Due Diligence for Buying a Business: What Your Lender Expects to See

Key takeaways

• Due diligence happens before you sign an unconditional contract - make the contract subject to finance and to satisfactory due diligence.
• The lender wants the financials reconciled to BAS and bank statements, not just copied from the vendor's information memorandum.
• A lease the landlord will not transfer, or one that ends before the loan does, can stop a deal on its own.
• Customer concentration is tested with simple arithmetic: what happens to earnings if the largest customer leaves?
• Findings change terms rather than simply passing or failing the deal: a lower amount, extra security, a covenant or a condition precedent.

Why does your lender care about your due diligence?

A lender assessing an acquisition is lending against a business it has never operated, often with goodwill as the largest asset. It will do its own credit work, but it cannot interview the customers or read every contract. So it leans on the buyer's due diligence, and the quality of that work shows up directly in the credit decision.

The government's guide to buying an existing business sets out six steps, with due diligence - reviewing financial records, operations and legal documents - coming before you sign the contract. In practice that means signing a contract that is conditional on finance and on due diligence, so you can walk away or renegotiate if the findings are bad. Sign unconditionally before checking and you are bound to settle whether or not a lender agrees to lend.

Due diligence has three streams, and lenders read all three: financial (are the earnings real?), legal (does the business own what it says and can it be transferred?) and operational (will it keep running after the vendor leaves?).

What financial records will the lender expect?

business.gov.au recommends examining the past three to five years of financials, listing tax returns, BAS, accounts receivable and payable, balance sheets, profit and loss, cash flow statements and sales records. A lender will want most of these, plus the work that connects them:

Have an accountant who acts for you, not the vendor, reconcile the accounts to the BAS and bank statements. A lender that does that reconciliation itself and finds a gap will question every other number in the file.

Which legal checks matter most to a lender?

• The lease. business.gov.au asks the key question directly: will the landlord agree to transfer the lease into your name, or will you need a new one? A lender also checks the term remaining, including options, against the loan term. A business whose lease ends in two years is hard to fund over five.
• Licences and permits. Whether they are current and whether they transfer with the business or must be issued afresh to you.
• Contracts. Supplier and customer agreements, especially change-of-control clauses that let the other side terminate on a sale.
• Security interests. A search of the Personal Property Securities Register shows whether assets you are buying are already pledged; business.gov.au lists debts secured on the PPSR among the liabilities to check. Anything registered must be released at settlement.
• The company and its people. Search the entity and its officers on ASIC's registers, including the banned and disqualified lists and published insolvency notices, and confirm the ABN and GST status on ABN Lookup.
• Intellectual property. Who owns the trading name, website, domain, software and customer data.
• Disputes. Current or threatened claims by customers, staff or regulators.

What will the lender ask about customers and suppliers?

Concentration is the risk lenders test most simply. For illustration: a business has revenue of $3,000,000, a gross margin of 40% and EBITDA of $450,000. Its largest customer buys $900,000 a year, 30% of sales.

Losing one customer removes $360,000 of gross profit and 80% of EBITDA. A lender looking at that will want the customer's contract, its remaining term, how long the relationship has lasted and whether it depends on the vendor personally. It may reduce the loan, add a covenant or ask for extra security. Test your own numbers in the ICR and DSCR calculator with the largest customer removed.

Suppliers deserve the same question: is there a single supplier, distributor or franchisor whose decision could end the business, and does their agreement survive a change of owner?

How are staff and employee entitlements handled?

This is general information; take employment law advice for your deal. In an asset purchase, employees are usually offered new employment by the buyer, and the contract should deal with accrued leave: either the vendor pays it out, or the buyer takes it on and the price is reduced to match. In a share purchase, the company remains the employer, so every accrued entitlement and any past underpayment stays inside the business you are buying.

Lenders care for two reasons. Unfunded entitlements are a cash call after settlement, and underpayment claims can be large and backdated. Ask for:

• A staff list with roles, pay, award or agreement, start dates and accrued leave.
• Evidence that superannuation has been paid on time.
• Any underpayment reviews, claims or correspondence with regulators.
• Which staff are critical, and whether they intend to stay.

