What is due diligence and why is it crucial when buying or selling a business?

Imagine you are about to sign the purchase of a technical services company in the province of Valencia. The figures the seller has shown you are good, the team seems stable, customers come back year after year. You sign. And three months later you discover that there is an open employment dispute, that the contract with the main customer expires in six months with no renewal clause, and that the EBITDA was inflated by one-off income that will not be repeated.

This scenario is avoided with properly conducted due diligence. And it is not a luxury reserved for large transactions — it is a necessity for any business sale or acquisition, however small.

In this guide we explain what due diligence is, which areas it covers, how long it takes and why it is probably the most important step in the whole buying and selling process.

What exactly is due diligence?

Due diligence is a thorough, systematic investigation that the buyer (or their team of advisers) carries out on the target company before completing a sale and purchase transaction. Its purpose is to verify that the information provided by the seller is complete, accurate and consistent — and to detect hidden risks that could affect the price or the decision to buy.

The term comes from English and is literally translated into Spanish as "diligencia debida". In the Spanish M&A context it is used as it is — due diligence or DD — because it is standard industry terminology.

In the Valencian Community (Comunidad Valenciana), where a large share of transactions involve SMEs, due diligence does not need to be as extensive as in a large transaction. But it must cover the critical points. Illustrative example: the owner of a distribution company in the Vinalopó district (comarca) thinks his accounts are perfect until the buyer finds inconsistencies in the provisions. They are not serious, but they delay completion by three weeks.

Why is due diligence so important?

Because it is the only moment when the buyer has full access to the real information about the company — and the last opportunity to renegotiate terms or walk away without significant cost.

According to an article published in Harvard Business Review (Christensen et al.), the failure rate of mergers and acquisitions is between 70% and 90% [1]. Possible causes include insufficient due diligence, misaligned expectations and undetected operational problems.

For the seller, due diligence is also critical. A company that is not ready to be scrutinised inspires mistrust, slows down the process and, in many cases, gives the buyer arguments for lowering the price. Generally, sellers who prepare their documentation before starting the sale process achieve faster completions and prices closer to their initial expectations.

Which areas does due diligence cover?

Full due diligence analyses the company from several angles. These are the main areas [2]:

Financial due diligence

This is the core of any review. It analyses:

• Annual accounts for the last 2-3 financial years (balance sheet, profit and loss account)
• Normalised EBITDA — removing exceptional expenses, non-recurring income and the owner's personal expenses
• Net financial debt — loans, credit lines, outstanding obligations
• Working capital — debtors, creditors, stock, cash
• Financial projections and their consistency with historical performance

If you are thinking of finding out what your business is worth, bear in mind that due diligence is what turns that indicative estimate into a real, negotiable number.

Legal and corporate due diligence

The legal structure of the company is reviewed:

• Articles of association and shareholders' agreements
• Powers of attorney granted and in force
• Pending litigation or threatened litigation
• Key contracts (customers, suppliers, leases)
• Licences, permits and administrative authorisations
• Intellectual and industrial property

In the Valencian Community, municipal activity licences and environmental permits are points that frequently cause surprises, especially in industrial companies in Castellón and in hospitality businesses in Valencia (see our businesses for sale).

Tax due diligence

This reviews compliance with tax obligations:

• VAT (IVA), Corporate Income Tax (Impuesto sobre Sociedades) and personal income tax (IRPF) returns
• Open or recent tax inspections
• Debts with the tax authorities (Hacienda) or Social Security
• Tax incentives applied and their justification

A smart buyer wants to know they will not inherit tax problems. And a prudent seller resolves any contingency before putting their company on the market.

Employment due diligence

People are a fundamental part of the value of any SME:

• Employment contracts and working conditions
• Length of service of the workforce and potential severance costs
• Applicable collective agreement (convenio colectivo)
• Key staff and retention clauses
• Open employment disputes or risk of claims

In technical services and manufacturing companies, where the team's qualifications are a critical asset, the employment review is especially important (see our businesses for sale).

Operational due diligence

This assesses how the business works in practice:

• Documented processes vs. knowledge in the owner's head
• Dependence on the owner in day-to-day operations
• Condition of the assets (machinery, vehicles, facilities)
• Relationships with suppliers and concentration risk
• IT systems and technology

This is where many SMEs in the Valencian Community show weaknesses. Not because the business works badly, but because it works too well "in the owner's head" — which reduces its market value. If this is your case, it is something that can be improved before selling. The operational transformation team at Alcara Partners works on precisely this: systematising processes and reducing dependence on the owner so that the company is worth more when the time comes to sell it.

How is due diligence organised in practice?

The process follows a logical sequence of phases [3]:

1. Signing the NDA — Before sharing any sensitive information, seller and buyer sign a non-disclosure agreement (NDA). This is non-negotiable.

2. Preparing the data room — The seller (usually with help from their adviser) gathers all the documentation and organises it in a secure space — physical or virtual. Today, a virtual data room is the norm.

3. Review by the buyer's advisers — Lawyers, accountants and, if necessary, sector experts review the documentation. They ask questions, request clarifications and ask for additional documents.

