Due diligence is the buyer's investigation of the target before it commits. It has two jobs. The first is to confirm that the business is what the seller says it is: that the earnings are real and repeatable, the contracts say what the summary says, and there are no hidden liabilities. The second is to build the buyer's own view of what the business will do under its ownership, which drives the value creation plan and the financing.
Diligence is organized into workstreams, each run by a specialist adviser and coordinated by the deal team. The most important for valuation is the financial workstream, and its main output is the quality of earnings (QoE) report, which rebuilds the EBITDA on which the price and the debt are based and identifies the items that should reduce the price paid for the equity.
This topic covers the main workstreams and what each looks for, the structure of a QoE report, a worked bridge from reported EBITDA to diligence adjusted EBITDA, net debt and debt like items, and how findings change the price or the structure of a deal.
Key takeaways
- Diligence runs in parallel workstreams: financial, commercial, legal, tax, HR and benefits, IT and cyber, ESG and environmental, and insurance.
- A QoE report rebuilds EBITDA from reported figures through management adjustments to diligence adjusted EBITDA, accepting, rejecting or adding adjustments with evidence.
- Because the price is a multiple of EBITDA, each dollar of EBITDA removed in diligence removes the multiple times that dollar from enterprise value.
- Net debt in a deal includes debt like items, such as unpaid taxes, deferred consideration and deferred capex, which reduce the equity price dollar for dollar.
- Findings are handled through price, a special indemnity, an escrow, the working capital peg, a condition, or by walking away; the right tool depends on whether the issue is certain and quantifiable.
The workstreams
Financial diligence tests the historical earnings, the cash conversion, the working capital and the net debt, and usually reviews the forecast. Commercial diligence tests the market and the company's position in it: market size and growth, share, pricing power, customer satisfaction and churn, often through customer interviews and surveys. Its findings determine whether the forecast in the CIM is credible.
Legal diligence reviews corporate records, material contracts (especially change of control and exclusivity clauses), litigation, intellectual property, real estate, permits and regulatory compliance. Tax diligence looks for exposures in income, sales, payroll and transfer pricing, and designs the structure of the acquisition. HR and benefits diligence covers key employees, compensation, retention risk, pension and health plan liabilities and labour issues.
IT and cyber diligence assesses the systems, technical debt, data protection and security posture, including any past breaches, because a weak IT estate can need large investment after closing and a breach can create liabilities. ESG and environmental diligence covers contamination at sites (often through a Phase I environmental site assessment for US real estate), health and safety, governance and, increasingly for institutional investors, climate and social factors that their own limited partners ask about. Insurance advisers review existing coverage and, where used, arrange representations and warranties insurance.
| Workstream | Typical adviser | Key question | Typical red flags |
|---|---|---|---|
| Financial (QoE) | Accounting firm transaction team | Are earnings and cash real and repeatable? | Aggressive add backs, revenue cut off, weak cash conversion |
| Commercial | Strategy consultants | Is the forecast achievable in this market? | Customer concentration, share loss, price pressure |
| Legal | Law firm | What obligations and risks come with the company? | Change of control clauses, litigation, IP not owned |
| Tax | Accounting or law firm | What tax exposures exist and how should the deal be structured? | Sales tax nexus gaps, aggressive positions |
| HR and benefits | Benefits consultants, counsel | Will key people stay, and what do plans cost? | Underfunded plans, misclassified contractors |
| IT and cyber | Technology advisers | Do systems support the plan, and are they secure? | Unsupported systems, past breaches, no controls |
| ESG and environmental | Environmental and ESG consultants | Are there site, safety or reputational liabilities? | Contamination, safety record, governance gaps |
| Insurance | Insurance broker | Is coverage adequate, and is R&W insurance available? | Uninsured claims history, exclusions |
What a quality of earnings report does
A QoE report is not an audit. An audit gives an opinion that financial statements are fairly stated under accounting standards; a QoE asks whether the earnings are a reliable basis for valuing and financing the business going forward. It typically covers the last two or three years and the LTM period, and it is often prepared twice: a sell side QoE commissioned by the seller before launch, and a buy side QoE commissioned by the bidder, which tests the seller's.
The heart of the report is the EBITDA bridge. It starts with reported EBITDA from the financial statements, adds the adjustments management proposes (owner costs, one-off items, pro forma effects) to reach management adjusted EBITDA, then shows the diligence provider's view of each of those adjustments and any further adjustments it identifies. The result is diligence adjusted EBITDA, the figure the buyer will usually apply its multiple to and the figure lenders will size their debt on.
Other sections cover revenue quality (by customer, product and contract, with churn and concentration), gross margin trends, cash conversion from EBITDA to operating cash flow, normal working capital and the proposed peg, net debt and debt like items, and a review of the forecast's key assumptions.
| Adjustment | Direction | Typical diligence view |
|---|---|---|
| Owner compensation above market | Add back | Accepted if a market rate replacement cost is deducted |
| One-off litigation or settlement | Add back | Accepted if genuinely non recurring; rejected if the business is often sued |
| Pro forma cost savings not yet achieved | Add back | Usually rejected, or shown separately as upside |
| Run rate of new contracts | Add back | Accepted only with signed contracts and evidence of margin |
| Lost customer run rate | Deduction | Added by diligence when a customer has given notice |
| Revenue recognized early (cut off) | Deduction | Added by diligence |
| Costs capitalized that should be expensed | Deduction | Added by diligence |
| Under accrued bonuses or reserves | Deduction | Added by diligence |
| Related party costs below market | Deduction | Adjusted to market rate |
A worked QoE bridge
The example below follows a hypothetical logistics business through the bridge. Management proposes four add backs; the QoE provider accepts two, rejects two, and adds six of its own. The direction matters: management adjustments almost always increase EBITDA, and diligence adjustments often reduce it.
