Due diligence gets described as verification, which undersells it. You are not confirming that the seller’s numbers add up. You are working out what you are actually buying, which is usually a slightly different business than the one in the deck.
The gap is rarely fraud. It is more often a seller who ran things a certain way for years, made choices that were reasonable while they owned it, and never had to write those choices down. When you own a business, you can roll with the punches on a compliance gap or a sloppy account. When you are buying one, you are buying the exposure. That is the difference diligence makes.
What follows is the order we work in on financial due diligence engagements, roughly from the items that most often kill or reprice a deal down to the ones that shape your first year. Here’s a checklist when doing buy-side due diligence.
Sales Tax Is the First Thing to Look At in an Asset Deal
Most buyers assume an asset purchase walls them off from the seller’s tax history. For income tax that is broadly the case. It stays with the seller, and the purchase agreement handles it.
Sales tax behaves differently because of successor liability. Even when you buy assets rather than equity, an unpaid sales tax obligation can follow the business to you. In an asset deal, income tax stays with the seller and sales tax can follow you home. That is why it sits at the top of the list.
The pattern shows up most in businesses that operate across state lines. On trades and service businesses you tend to find one of two things: they never charged sales tax on out-of-state work, or they charged their home state’s rate on work performed somewhere else. Either one is an exposure you are inheriting, and neither will be flagged in the financials, because from the seller’s point of view nothing was ever wrong.
Worth saying plainly: indemnification language is not the same as protection. Something can be legally the seller’s problem and still be your headache for a year. Legal responsibility and practical pain are two different things.
How Do You Know the Revenue on the Page Is Real?
Revenue is the number everyone trusts and the one most often distorted by how the seller used their software rather than by any intent to mislead.
The most common version we find is the accounting file used as a customer relationship manager. Some owners create an invoice to log an estimate or a phone quote, never close it out, and never reverse it. Pull revenue from that file without knowing the habit, and you are counting quotes that never converted as sales. Always ask how they used the tool, not just what it printed.
Promotional mechanics are the other big one. On e-commerce targets, giveaway discounts and free gift cards drive conversions, which means the reported conversion rate and average order value already carry the effect of the promotion. The revenue is real, but it is not the revenue you would produce without running the same promotion, and the cost of honoring what was given away is still ahead of you.
The last check is directional rather than forensic. Look at top line and profit together. A business holding profit while revenue contracts is a different risk than one where both are growing. Profit tells you it is managed well. Revenue tells you people still want what it sells.
Liabilities That Never Made It Onto the Balance Sheet
The obligations that hurt are the ones nobody put in the accounting system, because they do not show up in any ratio you would think to run.
Outstanding gift card and store credit balances are the standard example in consumer businesses. On one e-commerce diligence, we found a six-figure balance issued through a promotional program, with redemptions running at a small fraction of it. On the surface, it read as a minor line item. In reality, the buyer would inherit the whole obligation; the redemptions carry real product and shipping costs when they land, and these balances tend to have a long legal shelf life. Selling the business later does not make them disappear either. The next buyer asks the same question.
Uncollected sales tax belongs in this category too, alongside unremitted payroll obligations and customer deposits. On one deal, the sellers had been operating for over a year without collecting or remitting sales tax, and had unrecorded gift card liabilities sitting off the books. Neither appeared anywhere in their own financials. Diligence was the only reason it surfaced.
One more place this surfaces is at the closing table itself, when the parties have to agree on what working capital actually transferred. If you haven’t thought through how that number gets calculated, the post-close true-up can catch you off guard. It’s worth understanding how working capital adjustments work before you’re negotiating them under deadline pressure.
Accounts receivable deserves a specific mechanic rather than a spreadsheet. After close, customers keep paying the account they have always paid. We worked a purchased receivables reconciliation where a meaningful sum landed in the seller’s old account before anyone caught it, and the seller had to remit it back. A proper reconciliation template on day one prevents that from becoming an argument in month three.
