A Guide to Due Diligence for Buying a Business

Due diligence is a vital process for anyone looking to buy a business. It involves scrutinizing the target company’s financials, assets, and operational details to uncover potential risks. This thorough examination will help you make an informed investment decision and avoid costly mistakes. In this guide, you’ll discover how each step of due diligence contributes to a successful company acquisition. We’ll also highlight considerations specific to Texas business purchases to ensure you cover all bases.

Key Takeaways

Due diligence is essential in business acquisitions, allowing buyers to assess risks and validate financial information before finalizing the deal. Skipping this step can lead to unforeseen liabilities.
Core components of due diligence include evaluating finances, organizational structure, physical assets, and intellectual property. A good due diligence checklist ensures you leave no stone unturned when examining the target company.
Engaging professionals during due diligence (attorneys, accountants, and tax experts) provides expert insights and helps identify potential pitfalls, ensuring a smoother acquisition and transition.
Texas-specific considerations: If you’re buying a business in Texas, due diligence should also confirm compliance with state requirements – for example, verifying the company’s Texas good standing, franchise tax status, and any state or local licenses unique to Texas.

Understanding Due Diligence in Business Acquisitions

The due diligence process is like a magnifying glass, allowing you to scrutinize every aspect of the target company. It is a meticulous review of information and documents from the seller to assess risks and understand finances. Utilizing the due diligence process to identify potential issues before finalizing the acquisition can prevent significant financial losses.

A well-structured due diligence checklist is a roadmap to understanding the finances and legal issues associated with purchasing a business. From verifying legal compliance to engaging professionals who can provide expert insights, due diligence ensures that you leave no stone unturned. Without a thorough business due diligence checklist, you risk walking into a deal blindfolded, with unforeseen liabilities lurking around the corner.

This checklist typically covers various aspects of the business, such as:

Organizational structure
Financial information
Physical assets
Intellectual property

Each component plays a meaningful role in painting a complete picture of the target company’s health and potential. For instance, understanding the company’s purchasing policies and determining if any major customers were lost recently can provide insight into the stability of business operations. Customer satisfaction rates will help you determine what, if any, major changes to the business you ought to make as you take ownership. If the company has performed market research relevant to your plans or has data on the effectiveness of its advertising programs, those will also guide your path forward.

Due diligence is not just a formality; it’s a critical step in the acquisition process that shows you if the purchase price is justified and helps you secure financing. Even in business-friendly states like Texas, conducting thorough business and operational due diligence ensures a well-informed decision that aligns with your strategic goals.

Organizational Structure and Good Standing

Before examining the financials, verify the target company’s organizational structure and confirm it is in good standing. Review key documents like the Articles of Incorporation (or Organization for an LLC), bylaws, and corporate meeting minutes to ensure compliance with governance standards. Depending on the structure of the business, there may be stock purchase agreements or membership agreements, which will affect how the transaction can be undertaken. A Certificate of Good Standing is another crucial document that confirms the business is authorized to operate in its jurisdiction.

For a Texas company, due diligence includes confirming the business’s status with the Texas Secretary of State and ensuring it’s active and compliant. You might request a Texas “Certificate of Fact” (commonly known as a Certificate of Good Standing) as evidence that the company’s filings are up to date. Additionally, check that the entity is in good standing with the Texas Comptroller’s office regarding state franchise taxes (more on this in the Tax section). Key verification steps in this phase include:

Review the organizational chart to understand the company’s hierarchy and identify any potential management issues or key person dependencies.
Verify the company’s legal status to ensure you’re not dealing with an inactive or defunct entity. (A quick state business registry search can confirm the business’s active status.)
Confirm good standing by obtaining official certificates or records showing the business has complied with state requirements and paid its dues. This is a foundational step for a smooth transition and ongoing operations post-acquisition.

Evaluating Financial Information

Financial due diligence hinges on obtaining and analyzing the target company’s financial statements. Buyers should review audited statements covering the last three years, along with the auditors’ reports. These documents provide a clear picture of the company’s financial health and help identify any red flags in accounts receivable, revenue consistency, or expense management.

Key financial documents to review include:

Balance sheets – to see assets, liabilities, and equity.
Income statements – to evaluate profitability over time.
Cash flow statements – to assess liquidity and cash management.
Tax returns – to verify reported income and identify any tax issues.
Audit reports – to see if independent auditors noted any concerns.

