What is the process and how to best prepare for financial, tax and legal due diligence of a company?

Financial, tax and legal due diligence from a practical, legal and transactional perspective

Introduction: due diligence as one of the most important moments of a transaction

Naturally, when selling a company, the most discussed topics are its value, the purchase price and the closing of the transaction itself. In practice, however, there is a phase that has a major impact on the outcome of the deal – due diligence. This is the process of a detailed examination of the company by the buyer, the aim of which is to verify whether the information presented by the seller corresponds to reality and whether the business actually operates as presented in the introductory materials. It is at this stage that the “sales story” of the company meets the actual state of its finances, taxes, legal relations, internal processes and operational risks. What may appear to be a stable and growing company in the initial presentation breaks down on close examination into specific customer contracts, margins, receivables, payables, tax positions, licenses, litigation, employee relationships, or ownership of key assets. Due diligence is therefore not just a formal check, but a practical test of whether a company is truly ready for sale.

From the seller’s perspective, it is important to realize that due diligence has not only an analytical, but also a negotiation and psychological dimension. It is not only a way for the buyer to develop an overview of the risks, but also to build trust or distrust towards the seller and the company’s management. If the documents are incomplete, the answers inconsistent and the explanations unconvincing, the buyer naturally perceives a higher risk and translates it into a lower purchase price, broader warranties, retention mechanisms or requirements for special indemnities. Conversely, if the process is well prepared and the seller can name and explain the risks, due diligence can in turn boost buyer confidence and reduce the scope for aggressive price discovery at the close of the transaction.

In this article, we will look at how due diligence typically takes place, what areas are examined in financial, tax and legal due diligence and how to prepare for the process so that it does not become a source of unnecessary complications. We will also focus on the practical areas of due diligence that most often raise questions for buyers in Slovak transactions – from the quality of earnings and working capital, through VAT and transfer pricing, to contracts, employees, contractors, intellectual property rights, licenses and disputes.

How due diligence works in practice

The due diligence process usually starts after the signing of a non-disclosure agreement and the basic framework of the transaction, for example in the form of a term sheet or letter of intent. At this point, the buyer has typically already allocated internal capacity, engaged external advisors and prepared a detailed list of document and information requirements. This list may be relatively simple for smaller transactions, but for mid-sized and larger companies it often contains dozens to hundreds of items broken down by area. The seller then prepares a data room, a structured document repository in which the buyer and its advisors analyze information about the company. The quality of the data room has a major impact on the progress of the entire transaction. If the documents are clear, complete and logically organized, the process is faster and the buyer has less reason to question the company’s readiness. If the data room is chaotic or documents are only completed under pressure of questions, the buyer often forms a negative impression of the company’s level of management.

Due diligence is almost always an iterative process. The buyer first analyses the provided documents, then identifies ambiguities and asks additional questions during the Q&A phase. The answers often lead to further questions, as one contract, accounting item or tax setup can open up a broader topic. It is at this stage that it becomes apparent whether the seller understands their own data and can explain it consistently. In practice, it is very important that communication is not uncoordinated across multiple people with no central management. If the finance team provides one answer, the legal team another and management a third, the buyer will naturally begin to perceive an increased risk, even though the problem itself may not be material.

Due diligence generally results in financial, tax and legal reports. These do not only serve an informative function, but also directly enter into the transaction documentation. The findings are reflected in the adjustment of the purchase price, the setting of the lock-box or completion accounts mechanism, the definition of net debt and working capital, the extent of seller guarantees, specific indemnities, retention mechanisms or closing conditions. Due diligence is therefore not separate from contract negotiation; on the contrary, it often determines what will be negotiated the most in the SPA and where the buyer will require the most protection.

