Due diligence on a business purchase: a guide

What is due diligence, and why is it decisive?

When you buy a business, you do not just buy turnover and assets, you take over everything: contracts, employees, customer relationships, debt and potential lawsuits. Due diligence is the systematic review you carry out before you sign a purchase agreement.

The purpose is simple: to ensure that what you pay for actually corresponds to what you get. And to uncover the risks that can affect the deal, in price, terms or the decision to go through with the purchase at all.

For many SME deals, due diligence is done to a limited extent, or not at all. That is a mistake that can prove costly.

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The three tracks in due diligence

A thorough due diligence typically covers three areas:

1. Financial due diligence

A review of the business's finances for the last 3 to 5 years:

• Annual reports and accounts
• Budgets and forecasts
• Overdrafts, loans and pledges
• Debtors and creditors, including overdue amounts
• EBITDA normalisation (adjusting for owner-adjusted items)
• Tax and any tax arrears
• The auditor's report and any qualifications

The auditor's role: Financial due diligence is typically carried out by an auditor, who can identify items that do not appear clearly in the annual report, for example deferred tax, obsolescence or hidden obligations.

2. Legal due diligence

A review of the business's legal affairs:

• Company documents: articles of association, shareholders' agreement, formation documents
• Contracts with customers, suppliers and partners
• Employment contracts and any directors' contracts
• Intellectual property: trademarks, patents, licence agreements
• Pending lawsuits or arbitration
• Leases and property matters
• GDPR and data processing agreements

What you are looking for: Contracts with inconvenient ties, change-of-control clauses (that can be terminated on a change of ownership), a lack of rights to business-critical assets, and unresolved disputes.

3. Commercial due diligence

An assessment of the business's market position and prospects:

• Customer base and customer concentration (is one large customer decisive?)
• Market trends and the competitive situation
• Employee key figures: key employees, staff turnover, sickness absence
• The competitiveness of products and services

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Legal documents at the centre

Shareholders' agreement and articles of association

The first thing you should ask for is the company's shareholders' agreement and articles of association. These documents tell you:

• Who owns what, and with what rights
• Whether there are pre-emption rights or other ties on the shares
• The decision-making structure in the company
• Whether there are options, warrants or other latent ownership interests

If the shareholders' agreement is missing, or is out of date, it is a warning sign. It can mean unresolved ownership matters that can complicate the deal.

Employment contracts and key employees

Review all employment contracts, especially for senior staff and key people. Check:

• Notice periods, what happens if you want to adjust the organisation?
• Non-compete clauses, can key employees leave and start competing activity?
• Bonus and incentive schemes triggered by a change of ownership
• Pension obligations

Remember: employees transfer in both forms of transaction. In a share sale, the company (the employer) is unchanged, so the employment relationships continue automatically. In an asset sale, the Business Transfer Act ensures that employees pass to the buyer on their existing terms.

Customer contracts

Are the customer agreements in writing? Do they have change-of-control clauses? These clauses give the customer the right to terminate the contract on a change of ownership, and they can markedly undermine the sale price if key customers can leave the business immediately after your takeover.

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Asset purchase vs. share purchase, a decisive distinction

Before you dive into due diligence, you must decide whether you are buying the assets or the shares in the company.

Share purchase: You buy the company as a whole, including all historical obligations and hidden risks. Here due diligence is especially important, because you take over everything.

Asset purchase: You buy the specific assets (customer list, trademark, machinery, contracts). You as a rule avoid historical obligations, but it is more complicated to move rights and contracts, as they often require the counterparty's consent.

For most SME deals in Denmark, a share purchase (sale of shares) is common. It can give the seller tax advantages, but it requires the buyer to be extra thorough in their due diligence.

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Typical pitfalls, and what to do about them

1. Hidden obligations

Old warranty obligations towards customers, pending complaint cases, unknown tax arrears, these can hide in the accounts.

Solution: Ask for a declaration from the seller that no obligations exist beyond those appearing in the accounts. Also secure a warranty and indemnification clause in the purchase agreement.

2. Customer concentration

50% of turnover from one customer. What happens if that customer disappears?

Solution: Assess the customer's stability and contractual basis. Consider setting part of the purchase price as an earn-out that depends on the customer remaining for a period after the takeover.

3. Dependence on key employees

The business runs on two key people whom the seller takes with them, or who quickly jump ship.

Solution: Retention bonuses and lock-up agreements with key employees as part of the deal. This can also be reflected in the seller's warranties.

