Due Diligence When Buying a Business

Due diligence is the homework you do before you sign a purchase agreement and hand over money: verifying that the business is what the seller says it is, finding out what liabilities might come with it, and using what you learn to set a fair price and write protective terms into the contract. It runs in both directions. You're investigating; the seller is watching you investigate, and a seller who resists reasonable requests or can't produce basic records is telling you something important on its own.

This guide is about the investigation itself. The deal structure around it — asset sale vs. stock sale, the purchase agreement, and successor liability — is covered separately in our guide to buying an existing business, so we won't re-explain those here.

Think of diligence in four lanes: financial, legal, operational, and people. Work through all four before you're emotionally or financially committed — diligence done after you've already wired a deposit is much weaker leverage than diligence done before you sign a letter of intent.

Financial diligence: what the numbers actually show

The seller's own summary or spreadsheet is a starting point, not proof. Ask for the underlying documents and reconcile them against each other:

• Tax returns matched to the books. Get several years of business tax returns and compare them line by line to the bookkeeping records (bank statements, point-of-sale reports, general ledger, profit-and-loss statements). A business that reports one income figure to the IRS and a higher one to a buyer has a serious credibility problem, not a "that's just how small businesses do it" quirk. Unreported income is not a hidden asset you're buying — it's the seller's tax exposure, and it tells you the rest of the records may not be reliable either.
• Revenue quality. Is revenue steady and recurring, or lumpy and dependent on one contract, one season, or one referral source that might not follow the sale?
• Customer concentration. If a small number of customers account for a large share of revenue, ask whether those relationships are tied to the owner personally and whether the contracts survive a change of ownership.
• Add-backs you can verify. Sellers often present "adjusted" earnings that add back the owner's salary, personal expenses run through the business, one-time costs, and so on. Each add-back should be documented with a receipt, invoice, or payroll record — not just asserted. Unverifiable add-backs are a red flag.
• Deferred revenue and open obligations. Prepaid contracts, gift cards, deposits, memberships, or service plans the business has already been paid for but hasn't yet delivered may become your obligation to fulfill after closing, depending on how the deal is structured. Ask for a full accounting of what's been collected but not yet earned.
• Accounts receivable quality. Ask for an aging report. Receivables that are months old, or owed by customers who are disputing them, are worth less than face value — and whether they even come with the business depends on the agreement.

The IRS publishes guidance on business recordkeeping and income reporting at irs.gov if you want to understand what the underlying returns and forms should look like.

Legal diligence: what you'd be inheriting

• Good standing. Confirm the entity is validly formed and currently in good standing with the state where it was formed and any state where it's registered to do business. A lapsed or administratively dissolved entity can complicate a sale and may need to be reinstated first. Check with the relevant Secretary of State (or equivalent state office).
• Litigation and disputes. Ask directly about pending or threatened lawsuits, regulatory complaints, or unresolved customer or employee disputes, and independently check available state and federal court records.
• The lease. If the business operates from leased space, read the lease itself, not a summary of it. Commercial leases commonly require the landlord's written consent before the lease can be assigned to a new tenant, and the landlord may use that leverage to ask for a personal guarantee, higher rent, or other new terms. Get landlord consent in writing before you close, not after.
• Change-of-control clauses. Key contracts — with customers, suppliers, franchisors, software vendors, or lenders — may terminate automatically or require consent when ownership changes. Read every material contract for this language before you assume it transfers. If it's a franchise, the franchisor almost certainly has approval rights and its own transfer process.
• Liens. Run a UCC search to see whether the business's equipment, inventory, or receivables are already pledged as collateral for a loan you didn't know about. UCC financing statements are usually filed with a central state office — most often the Secretary of State — but the correct office and the state to search depend on where the debtor is located, and fixture filings are recorded locally. Ask the filing office or your attorney where to search.
• Tax clearance. Many states have successor-liability rules under which a buyer of business assets can become responsible for the seller's unpaid sales tax — and in some states other state taxes — up to the value of the assets purchased, even though the buyer never owed that tax. Whether it applies, how the withholding or escrow procedure works, and how far back it reaches all vary by state; contact the seller's state tax or revenue agency directly and ask about a tax clearance certificate or comparable procedure before closing.
• Intellectual property and domains. Confirm who actually owns the trademarks, the website, the domain name, the social accounts, and any registered IP — sometimes it's the owner personally, a developer, or an old business partner, not the entity being sold. The U.S. Patent and Trademark Office (uspto.gov) lets you search registered trademarks. Anything significant here is worth an IP attorney's eye.
• Licenses and permits. Business, professional, and industry licenses are typically issued to a specific person or entity by a state or local agency, and they often do not automatically transfer with a sale — some must be reapplied for from scratch, with processing time you need to plan around. Which licenses the business needs, whether they transfer, and how long a new application takes vary by state, by city or county, and by industry. Ask each issuing agency directly rather than assuming.

Operational diligence: how the business actually runs

• Why they're really selling. Retirement and burnout are common and legitimate reasons. Declining sales, a lost key contract, a new competitor, or an approaching lease expiration are reasons too — ask directly, and verify the answer against what the financials and contracts show.
• Owner dependence. Do customers come because of the business, or because of a personal relationship with the current owner? A service business built entirely around one person's reputation may lose much of its value the day that person leaves. This is also why a transition or training period often gets negotiated into the deal.
• Equipment condition. Have equipment, vehicles, or systems inspected rather than taking the seller's word for their condition and remaining useful life. Ask for maintenance records, and check whether anything is leased rather than owned — leased equipment isn't the seller's to sell you.
• Supplier terms. Confirm pricing, payment terms, exclusivity arrangements, and whether suppliers will extend the same terms to a new owner.
• Inventory. Count it, or have it counted, near closing rather than relying on a stale list — and look for what's obsolete or unsellable.