Beyond audited financial statements, the following documents are also important in a financial review:

Recent unaudited financial statements – these show the latest performance and can reveal any recent changes in the business.
Comparative statements from previous years – side-by-side annual comparisons help you spot trends and assess financial performance over time.
Internal control procedures – documentation of the company’s accounting methods and compliance standards, which can indicate how well financial processes are managed.
Projections, budgets, and strategic plans – these forward-looking documents let you gauge the company’s future growth potential and whether the current owner’s plans align with your expectations.

Analyzing a schedule of all debts and contingent liabilities is vital for assessing the company’s financial health. This includes looking at loans, lines of credit, pending lawsuits or judgments, and any off-balance-sheet liabilities. Consulting a CPA during this review can provide valuable insights and ensure accurate interpretation of financial statements. This thorough financial review is a cornerstone of a comprehensive due diligence checklist, enabling you to make an informed investment decision.

Assessing Physical Assets

Physical assets are the tangible backbone of any business, and evaluating them is a critical part of due diligence. These assets include land, buildings, inventory, and equipment that are essential to operations. A comprehensive assessment should include a schedule and the locations of all fixed assets, details of equipment leases, records of major capital equipment purchases over the last three years, and an analysis of fixed and variable expenses related to these assets. Understanding the company’s depreciation and amortization methods is also key to determining the valuation of these assets in an asset transaction, influencing both current value and future financial performance.

Ensure there are clear titles to any real property involved in the deal. Review related documents such as deeds, mortgages, and leases to check for liens or restrictions, and consider performing a title search for any real estate. It’s also wise to review any environmental audits or zoning permits associated with facilities, so you’re aware of potential constraints or liabilities tied to the property.

Moreover, obtaining independent appraisals for real estate, significant equipment, and inventory can help verify that the seller’s stated values are in line with market worth. Conduct physical inspections of key assets to identify any maintenance issues or needed repairs. For example, inspect machinery for wear and tear, or have a specialist evaluate any specialized equipment. This thorough evaluation of physical assets helps you understand the true condition and value of what the business owns, ensuring there are no expensive surprises post-acquisition. (Tip: In Texas, you may also want to search the Texas UCC filings for any liens on equipment or other assets, as these filings can reveal if assets are collateral for loans.)

Intellectual Property and Trade Secrets

Intellectual property (IP) and trade secrets are often the crown jewels of a business. During due diligence, it is crucial to evaluate the company’s intangible assets and ensure they truly belong to the business. Key areas to examine include:

Patents – Check for any patents the company owns or licenses. Ensure filings are current and that the patent truly covers the company’s products or processes.
Trademarks – Review trademarks (names, logos, slogans) for proper registration and usage. Determine if trademarks are federally registered or just used locally (and if locally, consider if a federal registration is needed for protection).
Copyrights – Identify any copyrighted material (software, content, publications) the company has and verify ownership.
Licenses – Look at licensing agreements for technology or content the business uses. Are they up to date and transferable?
Outstanding applications – Note any pending patent or trademark applications that could affect future rights.
IP litigation or disputes – Inquire about any existing or threatened litigation over IP, such as infringement claims or cease-and-desist letters.

Ensuring that all documents relating to trademarks and patents are properly filed and that the company isn’t infringing on others’ IP is important for protecting your investment. Confirm that the company owns the rights it purports to have. For example, if the business uses a unique software or formula, was it developed in-house and properly assigned to the company by its creators?

If there are data security issues or concerns about trade secrets, assess how well those secrets are protected. Consider whether the company has adequate non-disclosure agreements (NDAs) with employees and partners to safeguard proprietary information. If not, competitors could more easily obtain and exploit the company’s “secret sauce.” Consulting with an IP attorney can help address any complex questions or threatened claims against the business that could affect its value or operations.