4. A lack of IP rights

The software was built by a freelancer without a transfer of copyright. The trademark is not registered. Trade secrets are not protected.

Solution: Map all intangible assets and make sure there is a proper transfer as part of the deal.

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The purchase agreement and the shareholders' agreement

Once due diligence is complete, it is time to negotiate and enter into the agreement. The most important documents:

Purchase agreement (Share Purchase Agreement / SPA)

A purchase agreement for a business should contain:

• The precise price and payment structure (including any earn-out)
• The seller's warranties and representations
• Indemnification clauses (who is liable for what, and with what)
• A non-compete for the seller
• Closing conditions
• Mechanisms for price adjustment (locked box or completion accounts)

Shareholders' agreement on partial ownership

If you take over only part of the company, typically as a strategic investor, you should secure a shareholders' agreement that protects your investment. See our shareholders' agreement guide.

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The process in practice

A typical business transaction looks like this:

1. Letter of Intent (LOI), a non-binding statement of intent with the overall terms
2. Exclusivity agreement, the seller commits not to negotiate with others during the due diligence period
3. Due diligence, typically 4 to 8 weeks for an SME
4. Negotiation of the SPA, based on findings from due diligence
5. Signing, signature of the purchase agreement
6. Closing, payment and handover

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When should you get help?

For a single purchase of a small business you can handle parts of the process yourself, especially with the right document templates. But for deals over DKK 1 to 2 million you should have an auditor for the financial due diligence and a lawyer for the review of the contracts.

It is an investment that is cheap compared with the problems you avoid.

Read more in our guides:

• Business transfer, general guide
• Buyer's guide to business transfer
• Purchase agreement on a business sale

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Data room, organising documents for due diligence

A data room is the organised archive of documents that the seller makes available to the buyer in the due diligence process. Today this almost always happens digitally via platforms such as Dropbox, Google Drive or specialised solutions such as Datasite or Intralinks.

As a seller you should prepare a data room with:

• Company documents: Articles of association, shareholders' agreement, formation documents, share register, minutes of general meetings from recent years
• Finances: Annual reports (3 to 5 years), ongoing accounts, tax documents, bank agreements
• HR documents: Employment contracts for all employees, the director's contract, any pension agreements and bonus schemes
• Agreements: All material customer and supplier contracts, leasing agreements, licence agreements
• IP and intellectual property: Trademark registrations, patents, software licences, copyright agreements
• Property: Leases, land-registration documentation
• GDPR and IT: Data processing agreements, privacy policy, IT-security policy
• Insurance: An overview of insurance cover
• Pending cases: Correspondence with lawyers, case documents

The better organised the data room, the faster and cheaper the due diligence, to the benefit of both parties.

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Due diligence on the purchase of a digital business or webshop

Are you buying a webshop, a SaaS business or another digital business? In addition to the classic due diligence elements, there are special topics you should investigate:

Technical due diligence

• Who owns the source code of the software, and is the transfer of rights clear?
• Are there pending software-development contracts, and on what terms?
• Are the systems scalable, and what is the technical debt?
• Where does the business depend on third-party suppliers (hosting provider, payment gateway)?

Digital marketing and SEO

• Is the domain name owned by the company, or by an individual?
• Are the SEO rankings organic and stable, or do they build on short-term tactics?
• Are the social media accounts and Google Ads accounts transferable?

GDPR and customer data

A digital business typically processes large volumes of customer data. Check:

• Is there valid consent for the customers on the mailing lists?
• Are the GDPR procedures well documented, data processing agreements, privacy policy, deletion routines?
• Are there historical data breaches that have not been reported to Datatilsynet?

A lack of GDPR compliance can constitute a significant hidden risk that does not appear in the annual report.

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What you can prepare as a buyer

For the due diligence process to run efficiently, you as a buyer should prepare:

1. A due diligence checklist, adapted to your industry and transaction size
2. A list of your primary risk tolerances, what are dealbreakers, and what can be negotiated?
3. A budget for due diligence costs, auditor, lawyer and possibly technicians
4. A confidentiality agreement (NDA), make sure there is a clear NDA in place before the seller hands over confidential documents

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Start your due diligence right

With LegalDock you can quickly create the legal documents involved in a business transaction, from purchase agreement to shareholders' agreement. Our templates are legally verified and updated with Danish company law.

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This article is informational and does not constitute legal advice. For complex business purchases, it is always recommended to seek professional legal and financial advice.