With the purchase of a home, it is possible to employ an inspector, tour all of the rooms, and examine the roof before signing on the dotted line. However, with the acquisition of a business, there is much more that needs to be done. The “roof,” in this case, could be a precarious customer agreement, an overdue tax instalment, or a valuable employee looking for new employment. It is the buyer’s chance to look past the pitch deck and the seller’s optimism, and find out what they are really paying for before the money changes hands. If you are purchasing, selling, or simply interested in learning what a buyer looks for prior to consummation of the deal, this article provides an overview of that process, illustrated with actual cases from Canadian jurisprudence demonstrating what may go wrong when proper due diligence is not conducted.
What Due Diligence Actually Is (And When It Happens)
Business due diligence is the investigation a buyer carries out to confirm that a business is what the seller says it is- financially, legally, and operationally before the deal closes. Think of it as the verification stage that sits between “we have a deal in principle” and “the deal is done.”
In a typical transaction, due diligence begins after the buyer and seller sign a letter of intent (LOI) or term sheet. That document usually gives the buyer a defined due diligence period- often two to eight weeks depending on the size of the business during which they can request records, interview management, inspect the premises, and consult their accountant and lawyer. The purchase agreement itself is usually still being negotiated at this stage, and what the buyer finds during due diligence often changes its terms.
Due diligence is not an instantaneous process; rather, it occurs in stages. Usually, buyers begin with an overview of financial records and the organization structure. Only after they are satisfied that there is nothing wrong, they proceed to scrutinize contracts, staff, and compliance. A buyer who does not bother with these procedures and rushes into a contract without even opening the data room takes undue risks.
The Questions Every Buyer Is Really Asking
Each and every item on the checklist, each document requested and each inspection at a site inspection is actually just an effort by a potential buyer to get some answers to certain fundamental questions. It helps both the seller and the buyer know what lies ahead.
- Is the business what the seller claims it to be? Is the income, margin and client base of the business matching its claims?
- What are the possible risks after I have taken over the business? Are there any contracts ending, people quitting or licenses not transferred?
- What, exactly, am I buying? The shares of a corporation with its full history, or a defined set of assets?
- Are there liabilities hiding below the surface- unpaid taxes, pending lawsuits, unresolved employee claims, or environmental issues?
- Can the relationships that make this business valuable survive a change of ownership- key customers, suppliers, the lease, and the staff who know how things actually run?
A buyer’s due diligence team- usually a lawyer, an accountant, and sometimes an industry consultant is essentially built to answer these five questions as thoroughly as time and budget allow.
What Buyers Look For
The exact documents that the buyer needs will depend on the scale and industry of the business, but usually the due diligence process for a small or medium-sized business includes similar key components.
Financial Records
The purchaser requires at least two to three years’ worth of financials, tax information, and bank records as well as explanations for any unusual variances in income and expense flows. This is done in order to ensure that the data being provided by the seller is the same as what has been filed to the Canada Revenue Agency.
Contracts and Customer Relationships
This includes supplier agreements, customer contracts, franchise agreements, and any long-term commitments. Buyers pay close attention to “change of control” or assignment clauses, which can require a third party’s consent before a contract can transfer to a new owner and to how concentrated the customer base is. A business that depends on one or two clients for most of its revenue is a materially different investment than one with a broad client base.
Employees and Payroll Obligations
Buyers would be required to appraise the employment contracts, the contract for independent contractors, vacation payment, pension obligation or any other benefits, and restrictive covenants of key employees if any who are going to leave after closing of the deal. It should be mentioned that the employment status of employees is yet another matter.
Corporate Records and Ownership
The lawyer of the purchaser would request the minutes book, articles of incorporation, the shareholder agreement, and the share registry in order to prove that the seller indeed has the right to sell the shares because there are no other shareholders or options for the shares.
Legal Compliance and Litigation
This includes permits and licenses necessary for business operations, regulatory investigation records, and any litigation currently pending, threatened, or previously filed. One single legal suit, pending or otherwise, could make a significant difference on how an investor will view the entire deal.
Intellectual Property and Real Property
The buyers find out who owns the trademarks, domain names, software, and trade secrets that are important to the company. The buyers also examine the lease if there is any and the term remaining.