Key considerations regarding intellectual property include:

Usage restrictions: Determine if any prior agreements (like former owner agreements or vendor contracts) impose restrictions on the use of certain IP. Such restrictions can limit the business’s operational capabilities after you acquire it.
Encumbrances on IP: Check if any intellectual property assets are used as collateral for loans or have liens against them. Any encumbrances can affect ownership and transferability.
Continuity of IP rights: Ensure that critical IP will transfer with the sale. If the seller personally holds some IP rather than the company, you’ll need an assignment of those rights as part of the deal.
Maintaining competitive edge: Verify that patents or trade secrets actually provide a competitive advantage and that protections (like confidentiality policies) are in place to keep that edge. If key patents are near expiration or easily invent-around, note that risk.

Employee Benefits and Human Resources Information

A company is only as strong as its team, making employee information and benefits review a critical part of due diligence. Understanding the existing workforce and identifying key employees will help you plan for a smooth transition and continued success post-acquisition. Important documents and information to review include:

Organization charts and key employees: Identify who the key players are (executives, managers, lead salespeople, etc.). Obtain resumes or background information for these individuals to understand their experience and how vital they are to operations.
Employment agreements and contracts: Evaluate any contracts the business has with employees, especially executives or those with unique compensation arrangements. Look for clauses on severance, change of control (some contracts might give employees certain rights or payouts if the company is sold), non-compete agreements, and intellectual property assignment by employees.
Personnel handbooks and HR policies: A current employee handbook will reveal the company’s policies on vacation, benefits, conduct, etc. Check if policies are up-to-date and compliant with law. (For instance, ensure there are no policies that contradict Texas or federal employment laws.)
Collective bargaining agreements: If the company’s employees are unionized, review any union contracts to understand the obligations and pending negotiations.
Summary of benefits: Analyze the benefits offered (health insurance, retirement plans, bonuses). Note the costs of these benefits and any commitments to maintain them.
Employee lists and compensation: Request a list of all employees, their positions, hire dates, and current salaries or wages. This helps in budgeting for payroll and also spotting any potential inequalities or unusual compensation arrangements.
Pending labor issues: Inquire about any ongoing or past labor disputes, lawsuits, or complaints (e.g., discrimination claims, wage/hour audits, OSHA investigations). If any exist, assess their potential impact and whether they’ve been resolved or could recur.

Reviewing these details helps you plan for employee retention and integration. For example, if certain employees are crucial to the business, you may want to ensure they’re willing to stay on board after the sale, perhaps by using retention bonuses or new contracts. Also, if merging organizations, understanding differences in benefits and workplace culture will be vital to maintain morale. Texas is an “at-will” employment state (meaning employees can generally be terminated for any lawful reason), but having clarity on employment agreements and any promises made to employees is still essential to avoid surprises or liabilities when you take over.

Finally, ensure that any required employee-related filings or compliance matters are in order. Check that payroll taxes have been properly remitted, that the company is registered with the Texas Workforce Commission for unemployment tax, and that workers’ compensation insurance (if required or provided) is in place. Human resources due diligence is about making sure the company’s most important asset – its people – will continue to operate smoothly under your new ownership.

Reviewing Licenses and Permits

Evaluating licenses and permits is crucial to ensure the business operates in compliance with all legal and regulatory requirements. This aspect of due diligence is especially important in heavily regulated industries (such as food service, healthcare, finance, etc.), where failing to have proper licenses can result in severe consequences. Regulatory compliance lapses could lead to fines, operational shutdowns, or even voided business transactions in extreme cases. Simply put, failure to verify that all necessary licenses are valid and up-to-date may lead to legal penalties, operational disruptions, or loss of business value.

Start by identifying all government licenses, permits, or approvals the business needs. This includes federal, state, and local permits. For example, does the company need a city business license or professional licenses for certain employees? Does it hold permits from health or environmental agencies? Obtain copies of all such licenses or permits and verify their status (active, expired, pending renewal, etc.). Also review any records of inspections or correspondence with regulatory agencies, as these can reveal compliance issues.

If the business is in Texas, note that there isn’t a single general business license required at the state level, but many businesses need industry-specific licenses or permits. Texas publishes a comprehensive Business Licenses & Permits Guide that lists permits required for various types of businesses. Use resources like that to double-check that the target company has every license it should. For instance:

A restaurant or bar in Texas must have the proper Texas Alcoholic Beverage Commission (TABC) license if alcohol is served.
A construction or contracting business may need specific contractor licenses or building permits at the local level.
Professionals (like doctors, lawyers, real estate brokers) need state-issued licenses to practice, so if you’re buying a professional practice, ensure those credentials are valid and transferable.