4. Q&A sessions — Rounds of questions and answers between the teams. In SMEs, many of these conversations take place directly between buyer and seller.

5. Due diligence report — The buyer's advisers issue a report with findings, identified risks and recommendations. This report is the basis for the final price negotiation.

6. Renegotiation (if applicable) — If the due diligence reveals problems, the buyer can ask for a price reduction, additional guarantees or, in extreme cases, withdraw from the transaction.

What common mistakes are made in due diligence?

These are the most common mistakes:

• Relying only on the official accounts: The annual accounts do not always reflect the economic reality of the business. Normalised EBITDA can be very different from the reported figure.
• Not reviewing key contracts: A lease that expires in 6 months can completely change the valuation.
• Ignoring dependence on the owner: If the company does not work without the seller, that affects the value and the risk of the transition.
• Doing the due diligence too late: When there is already emotional and financial pressure to complete, it is harder to walk away in the face of negative findings.
• Not asking for professional help: In SMEs, there is a temptation to "do it yourself". The risk of overlooking something does not justify the saving.

What happens if the due diligence reveals problems?

The deal does not necessarily fall through. In fact, it is rare for due diligence not to reveal some finding. What matters is how it is managed:

• Price adjustment: The most common route. If a tax contingency of €30,000 appears, the price falls by €30,000 (or a proportional discount is negotiated).
• Seller's warranties (reps & warranties): The seller undertakes to indemnify the buyer if certain risks materialise after completion.
• Retention of part of the price (escrow): A percentage of the price is deposited in an escrow account for a set period.
• Conditions precedent to completion: The seller must resolve certain problems before final signing.

Transactions that reach due diligence rarely fall through because of minor findings. They fall through when serious problems appear that the seller had not disclosed — or when the real figures are significantly worse than those presented.

How do you prepare your company to pass due diligence?

If you are thinking of selling your business, these steps will help you get through due diligence without any shocks:

1. Put your accounts in order in good time, well before starting the sale. Remove personal expenses and regularise any outstanding tax matters.
2. Document your processes. A buyer wants to see that the business can run without you.
3. Review your contracts. Renew those about to expire, especially leases and contracts with key customers.
4. Resolve pending litigation. Any open claim is a warning sign.
5. Prepare a basic data room. Having all the documentation organised before the buyer asks for it conveys professionalism.

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At Alcara Partners we support both buyers and sellers during due diligence. For buyers, we help identify what to review and what questions to ask. For sellers, we prepare the company and the documentation so that the process runs smoothly and the price holds.

If you are thinking of selling, the first step is to know the real value of your company. Our tool gives you an indicative estimate in less than 3 minutes.

How much is your business worth? Find out free in 3 minutes →

Frequently asked questions

What is due diligence in the sale and purchase of a business?

Due diligence is a thorough investigation that the buyer carries out on the target company before completing the acquisition. It covers financial, legal, tax, employment and operational areas with the aim of verifying the seller's information and detecting hidden risks that could affect the price or the viability of the transaction.

How long does due diligence take for an SME?

For a typical SME in the Valencian Community, due diligence usually takes several weeks, depending on the complexity of the company, the quality of the documentation available and the number of areas to be reviewed. If the seller has the documentation well organised, the process is considerably shorter.

Who pays for the due diligence?

Generally, the buyer pays the costs of the due diligence, as they are the one who hires the professionals who carry it out (lawyers, auditors, consultants). The seller bears the costs of preparing and providing the documentation, and of answering the buyer's queries.

Can due diligence be done without advisers?

Technically yes, but it is not advisable. A buyer without M&A experience can overlook significant risks in financial, legal or tax areas.

What documents do I need for due diligence?

The basic documents include: annual accounts for the last 2-3 financial years, tax returns, contracts with main customers and suppliers, employment contracts, property deeds or leases, activity licences, and any pending or potential litigation. At Alcara Partners we provide every seller with a detailed checklist.

What happens if the due diligence uncovers problems?

It depends on how serious they are. Minor findings (small tax contingencies, contracts about to expire) are usually resolved with a price adjustment or with seller's warranties. Serious findings (fraud, significant hidden debts, serious undisclosed litigation) can lead to the transaction being cancelled.

Is due diligence compulsory?

It is not legally compulsory, but it is standard in any professional sale and purchase transaction. Not carrying out due diligence is comparable to buying a house without having it inspected — you can do it, but you are taking on an unnecessary risk.

How do you carry out due diligence on a small company?

For small companies, due diligence can be simplified by focusing on: verifying the real accounts (not just the reported ones), reviewing the main contracts, the tax and employment situation, and assessing dependence on the owner. A lawyer and an accountant with experience in business sales and acquisitions can complete it in a short time.

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References

[1] Christensen, C. M., Alton, R., Rising, C. and Waldeck, A. "The Big Idea: The New M&A Playbook." Harvard Business Review, March 2011.

[2] Cámara de Comercio de Sevilla (Seville Chamber of Commerce). "Contenido Due Diligence." (Due diligence contents). camaradesevilla.com.

[3] Mariscal & Abogados. "Fases de la due diligence en el marco de la transmisión de empresas en España." (Phases of due diligence in the context of business transfers in Spain). mariscal-abogados.es.