors and creditors.
- Drafting sale and purchase agreements.
Other Issues to Consider
- How is the company organized?: A company's organization structure is key for liquidity and return on an investment. Potential incorporations include an LLC, LP, C-Corp, and S-Corp.
- Does the corporate structure foster growth?
- Who is on the board of directors?: You need a board of directors whose goals are in line with your own.
- Does the company do its financial auditing in-house or outsource it?
- Are revenues realistic?
- What is the current and potential market size?
- Interview all employees.
- Conduct an independent competitive analysis.
- Consult a tech firm.
- Conduct independent market analysis.
- Review all financial documents.
- Interview board members, consultants, and advisers.
Questions to Ask With a Due Diligence Checklist
A long list of documents and correspondence from the company you wish to buy is not always enough. You must ask questions about the sale or the business. You might also need answers the documents don't offer.
- Why are you selling the business?
You must ask this question before buying a business. If a seller doesn't have a good answer, it's a red flag. Most often, the business is being sold to raise funds for another business venture, divorce, estate tax, or retirement. Some are sold because of poor business practices or operating at a loss.
- Have you attempted to sell before?
Sellers are reluctant to tell about failed sales. However, it might shed light on the company's underperformance.
- Do you have a business plan?
A business plan is important to see how a business operates. Without one, must find out on your own. You can also use this document to compare projections to actual sales.
- How easily can competitors enter or leave the market?
This question helps you find out how hard or easy it is to start the business. If competitors leave and enter freely, you might be able to start a project on your own.
- How complex is the business model?
Every business has many moving parts. If there are too many subsidiaries or the model is too complex, managing it could be difficult.
- Do you have an organizational chart?
An organizational chart shows you the departments within a company. It lets you see which managers deal with certain parts of the organization. A legal organizational chart helps you see subsidiaries, incorporations, and minority and majority investors hidden within the company.
- What is your geographic structure?
If the organization operates in many regions, knowing the geographic structure is important. This shows how regions are carved up. In addition, it shows if there are enough sales, marketing, and distribution to support each region. If not, you can see where to improve from within.
- Have there been any other acquisitions?
Knowing if there have been any other sales of companies in the industry lets you see trends. If there's a period of consolidation, this might affect the price you're willing to pay.
- Do you have an online data room?
Online data rooms allow you to find the information you want quickly and easily. A good seller will make this room available to you as soon as you start negotiations. Quality data rooms make it easy to search via an index, table of contents, or search bar. If possible, you should be allowed to print documents.
- What is on your disclosure schedule?
Anything not covered in the due diligence checklist must be included on a disclosure schedule. This document should make sure everything is covered. If something isn't, you can add it to your list of demands.
Buying a business isn't easy. It requires planning and a thorough analysis of your due diligence checklist. Even with experience, you'll probably have questions along the way. That's why you should post your legal need at UpCounsel. These lawyers know the ins and outs of business sales, mergers, and acquisitions.