Ensure any environmental permits are in order as well, such as waste disposal permits or air/water emissions permits if the business’s operations require them. Copies of any governmental consents or zoning approvals related to the business property should also be reviewed.

Lastly, check for any records of regulatory actions: have there been any fines, suspensions, or warning letters from agencies? If so, understand if those issues have been resolved or could pose a risk going forward. The goal is to make sure you can step into the business without facing a closure or penalty for lack of a proper license.

Tax Documentation

Reviewing tax documentation is a critical element of business due diligence. Taxes can be complex, and any hidden issues here can become your problem after the purchase. Key documents to examine include:

Federal, state, and local tax returns for at least the last three years. These will show whether the business has been reporting income accurately and if there are any ongoing disputes with tax authorities.
Auditor’s tax reports or IRS correspondence. If the IRS or state tax authority has conducted any audits, review the results. Audit reports can reveal past compliance issues or adjustments that were required.
Tax settlement documents or payment plans. If the company negotiated any settlement of tax liabilities or is on a payment plan for back taxes, you need to know the details.
Revenue agency reports. Sometimes state or local tax agencies issue reports or account statements—check for those to see the status of accounts like sales tax or payroll tax.
Tax liens. Do a search for any tax liens filed against the company or its principals, as these indicate unpaid taxes that could become your responsibility if not resolved.

Understanding the target company’s tax obligations and history will help you evaluate its overall financial health. If you can confirm that employment taxes, sales taxes, and income taxes have all been filed and paid correctly, that will alleviate a lot of stress about inheriting tax problems. Future tax liabilities can impact cash flow, so it’s essential to assess them during due diligence and factor them into your financial planning for the acquisition.

For Texas businesses, pay special attention to the Texas franchise tax. Texas imposes a franchise tax on most businesses (in lieu of a corporate income tax). Verify that the company has filed its franchise tax returns and paid any due taxes to the Texas Comptroller. You can use the Comptroller’s online system to check the Franchise Tax Account Status, which is effectively a Texas good-standing indicator for taxes. In fact, obtaining a Certificate of Account Status (No Tax Due) from the Comptroller’s office is a common step in Texas business acquisitions. This certificate will confirm that the entity has no outstanding state tax obligations as of the date of issuance, giving you confidence that you won’t be surprised by a tax bill later. Keep in mind that failure to comply with Texas tax requirements can have serious consequences – the state can even forfeit a company’s right to do business if franchise taxes aren’t paid.

Given the complexity of tax matters, consider having a tax lawyer or accountant as part of your due diligence team. They can interpret the tax documents, identify any aggressive tax positions or red flags, and advise on the tax implications of the transaction (for example, how an asset purchase vs. stock purchase might affect taxes). This comprehensive review of tax documentation ensures there are no hidden tax liabilities that could affect the value of the business post-acquisition.

Material Contracts and Agreements

Material contracts are the lifeblood of a company’s operations and revenue. As part of due diligence, you need to review all significant contracts to which the business is a party. This includes customer contracts, supplier/vendor agreements, employment and independent contractor agreements, leases, loan agreements, partnership or joint venture agreements, franchise agreements, and so on. The goal is to understand the commitments the business has made and any obligations or restrictions that will carry over after you buy it.

Start by requesting a schedule of all material contracts and then dig into each category:

