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The Due Diligence Checklist for SMEs

?Why do you need a due diligence checklist at all?

A due diligence review in the context of a Company sale is new territory for the vast majority of all business owners. What information does the buyer specifically need in order to successfully buy the company, for example, if you have a Sell limited liability company would like? What information should a salesperson under no circumstances disclose at this point in order not to jeopardise his or her market position if the sale fails?

How extensive must a Due Diligence and which documents and contracts must be made available for this?

The following article offers you orientation and support for the Individual preparation of your business succession. You will learn whether and when due diligence becomes relevant for you within a company sale, what function due diligence has in a company transaction in the first place, what types of due diligence there are and which side pays for which costs.

With the help of our free due diligence checklist from KERN Business Succession, you will also receive valuable information, suggestions and tips to help your Successfully prepare the sale of a company and sustainable.

Table of contents

What is due diligence?

The term "due diligence", as you might have guessed, has its origins in English, like so many other terms in business administration. Literally translated it means ?duty of care? in the context of company successions and company sales (M&A), it is often also translated as 'due diligence'. In practice, it means that all relevant strengths, weaknesses, opportunities and risks of a company are examined.

The seller underpins with due diligence the Strengths of his companyin order to achieve the targeted purchase price. The buyer and his advisors sift through documents provided to them by the seller in small transactions, either in binders or usually in a safe, secure and internet-based data room. With as accurate a knowledge as possible of the value of the business to be bought, he wants to secure the payment of a Avoid inflated purchase price.

Where in the M&A process is due diligence located?

A M&A process extends over several phases and steps. Due diligence usually begins following the signing of an LoI (Letter of Intent - letter of intent) or a concrete purchase offer in a bidding process. The buyer and his advisors review the documents provided to them by the seller. At KERN Corporate Succession, we set up a protected digital data room for this purpose. This data room usually contains tax, legal and financial (as well as other) documents, records and contracts that are reviewed in detail.

This almost always results in further questions from the buyer, which the seller should answer as well as possible.

The buyer then receives the summarised results in a due diligence report. This report points out the identified strengths and weaknesses of the company to be sold. Quantifiable results flow into the company valuation and thus into the determination of the buyer's purchase price. Non-quantifiable results, on the other hand, more often lead to the demand for indemnification declarations and warranties in the Company purchase agreement.

Time in the M&A process to process a due diligence checklist

Types of due diligence

How extensive a due diligence review then turns out to be, and which types of due diligence review are applied in practice, naturally depends on several factors. For example, the size of the company, its business model, its location, fixed assets, cash flow and earnings are decisive criteria. Of course, it is also clear that not all business transactions and facts can be examined in detail, as otherwise the due diligence would no longer be economically appropriate. That is why it is important, the principle of materiality comply.

Tip: When preparing your company succession, call on the services of a transaction-experienced M&A consulting one. In his function as an experienced pilot, he can confidently assess which due diligence checklists and, derived from them, which measures are really necessary for you and your company in the due diligence process.

The following checklist illustrates how to proceed in a structured manner during the preparation phase: It is important for its use to record the priority and the respective status for each audit item.

 Action/ documents to be obtainedPriorityrequestedis presentcheckedNotes
A1Current excerpts from the commercial register including affiliated companies     
A2Current business information (Creditreform etc.) including affiliated companies and shareholders     
A3Current articles of association including minutes of all shareholders' meetings     
A4Historical list of all notarial deeds concerning the formation, the assignment of shares and any capital increases since the formation; information on an advisory board/supervisory board     
*Excerpt of a sample due diligence checklist

Legal due diligence (LDD) focuses on the examination of legal risks. This includes the transaction itself as well as risks affecting the company and potential liability risks for the parties involved. As with all other forms of due diligence, it is possible that so-called 'deal breakers' are uncovered, which can lead to the abortion of the transaction process. The buyer discovers previously unknown risks in the DD process and is unable to resolve them in negotiations with the seller. The scope of a legal due diligence depends on the legal complexity of the company to be sold.

  • Social conditions
  • Financial circumstances: Loans and collateral
  • Employees & labour law contracts as well as contracts of all kinds
  • Impending guarantee cases or cases in the process of being settled
  • Impending or pending legal or arbitration proceedings

Tax Due Diligence (TDD)

A tax due diligence (TDD) identifies tax opportunities and risks of the company acquisition with the aim of determining the optimal tax transaction structure. We also recommend our articles on the topics of Company sale taxes and Sell GmbH Taxes. In terms of content, it focuses either solely on income taxes or also examines social security contributions, withholding taxes and other types of taxes, such as turnover tax. So, has the seller always fulfilled his tax obligations correctly or are claims to be expected.