Red Flags That Make Buyers Nervous
Some issues discovered during due diligence do not kill a deal, they simply get negotiated around. Others make a buyer walk away entirely, or insist on far more protection than originally planned. Common red flags include an unexplained drop in revenue in the months before the sale, financial statements that do not reconcile with tax filings, missing or incomplete corporate records, unresolved litigation, unfiled tax returns, heavy reliance on a single customer or supplier, and important commitments that were only ever made verbally.
Verbal promises about profitability are a particularly common source of dispute after closing, and Ontario courts have dealt with this pattern more than once.
Case Law: 10443204 Canada Inc. v. 2701835 Ontario Inc., 2022 ONCA 745 (CanLII)
The purchaser acquired the business of the coin laundry company partly based on the verbal representations made by the seller regarding its profitability. Following the purchase of the business and the default by the purchaser in his obligation under the vendor take-back financing agreement, the seller initiated an action against the buyer for the outstanding balance.
There was an “entire agreement” clause in the contract and the buyer was given an opportunity to confirm the revenues of the business before the closing. The motion judge originally decided that this clause, together with the buyer’s ability to perform due diligence, was sufficient to defeat the claim of misrepresentation.
This opinion was rejected by the Ontario Court of Appeal. It was decided that neither a full agreement clause nor a chance to look into the matter would be sufficient to shield the seller who misrepresented the facts and persuaded the buyer to purchase the products. In accordance with Free Ukrainian Society (Toronto) Credit Union Ltd. v. Hnatkiw, 1964 CanLII 180 (ON CA), it was decided. According to the Court, it was the seller’s responsibility to demonstrate that the buyer actually knew the facts.
Both buyers and sellers should learn that contract boilerplate does not take the place of real due diligence and does not authorize a seller to fabricate information. Buyers should independently verify income rather than relying on promises, and sellers should make sure that any important claims about the business are backed up by paperwork.
Case Law: Beatty v. Wei, 2018 ONCA 479 (CanLII)
This Ontario Court of Appeal decision dealt with representations and warranties that were drafted to survive continuously through to closing, rather than being frozen as of the date the agreement was signed. The Court’s reasoning is a useful reminder that the wording of a representation including when it is made and for how long it remains true can determine whether a seller ends up in breach.
Takeaway: the buyer should make sure that material representations contained in the sales contract are represented as being true not only when signed but also at closing in case there are any negative developments between the two events.
How Sellers Prepare (Before A Buyer Ever Asks)
It’s usually the companies whose owners have already taken the time to prepare for due diligence prior to any potential buyer coming in that will sell the quickest and at the highest price. The business owner who does not have their ducks in a row creates only delays and mistrust.
- Prepare the minute book and corporate documents such that all the owners, directors, and any resolutions are in order and easy to retrieve.
- Ensure financial statements have been checked and/or audited, and reconcile these with the actual documents filed with CRA.
- Consider contract terms related to assignments or changes of control contained in significant agreements that may require consent of third parties.
- It is ideal to resolve any pending disputes or overdue remittances prior to disclosure to the purchaser.
- Sort out your personnel file, contract documents, and any severance liabilities, because it is one of the first things the buyer’s lawyers will ask you about.
- Create a document room; even something simple like a folder that you can use once a legitimate buyer emerges.
Being a seller who is able to provide an answer to the buyer’s questions concerning the business through documentation means that the business is really what it says to be. Such a sign can itself cut down on negotiations and protect the selling price.
How Due Diligence Can Affect The Purchase Price
Findings in due diligence are hardly ever left idle – they usually get immediately rolled into the transaction. The option facing a buyer, who discovers a problem during the process, includes withdrawing from the transaction, asking for a reduction in the price paid, requesting the seller to remedy the problem before completion, or getting additional contractual assurance in order to hedge against the risk.
Additional contractual assurance may come in one of the few well-known formats: purchase price holdback/escrow, which involves withholding part of the payment for a certain period after closing in case of a breach; indemnity, involving compensation from the seller to the buyer for any losses suffered by the buyer from a known risk; or an extended survival period for certain representations and warranties.