Customer contracts: Look at the largest or most significant customers. Are there long-term commitments or volume requirements? Any clauses that allow the customer to terminate or renegotiate if ownership changes? Understanding these terms will help you gauge the stability of future revenue.
Supplier and service agreements: Check if the company has long-term supply contracts for key materials or services. Are the prices fixed or variable? Are there minimum purchase requirements? Also, identify if any critical supplier is at risk (for example, a sole source supplier of a vital component).
Loan and security agreements: If the business has loans, review the loan documents. Are there liens on assets (check UCC filings to confirm), what are the repayment terms, and is the loan assumable or does it need to be paid off at sale? A security agreement will detail collateral pledged – ensure you know what assets are tied up.
Equipment leases and property leases: These can be significant liabilities. For property leases, note the remaining term, rent escalations, and assignment clauses (will the landlord require approval or new guarantees to transfer the lease to you?). For equipment leases, understand the payment schedule and any buyout options.
Employment and non-compete agreements: We touched on employment contracts in the HR section, but here specifically look at any non-compete or non-solicitation agreements the business has with key employees or that you might sign with the seller. These protect the business’s goodwill by preventing key people from immediately competing or stealing clients. In Texas, non-compete agreements are enforceable only if they are part of an otherwise valid agreement and contain reasonable limitations in time, geographic area, and scope. Ensure any such agreements meet Texas legal requirements so that they will remain in force after the sale. If the seller or key employees haven’t signed non-competes and the business’s value relies heavily on them, you might need to negotiate new agreements as part of the acquisition.
Nondisclosure agreements (NDAs): The company may have NDAs with employees, contractors, or third parties to protect confidential information. Verify these exist and assess their scope. (NDAs are generally easier to enforce than non-competes, and they help protect trade secrets and customer lists.)
Franchise or license agreements: If the business is a franchisee or holds a license to use a brand/technology, review those agreements carefully. What approvals are needed for ownership transfer? Will the franchisor require you to sign a new franchise agreement? Are there fees involved?

A thorough appraisal of these contracts can illuminate commitments that might impact cash flow or pose liabilities. For example, by reviewing customer contracts you might discover that some clients have very lenient payment terms or the ability to claim refunds or credits, which could affect cash flow. Or you might find a supplier contract that locks in a high price for raw materials, affecting profitability until it expires.

Pay special attention to change-of-control provisions in any contract. Some agreements state that they terminate automatically or can be terminated by the other party if the company is sold. This is crucial – you don’t want to close the deal and then find out a key client or supplier walks away because the contract ended upon transfer. If such clauses exist, you may need to get consents or waivers from those parties as a condition of closing the sale.

Also, evaluate any termination clauses and penalties. If contracts can be terminated with notice, consider what liabilities (like severance for a terminated contract or liquidated damages) might arise.

Finally, verify the accuracy of any customer data or contract summaries the seller provides. Ensure that what you’ve been told about recurring revenue, contract backlog, or order commitments is backed up by actual agreements. This can prevent future disputes or claims that the seller misrepresented the business.

Litigation and Legal Compliance

Investigating the company’s litigation history and overall legal compliance is another pillar of due diligence. You should inquire about and review any pending or past lawsuits, as well as any governmental investigations or regulatory enforcement actions involving the business. Ask the seller for a schedule of pending litigation (any lawsuits currently filed against or by the company) and descriptions of any threatened litigation (disputes that haven’t yet gone to court but could). Pay attention to:

Any lawsuits or legal claims currently pending. Get the details on parties, allegations, and potential damages. This could range from slip-and-fall injury claims, to contract disputes, to intellectual property infringement cases.
Threatened claims or disputes that the company is aware of. Sometimes a customer or partner might have sent a demand letter that hasn’t escalated to a lawsuit yet. These are important to know even if they’re not public record.
Past litigation in the last few years. Understanding what issues the company has faced (and how they were resolved) can be insightful. For instance, a history of employee lawsuits might indicate cultural or HR problems.
Unsatisfied judgments or liens. Check if any judgments against the company (from lawsuits or creditors) remain unpaid – they can attach to company assets.
Regulatory investigations or violations. Determine if any government agency has investigated or cited the business for violations. This could include OSHA (occupational safety) citations, environmental fines from the EPA or Texas Commission on Environmental Quality (TCEQ), or inquiries from the Texas Attorney General’s office, etc

It’s wise to have an attorney help with this portion of due diligence. They can perform independent searches of court records (including Texas state court databases for any lawsuits involving the company) and public filings to verify what the seller discloses. They’ll also know how to interpret the severity of any findings.

Assessing environmental liabilities deserves particular attention. If the business involves handling hazardous materials, manufacturing, or any environmental impact, ensure you review environmental compliance records. This might involve looking at any environmental audits, spill or contamination reports, and correspondence with agencies like the TCEQ. Environmental issues can sometimes impose costly cleanup obligations on a new owner, so you may even need a Phase I or Phase II environmental assessment for facilities (commonly done in real estate due diligence for certain industries).