People diligence: who works there and how

• Key employees. Identify who is essential to keeping the business running and find out whether they know a sale is happening, and whether they intend to stay.
• Worker classification. Ask for a full list of everyone paid by the business and how each one is classified — employee or independent contractor. Whether a worker is legally an employee or a contractor depends on the actual working relationship under the applicable legal test, not the label on a contract or the fact that someone signed one. Misclassification creates back payroll tax and back wage exposure. The IRS (irs.gov) and the Department of Labor (dol.gov) both publish guidance on how classification is determined, and some states apply stricter tests of their own.
• Unpaid wages and PTO. Ask whether any wages, overtime, commissions, or accrued paid time off are currently owed to employees, and get the answer in writing. Whether unresolved wage claims follow the business depends on the deal structure and on state and federal successor-liability doctrines — don't assume they stay behind.
• Payroll tax deposits. Ask for proof that withheld payroll taxes were actually deposited, not just withheld. Withheld payroll tax is trust-fund money, and unpaid amounts are a liability worth knowing about before closing rather than after.
• I-9 files. Employers are required to complete and retain a Form I-9 verifying each employee's identity and work authorization. Ask to review the I-9 files (with appropriate privacy handling) — missing or incomplete I-9s are a common finding. If you're buying assets and rehiring the workforce, there are rules about whether you complete new I-9s or may retain the seller's; U.S. Citizenship and Immigration Services (uscis.gov) publishes the current requirements and the successor-employer rules.

Traps that catch buyers off guard

• Undisclosed misclassification. A business that looks lean because much of its "team" is paid as 1099 contractors may be misclassifying employees. Whether that exposure follows the business depends on structure and on successor-liability doctrines — but a purchase agreement between you and the seller doesn't bind the IRS, a state agency, or a worker, so don't treat an indemnity clause as the whole answer.
• Tax debt that follows the assets. As noted above, unpaid state taxes can attach to the assets you're buying under many states' successor-liability rules, regardless of what the purchase agreement says between you and the seller. A clearance check with the state agency protects you; a promise from the seller does not.
• Licenses that don't transfer at all. Discovering after closing that a required license has to be reapplied for — and that you can't legally operate in the meantime — is one of the most damaging and avoidable diligence failures.
• No non-compete from the seller. Without a signed non-compete and non-solicitation from the seller, there may be nothing stopping them from opening a competing business nearby or calling their old customers next month. Non-competes given as part of the sale of a business are generally treated more favorably by courts than non-competes imposed on employees — several states that sharply restrict employee non-competes have a specific carve-out for the seller of a business — but scope, duration, and geography still have to be reasonable, and the rules are state law. Have an attorney licensed in the relevant state draft it as part of the purchase agreement.
• An indemnity that's only as good as the seller. A seller's promise to cover a problem is worth what the seller can actually pay after they've spent the sale proceeds. That's why buyers ask for escrows and holdbacks rather than relying on a clause alone.

Diligence sets the price and writes the contract

Diligence isn't just a pass/fail filter — it's how you and the seller arrive at a number, and how your attorney drafts the representations and warranties (the seller's written promises about the state of the business) in the purchase agreement. Every material fact you uncover — a customer concentration risk, an unclear IP ownership question, an unassignable lease — either adjusts the price, gets written into a specific seller warranty with a remedy if it's untrue, gets covered by an escrow or holdback, or becomes a reason to walk away.

There is no reliable shortcut formula for translating what you find into a price. What a business is worth depends on its industry, size, location, customer base, and the local market, and anyone offering you a rule of thumb is guessing at your specific deal. Valuation is a conversation for you, your accountant, and your attorney — and for anything significant, a qualified business appraiser.

What to do

1. Get a signed non-disclosure agreement in place before the seller shares sensitive records.
2. Request several years of tax returns, financial statements, and bank records, and reconcile them yourself or with a CPA.
3. Pull a UCC lien search in the right office and state, and contact the state's tax agency about successor-liability or tax-clearance procedures.
4. Read the lease and every material contract personally, watching for assignment and change-of-control language.
5. Confirm entity good standing with the Secretary of State and check available court records for litigation.
6. Contact each licensing agency directly to ask whether and how the license transfers, and how long a new application takes.
7. Review employee classification, payroll tax deposits, I-9 files, and any wage or PTO obligations.
8. Have equipment inspected, confirm what's owned vs. leased, and verify supplier terms in writing.
9. Make sure your diligence period and your exit rights are written into anything binding before you sign it.
10. Bring everything you found to an attorney to shape the representations, warranties, and any escrow terms — and to a CPA to translate it into a price you can support.

Free help is available: the U.S. Small Business Administration (sba.gov) and its network of Small Business Development Centers and SCORE mentors offer no-cost guidance on buying an existing business. A qualified attorney and CPA should review the specifics of any deal before you sign.

This article is general information, not legal, tax, or financial advice, and does not create an attorney-client or accountant-client relationship.