Toronto business and franchise lawyer Sukhi Hansra, JD, MBA, of Hansra Law explains what due diligence means, the three different things people use the phrase for, and what it involves when you are buying a business.
You have probably heard the phrase used three different ways in the same week. A lawyer uses it to mean the investigation before a purchase closes. A safety consultant uses it to mean a legal standard an employer has to meet. A friend uses it to mean checking someone out before you trust them. All three are correct, which is why the term is confusing.
This page separates those meanings, then goes into what due diligence involves when you are buying a business, which is where most people who ask the question are actually headed.
On this page
- What due diligence means
- What “doing your due diligence” means in everyday use
- What acting with due diligence means as a legal standard
- What to check when you buy a business
- What belongs on a due diligence checklist
- The steps in a due diligence process
- How much due diligence is enough
- Due diligence on a person or a counterparty
- What a due diligence report is, and who produces one
- How to write a due diligence report
- Where this becomes a legal question
This article is general business and legal information, not advice for your specific situation. What due diligence should cover, and how far it needs to go, depends on the business and the deal. Speak with a lawyer about your own transaction before you commit to anything.
What due diligence means
Due diligence is the investigation you carry out before you commit to something, so that you are deciding with facts instead of assumptions. In a business purchase it means examining the company’s finances, contracts, assets and legal position before you sign. The phrase also carries a second, older meaning as a standard of care in law.
Both meanings share the same idea. You are expected to take reasonable steps to find out what you are getting into, and the reasonableness is judged by what a sensible person would have done in your position rather than by what you happened to feel like doing.
The difference is what turns on the outcome. In a transaction, diligence protects your money. As a legal standard, diligence can protect you from liability.
Two features of the transactional sense catch people out. Diligence is something the buyer organises and pays for, so nobody will run it on your behalf unless you arrange it. And it is bounded by time, because the seller will only hold the business off the market for an agreed period, which means the investigation has to be scoped to what can realistically be finished inside that window.
What “doing your due diligence” means in everyday use
In ordinary conversation, doing your due diligence just means checking something properly before you rely on it. Reading the contract before signing. Looking up a supplier before placing a large order. Asking for references before hiring. The phrase has drifted well beyond its legal origins into general use.
That loose usage is fine, and there is nothing wrong with the phrase being used that way. It becomes a problem only when somebody assumes an informal look counts as the real thing in a transaction. Reading a seller’s summary of their own financial performance is not due diligence on a business, even though it feels like doing your homework.
The distinction worth holding is between looking at what you were given and testing what you were told.
What acting with due diligence means as a legal standard
Acting with due diligence means taking the level of care a reasonable person would take in the same circumstances. The Canadian Centre for Occupational Health and Safety defines it as “the level of judgement, care, prudence, determination, and activity that a person would reasonably be expected to do under particular circumstances”. Meeting that standard can operate as a legal defence.
That standard-of-care sense is most often used in workplace safety, where an employer who can show reasonable precautions were taken may have a defence if something goes wrong. The critical part is timing, and CCOHS puts the point directly, noting that due diligence “is demonstrated by the actions taken before an event occurs, not after”.
The same logic runs through the transactional sense. Diligence done after closing is just discovery of a problem you now own.
What to check when you buy a business
When you buy a business, check the things that determine whether the earnings are real, whether the assets are actually the seller’s to sell, and whether liabilities follow the business to you. That means the financial records, the corporate records, the material contracts, the employees, the assets and any security registered against them, the premises, the tax position, and any litigation.
BDC describes the purpose plainly. Due diligence “allows you to understand the target business better. It confirms your investment thesis and identifies the risks involved.” You are testing whether the business you have been told about is the business you are buying.
Four Ontario items get missed because the standard American checklists never mention them. A PPSA search shows what security has been registered against the business assets in the provincial personal property registry, which tells you whether a lender already has a claim on the equipment you thought you were buying clear of debt. A WSIB clearance certificate shows whether the business is current on its workplace insurance premiums. The corporate minute book matters most in a share purchase, because you are buying the corporation itself and need to know the shares were properly issued. And the landlord’s written consent is needed before most commercial leases can be assigned to you.
That last one is the item that most often holds up a closing. In our own practice acting on business purchases, landlord consent is the item most often still outstanding when a buyer wants to close. Landlords run on their own timelines and they have no particular interest in yours, so the practical consequence is a closing that gets delayed until the landlord is ready to act.
If you are working through an acquisition end to end, our guide to buying an existing business sets out where diligence sits in the wider process.
What belongs on a due diligence checklist
A due diligence checklist for a private acquisition covers eight categories: financial records, corporate records, commercial contracts, employees, assets and liens, real property, tax, and litigation and compliance. Each category asks the seller for a defined set of documents and tests a single question about the business.
Eight categories is enough for almost any owner-operated company. The checklist a corporate development team would use for a public-company acquisition runs to hundreds of line items, and handing that to someone buying a single operating business teaches them to look for risks a small company does not have.
BDC recommends asking for “accountant-prepared year-end financial statements for at least the past three to five years”. The reason to ask for several years rather than one is that a single good year tells you nothing about whether the earnings repeat.
Go back further than that if you are buying shares, because you inherit the corporation’s tax history along with everything else. CRA’s normal reassessment window runs three years from the original notice of assessment for a Canadian-controlled private corporation, and four years for other corporations, businesses are required to keep their records for six years, and where there has been misrepresentation the window does not close at all. An asset purchase largely sidesteps this. A share purchase does not, which is why the tax file deserves more years than the commercial review strictly needs.
The steps in a due diligence process
The process runs in a fixed order. You sign a letter of intent, which usually includes exclusivity and a diligence period. You send the seller a single numbered request list. Documents arrive and you review them, with your accountant on the financial side and your lawyer on the legal side.