Ensuring legal compliance also means checking things like:

Corporate compliance: Has the company kept up with required filings (annual reports, franchise tax payments in Texas, etc.)? An out-of-compliance company could face penalties or dissolution.
Licensure compliance: As noted earlier, verify all required licenses are not only obtained but also in good standing (no pending revocations or fines).
Industry-specific laws: If the company is in a regulated field (for example, healthcare has HIPAA laws, finance has SEC/FINRA rules, etc.), confirm compliance with those specialized requirements.

By thoroughly reviewing litigation and compliance, you’re making sure there aren’t any lurking legal problems that could undermine the business’s value or even derail the acquisition. Dealing with known issues is one thing – inheriting a surprise lawsuit or regulatory penalty is quite another. This review helps ensure a smoother transition post-acquisition with minimal legal headaches.

Engaging Professionals

Buying a business is a complex endeavor, so engaging seasoned professionals to assist with due diligence and the transaction can be invaluable. These may include attorneys, accountants, business brokers, and consultants with experience in mergers and acquisitions. Here are key considerations:

Identify the seller’s advisors: It helps to know which law firm or accounting firm the seller has been using. Not only might you interact with them for obtaining documents, but this also flags potential conflicts of interest if you were considering using the same firm. Ensure the professionals you hire are only advocating for your interests.
Hire an experienced business attorney: An attorney well-versed in business acquisitions (and licensed in the appropriate state, such as Texas for a Texas business purchase) can guide you through the legal maze. They will help review the due diligence checklist, spot legal red flags, draft and review the purchase agreement, and make sure all necessary documentation is in order. Texas, for instance, has some unique legal considerations (like state-specific employment laws, franchise tax rules, etc.), so having a lawyer who knows the local law is crucial.
Use a knowledgeable accountant or CPA: A CPA can dig into the financial statements, perform a quality of earnings analysis, and advise on the financial implications of what you discover. They can also help structure the deal in a tax-efficient way. For Texas deals, an accountant familiar with Texas tax regulations (franchise tax, sales tax nuances) is especially helpful.
Consider specialists as needed: Depending on the business, you might need specialized consultants. For example, an environmental consultant if there are environmental concerns, an IT expert to review technology assets and data security, or a HR consultant to evaluate cultural fit and benefit plans.
Plan for integration: Some consulting firms specialize in post-merger integration. While that’s beyond the scope of due diligence, thinking ahead about how you will integrate the business (if it’s merging into your existing operations) can identify additional due diligence items (like compatibility of IT systems or company culture considerations).

Remember that investing in professional guidance up front can save a lot of money and heartache later. They might catch issues you would miss and can negotiate protections for you (such as warranties, indemnities, or price adjustments in the deal) based on the findings. Due diligence is about being as informed as possible; engaging the right team ensures you have experts interpreting the information correctly.

(On a related note, if you’re financing the purchase with a bank loan or investor money, those parties might require certain due diligence steps or audited financials. Professionals can help prepare the needed reports to satisfy lenders or investors, too.)

Summary

Conducting thorough due diligence is a critical step in the business acquisition process. By carefully evaluating financial information, legal and organizational structure, physical and intangible assets, and all the other areas discussed above, you develop a complete picture of the target company’s health and potential. A comprehensive due diligence checklist acts as your roadmap, ensuring nothing important is overlooked and helping you verify that the investment is sound.

In conclusion, due diligence helps you understand the benefits and risks of owning the business, gives you a clear picture of exactly what is being bought (and any issues attached to it), and protects you from unforeseen liabilities. It shows whether the purchase price is justified and can even help in securing financing by providing lenders confidence in what you’re buying. A well-executed due diligence process is truly the key to a successful business acquisition.

Whether the company you’re looking to buy is in Texas or elsewhere, the fundamental goal is the same: leave no stone unturned. In Texas specifically, make sure to incorporate state-specific checks (tax status, licenses, compliance with Texas laws) into your due diligence. Armed with the knowledge gained from due diligence, you can move forward with the transaction with confidence or walk away from a bad deal – both outcomes far better than going in blind.

Ready to buy a business in Texas? The experienced team at Roquemore Skierski is here to assist you at every step of the due diligence and acquisition process. We can help coordinate your due diligence efforts, identify potential legal pitfalls, and ensure a smoother transition. Contact us today for a consultation and let us help you make your Texas business purchase a success.