Audit points in tax due diligence include:
  • Annual financial statements and tax balance sheets for the last three years (sometimes beyond)
  • Tax balance sheets, tax returns and tax assessments mostly for the last three assessment periods
  • Tax and social security audit reports
  • Statement of provisions and evidence of pension provisions

Market Due Diligence Checklist (MDD)

In this part of the investigation, the market in which the company for sale operates is examined. This includes, among other things, an examination of the competition, the company's own market position and the potential market volume. The result is a detailed overview of the existing organisation, processes and competencies in marketing and sales as well as a realistic assessment of the risks and potential of this asset in the context of a transaction. After all, the buyer is buying the future and wants to ensure that the business model will continue to function in the market for many years to come or can be expanded.

Audit points in market due diligence include:.
  • Organisation
  • Overview of sales in the last three business years broken down
  • according to the main product groups
  • Market and competitiveness
  • Degree of digitalisation and innovation Presentation of the short, medium and long-term market strategy
  • Dependencies or so-called "cluster risks" (this is the term used when there are above-average dependencies on a small number of suppliers or customers). (this is the term used to describe risks when there are above-average dependencies on a few suppliers or customers) on the customer or supplier side.
 Action/ documents to be obtainedPriorityrequestedis presentcheckedNotes
C1Overview of turnover in the last three business years broken down by the main product groups     
C2Listing of the most important competitors with estimated market shares     
C3List of all active customers (ABC) with their turnover and special characteristics     
C4Presentation of the short-, medium- and long-term marketing strategy     
*Excerpt of a sample due diligence checklist

Commercial Due Diligence (CDD)

Commercial due diligence deals with the business model of the target company. It is considered the mother discipline of all due diligences, as it requires special expertise in the company's business. Due to the high effort and costs involved in commercial DD, it is only used for large corporate transactions. In practice, there are overlaps with MDD.

Audit points in commercial due diligence include:
  • Success factors of the business model
  • Crisis resilience
  • Market development

Financial Due Diligence Checklist (FDD)

Financial due diligence comprises the detailed analysis of the current financial situation of a company as well as its planned financial development. The results of financial due diligence are used for determining the purchase price, drafting purchase agreements, conducting negotiations and as a basis for integration plans.

Audit points in financial due diligence include:
  • Earnings, assets and financial position
  • Financial debt
  • Working capital
 Action/ documents to be obtainedPriorityrequestedis presentcheckedNotes
B1List of bank accounts incl. balances and credit lines     
B2Balance sheets and G & V accounts together with auditor's reports for the last three financial years     
B3Financial planning for the next 12 months (G. U. V., liquidity, cash flow) and 60 months (G. U. V. roughly calculated)     
B4Investment planning for the next 36 months     
*Excerpt of a sample due diligence checklist

Technical Due Diligence (TDD)

Technical due diligence covers all technical aspects of the company to be sold: starting with the building fabric, building technology and maintenance/settlement up to building law. All technical aspects, especially of plants and real estate, are put to the test here in order to obtain a precise knowledge of their condition and to identify a possible investment backlog.

Environmental Due Diligence (EDD)

Environmental due diligence provides detailed information and statements on the current status of compliance with environmental regulations and environmental liability law. In addition, costs for the elimination of environmental risks such as contaminated sites, soil contamination, hazardous substances or emissions are determined. Since these items harbour immensely high cost risks or can even develop into "deal breakers", an ESG DD is indispensable, especially for industrial and commercial sites as well as for real estate objects.

IT Due Diligence (ITDD)

Digitalisation is changing traditional business models and thus entire industrial landscapes. The inclusion of the IT infrastructure audit should be a matter of course by now. A decisive factor in IT due diligence relates to the plans and intentions of the buyer. The crucial question here is whether the IT of the acquired company is either to continue to be used or is to be migrated to a uniform system after the acquisition. This can then entail considerable investments.

Audit points in IT due diligence include:
  • IT Infrastructure: Hardware & Software
  • Nets
  • Resources
  • Processes
  • DSGVO & Data Security

What is vendor due diligence and what are its benefits?

If the seller commissions the due diligence, this is referred to as a "Vendor Due Diligence". While in 'buy side due diligence' the buyer is the client of the due diligence (careful analysis and evaluation of companies in the run-up to M&A transactions), the initiative for the examination in 'vendor due diligence' comes from the seller. This is less often the case with SMEs, but it does happen.

Advantages:

On average, a VDD leads to a larger selection of suitable (!) prospective buyers, especially financial investors. The VDD is often used in bidding procedures. Particularly for less experienced sellers, VDD offers the opportunity to identify potential successes at an early stage, to realistically estimate the purchase price and to maintain better control over the process. In addition, risks can be identified and ideally eliminated before the sales process begins. Nevertheless, the VDD makes it more difficult to keep the transaction process secret in one's own company.

Disadvantage:

The seller invests considerably in this effort in advance and could, in the worst case, be left sitting on it without success.

The Due Diligence Checklist as PDF for Download

Download KERN's Due Diligence Checklist for free NOW!

