Definition
Due diligence is the investigation you carry out before committing to buy a business. It tests the financial records, tax position, contracts, employees, legal matters, operations and technology against what the seller has told you. Most of it happens after the letter of intent (heads of terms in the UK) and before the purchase agreement is signed, usually with an accountant and a lawyer. What you find shapes the price, the deal structure, the protections in the contract and whether you proceed at all.
A letter of intent sets out the main terms on which a buyer proposes to acquire a business, before due diligence and the full purchase agreement. In the UK the equivalent is usually heads of terms.
Heads of terms is the UK name for a short document recording the main commercial terms of a deal before the legal documents are drafted. It is the equivalent of a US letter of intent.
Worked example
Driftwood Pool Services is a fictional US business listed at $1,500,000 on SDE of $500,000.
- The buyer's accountant matches bank deposits to reported revenue and finds that $60,000 of the SDE came from a one-off contract that has ended.
- The buyer's lawyer finds that the largest customer can end its contract if the business is sold.
The buyer renegotiates to $1,300,000, with $100,000 held in escrow until that customer signs a new contract.
Seller's discretionary earnings (SDE)
Seller's discretionary earnings is the yearly financial benefit a business gives one full-time working owner, before financing costs, non-cash charges and one-off spending.
Escrow is an arrangement in which an independent third party holds money until agreed conditions are met. In a business sale it keeps part of the price available to cover claims after completion.
Why buyers care
Diligence is where the listing meets the evidence. It costs time and fees, so the order matters: check the issues that could end the deal, such as unreliable records, a dominant customer or contracts that do not transfer, before paying for detailed legal and accounting work.
Some checks can be done before you sign an NDA, using the listing and public records. The red flag screen and a Loupe dossier sit at that early stage. Neither replaces full diligence with access to the seller's records and your own professional advisers.
Non-disclosure agreement (NDA)
A non-disclosure agreement is a contract in which a potential buyer promises to keep information about a business confidential. Sellers usually ask for one before sharing the business's name or detailed figures.