Costs That Are Understated Rather Than Hidden
Some expenses are on the profit and loss statement at a number that was true for the seller and will not be true for you.
Insurance is the reliable one. Small operating businesses are almost always underinsured relative to their actual volume. A basic liability policy at a few hundred dollars a year does not cover a business that needs real product liability or errors and omissions coverage, and benchmarking it properly can move that line by several multiples. That delta is a cost you normalize in before you price the deal.
Shared services are the subtler one. On a recent engagement, part of the target’s accounting cost was hitting its own profit and loss statement while other work flowed through a parent entity. From the outside the target looked leaner on overhead than it was. The adjustment was not about disputing anyone’s books. It was about surfacing the costs the buyer absorbs once those shared services go away.
Performance-based contractor pay needs the same treatment. If someone is compensated on attributed revenue, you have to understand the attribution model before you accept the number, then reconstruct what the compensation would have been under that same method in earlier periods and project it forward. Skip that and you are budgeting an ongoing cost at less than it will be.
Who Actually Knows the Answer to Each Question?
Map the target’s finance function early, because the person who prepares the tax return and the person who keeps the books usually see completely different things.
We have worked deals where the seller’s accountant handled annual compliance only. When asked whether the business was profitable, the honest answer was that they saw taxable income, which is not cash flow. That is not incompetence. It is scope. You just have to know it before you route a question to the wrong person and take the answer at face value.
One question worth asking every time: when did the current accountant take over, and why? If there was a sudden transition, the documentation from before it may simply be gone. Election confirmations, prior amended returns, entity history. That answer tells you exactly where the paper trail goes cold.
If you are getting inconsistent explanations of the same transaction from different people at an outsourced provider, treat that as a finding in itself. Messy books do not only slow diligence down. They create doubt about everything else in the financials.
Handshake Arrangements Are a Finding, Not a Footnote
When a seller says an arrangement is in place but nothing is documented, do not take the word for it. Either get an agreement executed before close or model it conservatively and carry it as a risk item.
This matters most with suppliers and overseas agents, where terms can shift the moment ownership changes. On one e-commerce target, the goods came through an agent who verbally claimed to handle all import compliance. Once we dug in, the representations were unverifiable, and there were real questions about declared values. The buyer had assumed the agent was clean. “The agent handles it” is not something you can put in a representation and warranty.
Payment terms deserve the same skepticism. Sellers will sometimes give three different answers about supplier timing, usually because there is no formal agreement and they are describing what they think happens. Pull the actual invoices and payments and reverse engineer it. The data tells a tighter story than the conversation will.
How Do You Deliver Findings Without Torching the Deal?
You almost never hand a seller the full report. Extract the relevant findings, frame them clearly, and leave room to respond. Walking into a call with a dense document and line-by-line commentary puts everyone on the defensive before anyone has said anything useful.
A short written summary sent ahead of the call works better. Present preliminary numbers as directional: the figures will tighten as documentation comes in, but the direction is clear. That sets the expectation that you have done real work while keeping the door open for corrections.
Hold your outlier months in reserve. If the deal is moving smoothly, leave them alone and stay on the main adjustments. If the seller starts contesting every line, those months become quantifiable negotiating currency.
Two Scopes, and Buyers Often Assume One Firm Covers Both
Quality of earnings and tax diligence are separate disciplines with different risk lenses. On plenty of deals, a quality of earnings provider is already engaged, and the tax scope is carved out entirely, which is where we come in. It is worth confirming rather than assuming that whoever you have hired is covering both.
A quality of earnings review tests whether the earnings are repeatable before your price is locked. The exposure items above are the reason a separate pair of eyes on the tax and liability side is usually worth what it costs, particularly on an asset deal where successor liability is live.
If you have a target under a letter of intent and want the financial side worked properly before you are committed, reach out to Ashford Sky.