Financial due diligence: detailed analysis of performance, margins and cash flow

Financial due diligence focuses on a deep understanding of a company’s economics. The buyer does not rely solely on financial statements, but seeks to understand how the company actually generates revenue, what its cost structures are, what the quality of its earnings are, and how sustainable its historical results are for the future. One of the first areas is revenue analysis. The buyer examines the evolution of revenues over time, their distribution by product, service, customer, geographic market or business channel. Particularly important is the issue of concentration. If a significant part of the revenue comes from one or a few customers, the buyer sees this as a risk, because the departure of a key customer can fundamentally change the economics of the company. In addition, for companies with a project-based nature, it is analysed whether the revenues are derived from repeat business or from one-off contracts that may not be repeated in the future.

Closely related to revenue analysis is margin analysis. The buyer examines whether margins are stable, increasing or decreasing, and what factors affect them. For trading companies, purchase price, pricing and the ability to pass on input cost growth to customers are analysed. For manufacturing firms, the evolution of material prices, energy costs, labour costs and production efficiency are monitored. For service firms, capacity utilization, hourly rates, team efficiency, and the ratio of fixed to variable costs are often analyzed. It is the margin analysis that often reveals whether historical profitability is the result of sound business economics or rather temporary factors such as extraordinary pricing, underinvestment in the team or short-term cost cutting.

A key theme of financial due diligence is the normalisation of EBITDA. This is because reported EBITDA often does not represent a pure picture of a company’s recurring performance. Therefore, the buyer identifies non-recurring income and expenses, extraordinary projects, transaction costs, costs or benefits to related parties, non-standard management fees, personal or family expenses of owners, as well as items that will expire or be added after the transaction. In founder-managed firms, the issue of owner adjustment, i.e. whether the founder’s remuneration is at market level and whether it will be necessary to replace the founder’s work with professional management after the transaction, is also often addressed. The result is so-called normalised EBITDA, which may be higher or lower than reported EBITDA and which is then often used as a basis for valuation.

A very important area is cash flow. A company may show an accounting profit, but it may not generate cash at the same rate. Therefore, the buyer analyzes the conversion of EBITDA to cash flow, the development of accounts receivable, accounts payable, inventory and capital expenditures. For receivables, the age structure, quality of debtors, historical write-offs, allowances and fair recoverability are examined. For accounts payable, it is analysed whether the company is financing its cash flow by overextending its suppliers. For inventories, turnover, obsolescence and revaluation risk are examined. These items are particularly relevant in the setting of normalised working capital, which can significantly affect the final purchase price, especially if a completion accounts mechanism is used.

Financial due diligence often also focuses on debt and financial obligations. The buyer analyzes loans, leases, factoring, guarantees, hedges, financial derivatives, liabilities to shareholders, contingent liabilities and any off-balance sheet items. It is important to assess what will be considered net debt and how these items will be reflected in the price. For loans and leases, the existence of covenants and change of control provisions that may be triggered by the transaction are also examined. For example, if a loan agreement requires bank consent to a change of control, this is an issue that must be resolved prior to closing. The buyer also analyzes the CAPEX, or capital expenditure needs, of the company. If the business has been underinvested for a long time, the historical EBITDA may look attractive, but the future owner will have to make significant investments that realistically reduce the value of the business.

A separate topic is the quality of financial reporting and internal controls. The buyer examines whether the company prepares management reports, whether the numbers are available in a reasonable time, and whether management can explain the differences between accounting and management data. For smaller and medium-sized companies, it is often the case that reporting is dependent on one person or an external accountant and is not sufficiently prepared for the needs of the investor. This may not be a deal-breaker, but the buyer may perceive it as an integration risk. Quality reporting, on the other hand, helps defend the valuation because the buyer sees that the company is data-driven and not just owner intuition.

Tax due diligence: detailed analysis of VAT, income tax and transfer pricing

Tax due diligence focuses on identifying potential tax liabilities that may arise as a result of past periods. This is a particularly sensitive area for the buyer, as in a share deal the buyer is also buying the company with its historical tax risks. A review of filed tax returns, compliance with registration and reporting obligations, results of tax audits and communication with the tax authorities is essential. The buyer is interested not only in whether the company has formally filed returns, but also whether the tax positions it has taken in those returns have factual support and would stand up to scrutiny. In practice, the difference between a formally correct filing and an actually defensible tax position tends to be substantial.