Notice that the rejected items are not necessarily wrong as ideas. A warehouse closure may well save $2.5m a year. But it has not happened, it carries execution risk and cost, and if the buyer pays for it in the price, the seller gets the value of a plan the buyer will have to carry out. Sponsors who believe in such savings keep them in their own value creation plan rather than in the purchase price.
| Line | Management view | Diligence view | Comment |
|---|---|---|---|
| Reported EBITDA | 42.0 | 42.0 | From audited accounts and LTM management accounts |
| Owner compensation above market | 1.2 | 1.2 | Founder paid $1.6m; market rate CEO $0.4m |
| One-off legal settlement | 0.8 | 0.8 | Single dispute, settled, no similar claims |
| Pro forma warehouse closure savings | 2.5 | 0.0 | Not yet executed; rejected |
| Run rate of contract signed in month 10 | 1.5 | 0.0 | No margin history; rejected |
| Management adjusted EBITDA | 48.0 | ||
| Revenue cut off: shipments billed before delivery | (0.9) | Diligence adjustment | |
| Maintenance costs capitalized | (0.6) | Should be expensed | |
| Inventory reserve shortfall | (0.7) | Obsolete packaging and spares | |
| Bonus under accrual | (0.4) | LTM bonus pool understated | |
| Related party rent to market | (0.3) | Founder owned depot: $0.5m paid, $0.8m market | |
| Lost customer run rate | (1.1) | Customer gave notice in month 11 | |
| Diligence adjusted EBITDA | 48.0 | 40.0 |
Net debt and debt like items
Because deals are priced cash free and debt free, the definition of net debt at closing moves the equity price dollar for dollar. Funded debt is the easy part. The QoE report then lists items that behave like debt: obligations accrued before closing that the buyer will pay after it. Common examples are income taxes accrued but unpaid, bonuses earned for the prior year but not yet paid, deferred or contingent consideration from the target's own earlier acquisitions, finance leases, capital expenditure the seller deferred to flatter cash flow, and customer deposits for work not yet done.
Cash needs the same scrutiny. Cash trapped in a foreign subsidiary, held as collateral, or needed as a minimum operating balance is not free cash the seller should be paid for. Some items, such as deferred revenue, are argued both ways: a seller says the cost to deliver the service belongs in working capital, a buyer says the cash was collected by the seller for work the buyer must do. How each item is treated is a negotiation, and the QoE gives the buyer the evidence.
| Item | Amount | Comment |
|---|---|---|
| Funded bank debt | 120.0 | Term loan and revolver drawings |
| Finance leases | 6.0 | Truck fleet leases |
| Cash on balance sheet | (50.0) | |
| Less trapped or minimum operating cash | 5.0 | Added back: not free cash |
| Accrued and unpaid pre-closing income taxes | 3.5 | Debt like |
| Unpaid prior year bonuses | 2.0 | Debt like |
| Deferred consideration from a 2025 acquisition | 3.0 | Debt like |
| Deferred capex on fleet maintenance | 4.0 | Debt like, negotiated |
| Customer deposits for future work | 1.5 | Debt like, negotiated |
| Adjusted net debt | 95.0 | Reported net debt (120.0 - 50.0) was 70.0 |
How findings change price or structure
A finding that is certain and quantifiable, such as a lower run rate EBITDA or an extra debt like item, normally goes into the price. A finding that is uncertain but specific, such as a tax audit in progress or a pending lawsuit, is better handled with a special indemnity from the seller, often backed by a dedicated escrow, because neither side knows the cost. A working capital issue goes into the peg. A finding that might stop the business working, such as a key contract that terminates on a change of control, becomes a closing condition. And a finding that destroys the investment case is a reason to walk away.
The example below shows why the QoE is often the most valuable diligence a sponsor buys. The buyer had agreed in its LOI to pay 10.5x adjusted EBITDA on a cash free, debt free basis, and both the EBITDA and the net debt changed.
Granger Logistics: what the QoE does to the equity price
- LOI price: 10.5x management adjusted EBITDA of $48.0m, with reported net debt of $70.0m.
- QoE findings: diligence adjusted EBITDA $40.0m; adjusted net debt $95.0m.
- 1. Enterprise value at LOI10.5 x 48.0$504.0m
- 2. Equity price at LOI504.0 - 70.0$434.0m
- 3. Enterprise value on diligence EBITDA10.5 x 40.0$420.0m
- 4. Equity price on diligence figures420.0 - 95.0$325.0m
- 5. Reduction from EBITDA10.5 x (48.0 - 40.0)$84.0m
- 6. Reduction from net debt95.0 - 70.0$25.0m
- 7. Total reduction in equity price434.0 - 325.0 = 84.0 + 25.0$109.0m
At the same multiple the equity is worth $109.0m less, a quarter of the LOI value. In practice the parties negotiate: the seller may contest the lost customer and deferred capex items, the buyer may accept some deposits as working capital, and the gap may be bridged partly in price and partly through an earnout tied to the warehouse savings. The QoE turns that negotiation from opinion into evidence.
Templates for this lesson
Included with a Premieur membership.
- WordBlind teaser and CIM outlineA one page anonymous teaser, then a confidential information memorandum outline saying what each section should hold.Download
- WordInvestment committee memoFrom the recommendation through thesis, risks, returns and sensitivities, the diligence EBITDA bridge, value creation, exit and approvals.Download
- ExcelDue diligence request listA buyside tracker of 72 requests across eight workstreams with owners, due dates, status, data room references, overdue flags and an aging of what is still outstanding.Download
- ExcelQuality of earnings bridgeReported to management adjusted to diligence adjusted EBITDA, debt like items to adjusted net debt, the equity price bridge and a grid of price by entry multiple and diligence EBITDA.Download