If the business would struggle without one or two people, a lender may ask what retention arrangements are in place before it agrees to lend.

What ATO and tax checks should you do?

Ask the vendor for an ATO account statement and the BAS lodgement history for at least the last two years. In a share purchase, any tax debt stays with the company you are buying, so it is your problem from settlement; the contract should require it to be paid out of the price. In an asset purchase the debt generally stays with the vendor's entity, but a lender will still want to know about it, because a vendor with tax trouble may be selling under pressure and may struggle to honour warranties. Our guide to loans and ATO tax debt explains how lenders treat an existing debt.

Ask whether the business has an ATO payment plan in place, and have the vendor warrant in the contract that all lodgements are up to date at settlement, with a specific indemnity for any tax relating to the period before you took over.

Check, too, whether the sale is structured as the sale of a going concern for GST, and who bears any duty. Those questions belong with your accountant and lawyer before you sign.

What operational checks protect the loan after settlement?

• Equipment. Condition, service history and remaining life. Worn equipment is a capital cost the forecast must include.
• Stock. A count close to settlement, with slow-moving or obsolete items excluded or discounted.
• Systems and data. Accounting, booking and customer systems, and whether licences and data transfer.
• Documented processes. Whether the business can run from manuals and systems rather than the vendor's memory.
• Insurance. business.gov.au's guide to types of business insurance is a useful checklist. Lenders commonly require insurance over the assets they hold as security, with their interest noted on the policy.
• Handover. How long the vendor will stay, in what role, and under what restraint of trade.

Then put the findings in one place. A two-page due diligence summary - what you checked, what you found, and how the price or contract changed as a result - answers most of a credit analyst's questions before they are asked, and shows the lender that the buyer understands the business it is about to own.

How do due diligence findings change the loan terms?

Lenders do not usually say yes or no on a single finding; they price and structure around it. Banks tend to set tighter conditions and want more evidence. Non-bank cash flow lenders may accept more concentration at a higher rate. Lenders secured by property lean on that security and look less closely at the business, though they still need an exit. Our guide to business acquisition finance covers the structures. When your due diligence is done, post one business acquisition loan request on ADS and 200+ verified lenders and brokers can ask about it.

Frequently asked questions

How many years of records should I review before buying a business?

business.gov.au recommends examining the past three to five years of financials, including tax returns, BAS, balance sheets, profit and loss, cash flow statements and sales records. Lenders typically want at least two to three years plus current-year management accounts, reconciled to BAS and bank statements.

Does the lender do its own due diligence on a business purchase?

It does its own credit assessment, may order valuations of property or equipment and will run its own searches. But it relies heavily on the buyer's financial, legal and operational due diligence, and often asks to see the accountant's and lawyer's reports. Weak due diligence makes for a weaker loan request.

What is a PPSR search and why does it matter?

A search of the Personal Property Securities Register shows whether anyone holds a registered security interest over the business's assets, such as an equipment financier or a lender with a security interest over all assets. Those interests need to be released at settlement, or you may buy assets that someone else can claim.

What if the landlord will not transfer the lease?

Then you need a new lease, or the deal may not proceed. Many businesses are worth little without their premises, and lenders will not fund a purchase where the right to occupy is uncertain. Make the contract conditional on the landlord consenting to the assignment or granting a new lease.

Can due diligence findings reduce the purchase price?

Often, if the contract is conditional. Lower earnings than presented, unpaid tax, worn equipment or a short lease are all reasons to renegotiate. The lender will resize the loan on the real figures anyway, so a price that does not move may leave you funding a larger share yourself.

Related reading

• Business Acquisition Finance
• Can You Get a Loan With an ATO Tax Debt?
• Cash Flow Forecasts Lenders Accept

Sources

• Buy an existing business: due diligence and three to five years of financials — business.gov.au
• Search ASIC registers — Australian Securities and Investments Commission
• ABN Lookup: ABN status and GST registration — Australian Business Register
• Types of business insurance — business.gov.au