In the area of income tax, the correctness of the calculation of the tax base, the application of tax expenses, depreciation, provisions, valuation allowances and tax losses are examined. The buyer analyses whether the company has included items in the tax expense that could be questioned, such as costs without sufficient evidence of economic purpose, costs related to the owners’ personal consumption, marketing and consulting services without clear documentation, or payments to related parties without an arm’s length basis. For tax losses, it is examined whether they have been recognised and carried forward in accordance with the rules and whether they can be realistically utilised after the transaction. In some cases, their value to the buyer may be significant, but only if their utilisation is not compromised by legal or economic constraints.

VAT is one of the riskiest areas of tax due diligence. It examines the correct classification of supplies of goods and services, the determination of the place of supply, the application of exemptions, reverse charge, intra-community supplies, imports, exports, chain transactions and the correctness of invoicing. In the case of companies with a cross-border element, it is checked whether the company was not obliged to register in another Member State or whether it correctly applied the reverse charge regime. For companies providing services, a specific examination is made as to whether the services have been correctly assessed in relation to foreign clients and whether there is sufficient documentation to demonstrate the status of the customer and the place of supply. VAT risks tend to be particularly troublesome because they can be associated not only with tax liability but also with interest and penalties, the financial impact of which can be high for repeated transactions.

For group structures, transfer pricing is a key area. The buyer examines whether the related party transactions were at arm’s length, whether transfer pricing documentation was prepared, whether it corresponded to the actual operation of the group and whether it used defensible benchmarks. In particular, management fees, royalties, group financing, distribution models, production models, cost sharing, cost recharges and the provision of services between group companies are subject to review. The risk is not only the price itself, but also whether the service was actually provided, whether it was of economic benefit to the recipient and whether documentation is available to demonstrate its content. Inadequately documented intra-group flows are a frequent source of requests for specific guarantees or indemnities in due diligence.

Tax due diligence further focuses on cross-border structures and permanent establishment risk. If the company operates abroad, has foreign sales representatives, warehousing or servicing capacities, or key persons operating outside Slovakia, the buyer examines whether a risk of taxation in another jurisdiction has arisen. Withholding tax on payments abroad, application of double taxation treaties, beneficial ownership on dividends, interest or royalties, and proper application of exemptions or reduced rates are also analyzed. International structures are not only about Slovak tax exposure, but also about the risk that the foreign tax administrator will have a different view of profit allocation or economic substance.

Tax governance, the way a company manages tax risks, is also an important part of the review. The buyer evaluates whether the company has internal processes, who approves significant tax positions, whether there is regular communication with tax advisors and whether key decisions are documented. A distinction is made between isolated errors that can be quantified and contractually treated, and a systemic problem in tax management that may pose a recurring risk in the future. It is this distinction that has a major impact on transactional documentation. Isolated risk is often addressed by a specific indemnity, while systemic weaknesses may lead to broader safeguards, retention mechanisms or even modification of the transaction structure.

Legal due diligence: corporate, contractual and operational aspects

Legal due diligence covers a very wide range of areas and its aim is to check whether the legal functioning of the company corresponds to what the buyer expects. It usually starts with the corporate agenda. It examines the incorporation documents, the memorandum or articles of association, the history of transfers of shares or stock, resolutions of the general meeting and statutory bodies, entries in the commercial register, records of beneficial owners and any shareholders’ or shareholders’ agreements. The aim is to confirm that the seller actually owns what he is selling and that the transfer will not be blocked by pre-emption rights, consents of the authorities, restrictions in the memorandum of association or rights of third parties. Even seemingly formal deficiencies may in practice delay the closing, cause the need for additional corporate approvals or require the buyer to provide specific warranties.