? To the checklist

We at KERN-Unternehmensnachfolge.Erfolgreicher. are aware of the complexity of both the sale of a company and the Company succession and the Company acquisition. For almost 20 years, our group of advisors has focused exclusively on business succession and, thanks to this experience, can now solve in depth all the questions and tasks that are of importance to entrepreneurs and companies in these important concerns. The due diligence checklist provided here for free download is based on Excel and can therefore be directly edited as a PDF. It does not (!) claim to cover all topics and possibilities, but represents a larger excerpt of usual contents. 

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How does due diligence work?

The due diligence process is similar in most projects. In the case of company takeovers, the due diligence is generally carried out by the buyer with the help of external advisors (exceptions are bidding procedures, which are not explained in more detail here). Depending on the issue, these can be lawyers, auditors or experts for specific audit fields. In the article Due Diligence ProcessLearn how to plan due diligence in a structured way.

What information should a seller not disclose?

The seller should anonymise essential points of his business model. This includes lists of employees, customers and suppliers, recipes, design documents with technical details or similar.

To what extent must data protection be observed in accordance with the GDPR?

In the context of a DD, prospective buyers regularly request the seller to disclose certain data. After all, the prospective buyer has an interest in obtaining as detailed information as possible about the target company in the run-up to a company purchase. In the past, data protection issues hardly played a role in corporate transactions. Due to the low sanctions, awareness of the problem was only weak among buyers and sellers. With the entry into force of the General Data Protection Regulation (GDPR) in May 2018, this has fundamentally changed due to the significant tightening of the sanction framework for data protection violations. Although the GDPR is not tailored to M&A processes, its contents must be complied with.

Tip: Company owners are therefore well advised to pay due attention to the issue of data protection well before the start of a DD. In family businesses in particular, we often recommend passing on employee and customer data in anonymised form (the key is only disclosed in the contract) and subsequently guaranteeing this data passed on as part of the DD in the purchase contract. On the one hand, this takes into account the requirements of the GDPR and, on the other hand, safeguards your business in the event that the sale of the company fails. Because in the event of a project termination, your prospective buyer only has anonymised data of your customers and employees.

What does due diligence cost?

Usually, buyer and seller agree on a time period for the due diligence. For smaller transactions, due diligence can be completed in a few days. Here, to ensure confidentiality, a selling entrepreneur will often compile the information himself or involve only a few trusted people in the company in the project.

The larger the company, the more extensive and time-consuming the process of due diligence becomes. In large transactions, a DD often takes several weeks or months and this costs time and money and ties up capacities. The time required for preparation varies from individual to individual.

In our medium-sized business projects from KERN-Unternehmensnachfolge. More successful. a DD takes on average between three and eight weeks and is usually accompanied by an experienced tax advisor and a lawyer. Depending on the effort and complexity, the costs for the preparation, the compilation of the information, the creation of the data room and the coordination between the buyer and the seller are as follows in the low to mid five-digit range.

Tip: In some cases, the high effort can be reduced by carrying out a red flag (see below for explanation) due diligence at the beginning of the process.

Does the buyer or seller bear the costs of the due diligence?

As a rule, due diligence is paid for separately by the buyer and the seller on both sides. The buyer decides which experts will carry out how intensive an examination and which risks he will take without an examination, or which warranties he will demand from the seller.

The opposite is the case with vendor due diligence: here, the company seller has all the important information gathered himself. Even if this variant initially involves more effort and higher costs, vendor due diligence also offers the seller advantages.

Among other things, the seller retains control over confidential information, as only the result of the VDD audit, but no other documents, are stored in the electronic data room. In addition, the audit allows the seller to identify weaknesses at a very early stage and either remedy them or proactively disclose them to potential buyers before the letter of intent phase. The otherwise not uncommon discussions about purchase price reductions in the contract negotiation compared to the letter of intent are thus minimised to a maximum.

What is Red Flag Due Diligence?

A red flag due diligence clarifies in advance, based on the most important points for the transaction, whether an extensive due diligence of the target company is worthwhile at all. Designed to be as lean as possible, it initially keeps time and costs low. The results, often summarised in key words with a view to the main risks or deal breakers in the so-called Red Flag Report, then decide on the further course of action. Company sale procedure.

After the red flag due diligence, the potential buyer already has an initial overview of the most important subject areas and can decide on this basis whether he would like to investigate further subject areas as part of a more in-depth due diligence.

Conclusion

Adequate and thorough due diligence is money well spent for buyers and sellers. The objection that the effort involved may be too high does not stand up to a fact check. During a due diligence, the information provided by the seller on the sales project is checked, the company is screened for hidden defects and checked against the sales price. If the due diligence confirms the information provided in advance by the seller, there is investment security. 

If the due diligence reveals clear, previously unnamed risks or weaknesses, there is room for renegotiation.

For further questions on our due diligence checklists and other supporting documents, please feel free to contact experts from our advisory group.

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