Findings then either change the price, become closing conditions, or get covered in the purchase agreement.
Here is how that runs in practice. A buyer signs a letter of intent with a 60-day exclusivity period, sends a request list in week one, receives financial statements in week two and the lease in week four, discovers in week five that the landlord will not consent to an assignment without a personal guarantee, and renegotiates the price to reflect it. That is a normal diligence process, and the problem surfaced in time to be worth something.
BDC puts the whole exercise at “six to 12 weeks or longer, depending on the complexity of the company and transaction”. Work backwards from that when you agree an exclusivity period, because exclusivity that expires mid-diligence protected nothing.
How much due diligence is enough
Enough is the point where the remaining unknowns are ones you would accept, priced, in writing. There is no fixed depth, and the sensible amount scales with what you are risking, how complicated the business is, and how much of the price you are paying on closing day rather than holding back.
Three things pull the scope up. A share purchase needs more than an asset purchase, because you inherit the corporation’s whole history. A business whose revenue sits with two or three customers needs more work on those relationships than one with two hundred. And a deal paid entirely in cash at closing leaves you nothing to set off against later, so anything you miss is simply yours.
Three things let you stop earlier. A short list of outstanding items you have deliberately accepted. A holdback or a vendor take-back note that gives you something to claim against. And representations in the purchase agreement, backed by an indemnity, covering the ground you did not have time to test yourself.
The most useful discipline is to sort every outstanding item into one of two piles as you go. Some things have to be confirmed directly, because no promise from the seller is worth as much as seeing the document. Others can safely be covered by a representation and warranty in the purchase agreement, backed by an indemnity, because if the answer turns out to be wrong you have a route to recover. Once an item is genuinely in the second pile, paying for another week of investigation is buying protection you already have.
The honest answer is that you never finish. You reach a point where the cost of another week of professional fees is larger than the risk that week would retire, and you should be able to say out loud what you are choosing not to check.
Due diligence on a person or a counterparty
Due diligence on a person means confirming who you are dealing with and whether they can do what they are promising. Some of it is documentary and some of it is searches, and the searches are the part buyers skip because they do not know the list exists.
On a person or a company you would normally run a corporate search to confirm the entity exists and who controls it, a PPSA search for registered security against their assets, a Bank Act security search, litigation searches in the relevant courts, and a search for writs of execution against them. Depending on the deal you may add bankruptcy and insolvency, corporate profile searches in other provinces, and lien searches specific to the industry.
Beyond the searches, confirm any licence or registration they claim to hold, and take references from people who have actually dealt with them rather than from the names they volunteer.
The scope should match what is at stake. Confirming a supplier’s corporate status before a modest order is proportionate. Taking on a joint venture partner, or agreeing to a vendor take-back where the seller finances part of your purchase, justifies considerably more.
Where the person is on the other side of a transaction, the most useful question is often the simplest one. Ask what they are going to do after the deal, and check whether the answer is consistent with what the documents say.
What a due diligence report is, and who produces one
A due diligence report is a written summary of what the investigation found, organised by category, setting out the issues, their significance, and what should be done about each. There is no single official version and no standard form. Different advisors produce different parts of it.
Your accountant produces the financial diligence report, covering earnings quality, working capital and tax exposure. Your lawyer produces the legal diligence report, covering corporate records, contracts, employment, litigation and any security registered against the assets. On larger deals a specialist may add an environmental or IT report.
You get one by engaging those advisors and telling them what the report is for. That last part matters more than buyers expect. A report scoped for your own information reads differently from one a lender will rely on, and retrofitting reliance afterwards usually means paying for a reissue.
How to write a due diligence report
Write it in the order a decision-maker needs it. Open with the findings that could change the deal, then the ones that change the price, then the routine confirmations. Group everything by category, state what was reviewed, state what was found, and say plainly what you recommend doing about each item.
Two habits make a report useful rather than decorative. Say what you could not verify, because an unanswered request is a finding in its own right and often the most important one. And attach each finding to an action, so the reader knows whether it means renegotiate, add a closing condition, or simply note it.
Keep the summary short enough to be read. A report nobody finishes has failed regardless of how thorough the underlying work was.
Where this becomes a legal question
Diligence findings have to land somewhere in the purchase agreement, and that is the point where the exercise turns legal. A problem you discover changes the price, becomes a condition of closing, gets fixed by the seller before you close, or is covered by a representation backed by an indemnity that survives long enough for you to use it.
Buyers who ran genuinely good diligence still lose money when nothing is done with what they found. Discovering an unpaid remittance or a customer contract that cannot be assigned is only half the work, and the easier half. How the finding is handled depends on the deal structure, which is why our guide to asset purchase versus share purchase is worth reading alongside this one, and why the terms you set in the letter of intent shape how much room you have to act on anything diligence turns up.
The underlying point is worth stating plainly. It is far better to find out a deal is bad early than to find out after you have spent tens of thousands of dollars on lawyers and other professional advisors.
Conclusion
Due diligence means checking properly before you commit, whether that is a legal standard of care or the investigation before a purchase. When you are buying a business, it means testing the financial records, the corporate records, the contracts, the employees, the assets, the premises, the tax position and the litigation history, and then making sure what you find actually changes the agreement.
Although these are good starting points, every acquisition turns up something the standard categories did not anticipate, and how it should be handled depends on facts a general article cannot know about your deal. A good next step is to speak with someone who has worked through it before, whether an Accountant or a Business Lawyer. Our guide to negotiating the purchase or sale of a business covers the stage that follows.
If you are partway through due diligence and want your findings read against the draft agreement, schedule a complimentary discovery call with our firm, or reach the office at 416-580-0345.