A very important part of legal due diligence is the contractual agenda. In particular, the buyer examines key contracts with customers, suppliers, distributors, partners, banks, landlords, IT service providers and other business partners. It is not just a question of whether contracts exist, but more importantly what rights and obligations arise from them. It analyses duration, notice periods, unilateral termination options, penalties, liability limits, exclusivity, minimum subscriptions, pricing mechanisms, indexation, arbitration, dispute resolution and restrictions on assignment or transfer of rights. Of particular note are change of control clauses, i.e. provisions that allow the other party to terminate the contract or require consent in the event of a change of ownership. If a significant portion of a company’s value is built on a few key contracts and these contracts are at risk in a transaction, this is a material risk to both the buyer and the valuation.

As part of legal due diligence, employees and contractors are also scrutinised in detail. For employees, employment contracts, addendums, bonus and incentive schemes, benefits, competitive clauses, confidentiality agreements, internal regulations, working hours, overtime, holidays, severance pay and any past claims are analysed. The buyer also focuses on key employees whose departure could threaten the continuity of the business. Contractors are examined to ensure that they are not relationships that could be reclassified as dependent employment, that rights to the results of the business are properly addressed, and that the company is not effectively dependent on outsiders without sufficient contractual protection. This area is particularly important for technology, consulting, creative and project companies, where the value of the business is often based on the people and their know-how.

Intellectual property rights deserve special attention. The buyer examines whether the company owns or has properly licensed all assets that are key to its business. These may include trademarks, domains, software, databases, designs, copyrights, patents, know-how, trade secrets or marketing materials. In practice, it often turns out that software or other deliverables have been created by external suppliers or contractors, but the contracts do not contain a sufficient transfer of rights to the company. A similar problem can arise with employees if the rules on employee works are not properly set or if the company uses materials without a clear licensing footprint. For technology companies, open-source software, licensing restrictions, security commitments and dependence on third parties are also analysed. If a company does not own key IP or does not have the rights sufficiently documented, this can significantly reduce its value or lead to a requirement to remediate the issue before closing.

Regulatory permits and licenses are another key area, particularly in regulated industries. The buyer examines whether the company has all the necessary permits to operate, whether these permits are time-limited, whether their conditions are met and whether the transaction will trigger the need for regulatory approval or notification of a change in ownership structure. For financial services, healthcare, energy, waste, telecommunications, food or transport, this issue may be crucial. If the licence is tied to specific persons, premises or technical conditions, the purchaser needs to know whether it will be able to continue the business without interruption. Compliance checks, for example in the areas of GDPR, AML, consumer protection, public procurement, competition or sectoral regulation, tend to be part of this area.

Legal due diligence also includes an analysis of disputes and potential claims. The buyer not only reviews existing litigation, arbitration or administrative proceedings, but also claims, pre-suit challenges, internal conflicts, and impending claims from customers, employees, suppliers or regulators. For each dispute, its value, likelihood of success, time horizon, litigation strategy and accounting capture are examined. Equally important are contingent liabilities, i.e. contingent liabilities that have not yet manifested themselves as a formal dispute but may arise in the future. Typically these are product claims, liability for defects, environmental claims, employment disputes, claims by former partners or breaches of contract. These risks are often dealt with by special indemnity or escrow mechanisms because the buyer does not want to bear the economic consequences of events that occurred prior to the transaction.

Real estate, leases and other property rights are also often examined in legal due diligence. If the company owns real estate, the title deed, encumbrances, easements, liens, third-party leases, construction documentation and compliance of the actual use with the approval status are examined. If the company operates in leased premises, the length of the lease, notice grounds, indexation of rent, renewal rights, consent to assignment or change of control, and termination obligations shall be analysed. For manufacturing or logistics businesses, it is the availability and stability of space that can be key to the value of the business. If the buyer were to lose access to the main operations after the transaction, this would be a material transaction risk.

Other types of due diligence

Although financial, tax and legal due diligence are the most commonly discussed, in many transactions due diligence extends to other specialised areas. For manufacturing companies, technical due diligence is often performed to assess the condition of machinery, equipment, production lines, maintenance, capacity, operational safety and the need for future investment. The buyer seeks to determine whether the manufacturing assets are adequate for their stated performance, whether they are obsolete, and whether significant CAPEX will be required shortly after the acquisition. Technical due diligence can significantly affect valuation, as historical EBITDA may not reflect the investment that the new owner will need to make to maintain or grow the operation.