Illustration
A buyer negotiating to purchase an HVAC company discovers, during due diligence, that the seller quietly laid off several technicians shortly before the sale. The purchase agreement’s representations about the business being run in the “ordinary course” only cover a period starting after that layoff. Because the specific wording of the representation does not capture the earlier conduct, a court may find there was no breach even though fuller disclosure would have been the better practice. That is more or less what occurred in the case of 1916458 Ontario Limited v. Beaulieu 2026 ONSC 3503 (CanLII), wherein the Superior Court of Justice of Ontario determined that it was more significant when and how the representations were made rather than what the purchaser thought he was receiving.
The lesson applies to both parties: sellers should realize that correctly phrased (and timed) representations might actually reduce their exposure, and purchasers should require that representations span the entire period relevant to the deal, not just a convenient slice of it. Conversely, sellers should exercise caution when depending too much on exclusion or restriction provisions to completely avoid liability. In Earthco Soil Mixtures Inc. v. Pine Valley Enterprises Inc., 2024 SCC 20 (CanLII), the Supreme Court of Canada affirmed that a clause excluding an implied warranty must expressly and clearly state so; ambiguous or general language will not automatically shield a seller from liability for issues with what was sold.
Asset Purchase vs Share Purchase: Why Due Diligence is different
One of the most important decisions in any transaction is whether the buyer is purchasing the shares of the corporation or only specific assets of the business and this choice changes what due diligence actually needs to accomplish.
In a share purchase, the buyer acquires the corporation itself, with its full history intact. That means all existing contracts, licences, and employment relationships generally continue without interruption but so does everything else: past tax liabilities, pending or threatened lawsuits, environmental exposure, and any obligations the corporation entered into years before the buyer ever appeared. Due diligence for a share purchase has to look backward as far as the corporation’s history goes, because the buyer is inheriting all of it.
In an asset purchase, the buyer selects specific assets and liabilities to acquire- inventory, equipment, contracts, goodwill, intellectual property while leaving the rest with the seller’s existing corporation. This generally offers more protection against unknown historical liabilities, but it introduces its own due diligence priorities: which contracts can actually be assigned without third-party consent, which employees will be offered new employment (and on what terms), and which licences or permits need to be reissued in the buyer’s name rather than simply continuing.
Case Law: Manthadi v. ASCO Manufacturing, 2020 ONCA 485 (CanLII)
A long-serving employee with 36 years at a manufacturing company was offered continued employment after the business was sold in an asset purchase. She was let go by the purchaser shortly afterward, without notice. The purchaser argued that, because it had only bought assets not shares- it owed her nothing beyond her short tenure with the new company.
The Ontario Court of Appeal sent the matter back for trial, confirming that whether a purchaser becomes a “successor employer” depends on the facts including whether the business was acquired and continued as a going concern and is not automatically resolved just because the deal was structured as an asset purchase rather than a share purchase.
Takeaway: In any asset sale, it is unwise for a buyer to presume that the structure of the deal takes care of employment risks. It is necessary for due diligence to evaluate the years of service of every employee involved, in addition to what the post-sale operations would actually look like.
Also Read: Asset Purchase vs Share Purchase: A Comprehensive Analysis
Should You Hire A Lawyer For Business Due Diligence?
Due diligence touches corporate law, employment law, real estate, tax, and contract law all at once which is exactly why business owners on both sides of a transaction typically do not go through it alone. A lawyer’s role in due diligence generally includes reviewing and negotiating the letter of intent and purchase agreement, coordinating the document requests and reviewing what comes back, examining contracts and leases for assignment or change-of-control issues, structuring representations, warranties, and indemnities to reflect what was actually found, and advising on whether an asset or share structure better protects the buyer’s interests.
A lawyer cannot make a struggling business profitable or a bad deal good, but they can make sure that what a buyer agrees to on paper actually reflects what due diligence uncovered and that a seller’s disclosures are complete enough to avoid a dispute long after the closing dinner is over. Bringing a lawyer in early, ideally before the letter of intent is signed, tends to save both sides time, cost, and stress by the time the deal is ready to close.
Conclusion
The whole essence of due diligence in business is much more than just doing the process because of the requirement to finalize the transaction. It is the process that guarantees that there will be no nasty surprises for either party that they cannot afford or even tolerate. The buyer who conducts the proper due diligence process enters the process with clear knowledge of what he/she is going to acquire while the seller becomes better prepared for a speedy closing of the deal.
Pacific Legal Professional Corporation can assist you in conducting the due diligence process when you prepare to buy or sell a business in Ontario.
Contact us now.