Environmental due diligence is particularly important for industrial, manufacturing, energy, real estate development and logistics projects. Compliance with environmental permits, waste management, emissions, water management, soil or groundwater contamination, operating history and potential remediation costs are examined. Environmental risks can be both financially very significant and difficult to quantify, as their impact may only become apparent years later. In some transactions, commercial due diligence is also carried out to analyse the market, competition, customer behaviour, pricing position, business pipeline and growth potential. For technology companies, IT or product due diligence may be performed, focusing on system architecture, scalability, cybersecurity, technical debt, quality of development processes, and dependence on key developers or suppliers.

How to prepare for due diligence

The best strategy is to start preparing well in advance of the actual sale, ideally 12 to 24 months in advance. Preparation is not just about “uploading documents to the data room”, but systematically identifying the company’s weaknesses and addressing them before the buyer opens the door. The seller should begin by auditing documentation, financial data, contracts, tax positions, licenses, employee relations and internal processes. The goal is to determine which areas may raise questions, which findings may affect price, and which issues can be resolved before the transaction process begins. Consistency between financial, tax and legal information is also very important. For example, if the financial model assumes growth in a particular product line, but customer contracts are short-term and easily terminable, a buyer will naturally question whether the projected growth is realistic.

A practical preparation tool is vendor due diligence or at least an internal pre-sales review. In this case, the seller checks his own company through the eyes of an investor before approaching buyers. The advantage is that it gives them time to prepare explanations, complete documentation, modify contracts, correct formal deficiencies or quantify risks. In a well-prepared process, the seller has a ready data room, a clearly defined internal team, a single communication channel and rules for answering questions. Storylining, the ability to explain the company’s development in a consistent way across all areas, is also important. If a seller can convincingly explain fluctuations in results, tax positions, changes in the customer base or the structure of contractors, it significantly reduces the risk that a buyer will use these topics to drive down the price.

Conclusion

Due diligence is a moment that tests both the quality of the company and the readiness of the seller. It is not a formality or an administrative exercise, but a crucial phase that can determine the economics of the entire transaction. A well-prepared company can get through the process faster, with fewer uncertainties and less risk of additional requirements from the buyer. Conversely, messy documentation, unclear tax positions, inadequately treated contracts or unproven ownership of key assets can lead to a reduced price, a delayed closing or a complete failure of the transaction.

Preparing for due diligence is therefore one of the most important steps in preparing a company for sale. A seller who knows his risks, can explain them and has solutions ready enters the negotiations in a much stronger position. Due diligence thus does not have to be a defensive phase in which the seller defends itself against the buyer’s questions, but can become a tool to confirm the quality of the company and support its valuation.

Our advice At Highgate Law & Tax, we help clients prepare for due diligence before they enter the actual sale process. We combine legal, tax and transactional perspectives so that clients do not see the various risks in isolation, but in the context of their impact on price, transaction structure and negotiating position. In practice, this means not only preparing or reviewing documentation, but also identifying areas that may be sensitive to the buyer, suggesting how to address them, and preparing explanations that will stand up in negotiations with an investor or strategic buyer. Properly prepared due diligence can be the difference between a transaction that only formally closes and one that is actually successful for the seller.

We are the Highgate Group, modern advisors for your law, tax and accounting under one roof.

If you are interested in this topic, please do not hesitate to contact us:

• Tomas Demo, e-mail: tomas.demo@highgate.sk

For more on asset protection and entrepreneurship, please visit the Venture capital, private equity and M&A section of our website.

If you are interested, you can subscribe to our newsletter for interesting practical legal and tax information.

You can address your specific questions in a consultation with our partner Tomáš Dem, who specializes in the area of sales and investments in companies and commercial law. You can book a consultation here: