Why Due Diligence Matters
South African law offers a buyer limited protection against latent defects and hidden liabilities once a business sale agreement has been signed. The common law principle of caveat emptor — let the buyer beware — remains the starting point. Unless the seller gave a specific warranty or made a fraudulent misrepresentation, the buyer bears the risk of problems that were not disclosed or discovered before signature.
Due diligence is the systematic investigation a buyer conducts before committing to a transaction. Its purpose is not to find reasons to walk away — it is to identify risks so that they can be priced into the deal, mitigated through warranties and indemnities, or used to restructure the transaction. A thorough due diligence process transforms the buyer from a passive recipient of information into an informed party who understands exactly what they are acquiring. For an overview of how due diligence fits into the broader transaction, see our guide on share sale vs asset sale.
Real South African cases illustrate the consequences of inadequate due diligence. Buyers have acquired companies with undisclosed SARS debt running into tens of millions of rands — debt that, in a share sale, becomes the buyer's liability on day one. Others have discovered after closing that key customer contracts contained change-of-control clauses entitling those customers to terminate, effectively destroying the value of what was purchased. Some have inherited undisclosed CCMA awards and pending class action claims from employees who were not informed of their rights under section 197 of the Labour Relations Act.
The cost of proper due diligence — typically R50,000 to R300,000 depending on deal size and complexity — is modest relative to the risks it identifies. In a transaction worth R5 million to R500 million, discovering even one significant liability can save multiples of the due diligence cost. More importantly, it determines whether the deal should proceed at all.
Contractual vs Statutory Protection
- Warranties: The seller contractually represents that certain facts are true. If a warranty is breached, the buyer has a claim for damages — but must still prove loss and may face protracted litigation
- Indemnities: The seller agrees to indemnify the buyer against specific identified risks — a stronger protection than a warranty because the buyer need not prove loss causation
- Price adjustment mechanisms: Identified issues are reflected in a reduced purchase price, earn-out arrangement, or retention — shifting risk allocation without litigation
- Conditions precedent: Identified regulatory risks (merger approval, licence transfer, third-party consent) are made conditions to closing — the deal does not complete unless these are resolved
The 7-Step Due Diligence Process
Due diligence is not a single exercise but a structured multi-disciplinary investigation conducted in parallel workstreams. Each stream feeds into the others — a tax finding may affect the financial valuation; a legal finding may reveal an HR problem; a regulatory gap may affect the structure of the deal. Below is the sequenced process from initial NDA through to the due diligence report. Total professional fees typically range from R50,000 to R300,000 for the full process, with a timeline of four to six weeks for a straightforward SME transaction.
Execute NDA and Term Sheet
No confidential information should be shared before a properly structured NDA is in place. The NDA must bind the buyer entity, its directors, and all professional advisors (accountants, attorneys, consultants) who will have access to the data room. It should specify the permitted purpose (evaluation of the proposed transaction only), the obligation to return or destroy documents if negotiations fail, and — critically — the remedy for breach, including the right to seek an interdict without proving damages.
Simultaneously, the parties should agree on a term sheet or letter of intent recording the indicative purchase price and basis (equity value vs enterprise value), the proposed transaction structure (share sale or asset sale), any material conditions, and an exclusivity period during which the seller agrees not to negotiate with other parties. While term sheets are typically non-binding on price and structure, the exclusivity and confidentiality provisions should be expressly stated as binding.
Establish the Data Room
A well-organised data room is the foundation of an efficient due diligence. The seller's advisors should populate the data room with documents organised under standard categories: corporate and legal, financial, tax, HR and employment, intellectual property, property and leases, regulatory and licences, and material contracts. A comprehensive document index should be provided at the outset.
Access levels should be tiered: the buyer's legal team sees all documents; the financial advisor sees financial, tax, and contract documents; HR specialists see employment-related documents only. A formal Q&A process should be established so that all questions are submitted and answered in writing — creating a record that becomes part of the disclosure bundle.
Virtual data rooms (iDeals, Intralinks, Datasite) provide audit trails showing which documents were accessed and when — important for establishing the buyer's knowledge at closing. The data room index and Q&A log typically form an annex to the sale agreement as part of the disclosure letter.
Financial Due Diligence
Financial due diligence verifies the financial performance and position of the business. The starting point is three years of audited financial statements and management accounts. The auditor's report and audit qualification (if any) should be reviewed carefully — a qualified audit opinion is a significant red flag.
The financial advisor will normalise EBITDA by adjusting reported earnings for once-off items, related-party transactions at non-arm's length pricing, discretionary owner expenses, and extraordinary items. The normalised EBITDA forms the basis for the purchase price multiple. Working capital analysis identifies the normalised working capital required to operate the business, which feeds into the working capital peg mechanism in the sale agreement.
Legal Due Diligence
Legal due diligence reviews all material contracts, leases, and regulatory instruments. The central focus is on whether key agreements can survive the change of ownership — many commercial contracts contain change-of-control clauses that entitle the counterparty to terminate or renegotiate if control of a party changes.
The legal team also reviews the company's founding documents and share register, all intellectual property registrations (trademarks, patents, domain names), the litigation register, and all regulatory licences and permits. In an asset sale, attention must be given to whether each asset can be validly transferred and whether any third-party consents to assignment are required.
Tax Due Diligence
Tax due diligence is conducted by a tax specialist, typically in parallel with financial due diligence. The advisor obtains SARS tax compliance status certificates confirming that the company is compliant for income tax, VAT, and PAYE — and verifies their authenticity with SARS directly where possible.
The advisor reviews all SARS assessments, objections, and appeals for the three-year review period; provisional tax calculations; VAT returns and any outstanding VAT refunds; transfer pricing arrangements with related parties; and any tax opinions or rulings obtained by the business. In a share sale, all of these tax liabilities (including contingent liabilities not yet assessed by SARS) transfer to the buyer with the company.
HR and Employment Due Diligence
HR due diligence covers the full employment picture: a complete employee register with remuneration, job titles, and contract terms; employment contracts, restraint of trade provisions, and commission structures; any outstanding disciplinary proceedings, grievances, or CCMA referrals; and provident or pension fund liabilities.
If the transaction is structured as a going-concern asset sale, section 197 of the Labour Relations Act automatically transfers employment to the buyer on the same terms and conditions. The buyer inherits all employees and their accumulated leave, tenure, and any existing CCMA awards. This is a significant liability in businesses with long-tenured staff or unresolved disciplinary matters.
Regulatory and Sector-Specific
Regulatory due diligence is highly sector-specific but applies to virtually every business. The advisor confirms that all licences and permits required to operate the business are validly held, current, and — critically — transferable to the buyer in the proposed deal structure.
Competition Act merger notification thresholds must be assessed. Depending on the combined turnover or assets of the parties, a merger may require prior approval from the Competition Commission or Competition Tribunal — closing without approval is unlawful and may result in substantial penalties. POPIA data protection compliance should also be assessed, particularly where the business processes personal information of customers or employees.
Financial Due Diligence Deep Dive
Financial due diligence goes beyond verifying the numbers in the audited financials — it reconstructs the true economic performance of the business by stripping out non-recurring items and related-party distortions to arrive at normalised EBITDA. This normalised figure is the foundation for the purchase price multiple.
Normalised EBITDA: Key Adjustments
| Adjustment Type | Example | Impact |
|---|---|---|
| Owner remuneration | Owner paid R3m salary; market rate is R1.2m | Add-back R1.8m |
| Related-party rent | Premises owned by owner's trust; rent above market | Add-back excess |
| Once-off items | Asset sale, insurance payout, legal settlement | Remove from EBITDA |
| Discretionary expenses | Personal vehicle, travel, club memberships | Add-back |
| Future cost obligations | Deferred maintenance, software replacement | Deduct from value |
The working capital peg is another critical financial mechanism. The sale agreement will typically specify a target working capital level — the normalised working capital required to operate the business at completion. If the actual working capital at closing is below the peg (because the seller has been drawing down debtors or deferring creditor payments to inflate cash), the purchase price is reduced by the shortfall. This protects the buyer from sellers who "window dress" the balance sheet in the months before closing.
The debtors age analysis deserves particular attention. A high proportion of debtors more than 90 days old suggests collection problems or disputed debts that may never be collected. In a share sale, bad debts that have not been written off become the buyer's problem.
Earn-Out Risk
Where the seller proposes an earn-out (deferred consideration contingent on future performance), the financial due diligence must scrutinise the reliability of the financial projections underlying the earn-out targets. Earn-outs are a frequent source of post-closing disputes — if the earn-out metrics are based on EBITDA, the buyer controls the P&L post-closing and can influence the outcome. Careful earn-out drafting and independent accounting verification are essential.
Legal Due Diligence Deep Dive
Legal due diligence covers the full contractual, corporate, and regulatory universe of the business. The objective is to identify commitments, restrictions, and liabilities that are not visible from the financial statements.
Change-of-Control Clauses
This is the single most important item in a share sale legal review. Many commercial contracts — including supply agreements, distribution agreements, franchise agreements, and software licences — contain change-of-control clauses that give the counterparty a right to terminate or renegotiate if there is a change in the ownership or control of a contracting party. In a share sale, the transfer of shares triggers these clauses. The legal team must identify every such clause and assess whether consent to the change of control must be obtained before closing. Where consent is required, obtaining it becomes a condition precedent to the transaction.
Leases
Commercial premises leases should be reviewed for remaining term, renewal options, rental escalation provisions, and — again — change-of-control or assignment clauses. A business that operates from leased premises has no value if the lease terminates or the landlord can demand a significant rent increase at the time of the sale. In an asset sale, lease assignment requires landlord consent as a matter of contract and, for notarially executed leases, as a matter of law.
Intellectual Property Ownership
IP ownership due diligence verifies that the business owns — or has valid licences to use — the IP that is central to its operations. Common problems include software developed by contractors whose work-for-hire agreements did not vest IP ownership in the company; trademarks registered in the name of the founder personally rather than the operating company; domain names registered by a former employee; and trade secrets that have been inadequately protected by confidentiality agreements.
Litigation Register
The litigation register identifies all current and threatened legal proceedings — including CCMA referrals, pending High Court matters, arbitrations, and regulatory investigations. Each matter must be assessed for quantum and likelihood of an adverse outcome. In a share sale, the buyer acquires all pending and threatened liabilities. The seller's representations about the completeness and accuracy of the litigation register should be one of the strongest warranties in the sale agreement.
Tax Due Diligence
Tax due diligence is conducted by a tax specialist and is one of the most consequential workstreams in a share sale. In a share sale, the buyer acquires all tax liabilities of the target company — including liabilities for prior periods that SARS has not yet assessed. SARS has five years from the date of a self-assessment to raise an additional assessment, and no time limit where there has been fraud or intentional misrepresentation.
Tax Due Diligence Checklist
- SARS tax compliance status certificates for corporate income tax, VAT, PAYE, and SDL — verify currency and obtain directly from SARS where possible
- Three years of income tax returns and SARS assessments — review for objections, appeals, or outstanding queries
- VAT returns and reconciliations — verify that output VAT has been correctly declared and input VAT claims are supported by valid tax invoices
- Section 7C inter-company loans — loans from companies to trusts at below-official-rate interest are subject to donations tax; verify correct treatment
- Transfer pricing — cross-border related-party transactions must comply with the arm's length principle under section 31 of the Income Tax Act; review documentation
- Tax opinions and rulings — whether any binding private rulings were obtained from SARS and whether the business has been conducted in accordance with them
- STC credits — legacy Secondary Tax on Companies credits should be confirmed; they expire if not utilised before a specified deadline
Where significant tax liabilities are identified, the buyer should seek a specific tax indemnity from the seller — an indemnity specifically covering all tax liabilities arising from the period before closing that are subsequently assessed by SARS. The tax indemnity should survive closing and run for at least five years. The seller should provide security (escrow, bank guarantee) for the indemnity where the quantum of the identified tax risk is material.
HR and Employment Due Diligence
Employment due diligence is frequently underestimated in business sale transactions. Employees are often the most valuable asset of a service business — but they can also represent its largest hidden liability.
Section 197 of the Labour Relations Act
Section 197 of the Labour Relations Act provides that when a business is transferred as a going concern, the employment contracts of all employees transfer automatically to the new employer on the same terms and conditions. The buyer cannot select which employees to retain — all of them transfer. The buyer also inherits all accrued leave, continuity of employment, and any outstanding disciplinary or arbitration proceedings.
Section 197 applies regardless of whether the transaction is structured as an asset sale or a share sale — the determining factor is whether a going concern is transferred, not the legal structure of the transaction. Parties cannot contract out of section 197. A buyer who dismisses employees transferred under section 197 without following a fair process faces automatic unfair dismissal claims.
Key-Man Dependency and Restraints
Key-man dependency is a common risk in owner-managed businesses. Due diligence should identify employees whose departure would materially damage the business — and assess whether those individuals are bound by restraints of trade that would prevent them from competing or soliciting customers if they leave.
Restraint of trade agreements are enforceable in South Africa if they are reasonable in scope, geographic area, and duration — but courts scrutinise them carefully and will not enforce unreasonably broad restraints. The due diligence should review each key employee's restraint for enforceability and identify gaps. Retention bonuses and new restraint agreements with key personnel are often structured as conditions to, or obligations arising from, the sale transaction.
Pension and Provident Fund Liabilities
Where the business contributes to a defined benefit pension fund, the due diligence should identify any actuarial deficit — the shortfall between the fund's assets and its liabilities. Pension fund deficits can be substantial and, in a share sale, transfer to the buyer with the company. Even in a defined contribution fund context, arrear contributions to provident and pension funds are a common discovery in SME due diligence processes.
Regulatory and IP Due Diligence
Regulatory due diligence is highly fact-specific — it depends entirely on the industry and the structure of the transaction. The following areas are most commonly encountered in South African business sale transactions.
Sector Licences — Non-Transferability in Asset Sales
Many sector licences are issued to a specific legal entity and are not automatically transferable on a sale of the underlying business. Financial services providers (FSPs) licenced under the Financial Sector Conduct Authority (FSCA) must apply to the FSCA for a new licence — or for approval of a change of control — before or shortly after a transaction. Credit providers registered with the National Credit Regulator (NCR) face similar requirements. Liquor licences, mining rights, and environmental authorisations are generally non-transferable without regulatory approval. The buyer must factor in the time and cost of re-licencing when structuring the transaction.
Competition Act — Merger Notification
Under the Competition Act 89 of 1998, mergers meeting the combined annual turnover or asset thresholds must be notified to the Competition Commission before implementation. The current thresholds for an intermediate merger are R600 million in combined annual turnover and R100 million for the target. Implementing a notifiable merger without approval is a contravention of the Act — a significant risk, as the Commission can require divestiture and impose substantial penalties.
POPIA Data Protection Compliance
The Protection of Personal Information Act 4 of 2013 (POPIA) imposes obligations on businesses that process personal information of data subjects. Due diligence should assess whether the business has appointed an information officer, implemented a POPIA compliance framework, and whether there are any ongoing Information Regulator investigations or data breach notifications. Non-compliant businesses carry a risk of enforcement action, administrative fines, or data breach liability that may materialise post-acquisition.
Data Room Best Practices
A well-managed data room accelerates due diligence, reduces information requests, and — critically — provides an audit trail of disclosure that protects the seller after closing. The following practices apply to both virtual and physical data rooms.
Data Room Setup Guidelines
- Use a virtual data room (VDR): Platforms such as iDeals, Intralinks, or Datasite provide document versioning, access logging, watermarking, and Q&A functionality. The access log becomes an exhibit to the sale agreement as evidence of what the buyer saw and when
- Redact sensitive third-party information: Customer names, supplier pricing, and personal information of employees should be redacted from documents shared at the initial review stage, before the deal has progressed to a stage where sharing such information is justified
- Formal Q&A process: All buyer questions and seller responses should be processed through the VDR Q&A module — not via email or informal conversations. This creates a written disclosure record that prevents later disputes about what was represented
- Disclosure letter: At the end of due diligence, the seller delivers a formal disclosure letter to the buyer, disclosing all exceptions to the warranties in the sale agreement. The data room index and Q&A log are typically annexed to the disclosure letter
- NDA enforcement: The data room access agreement should reiterate the NDA obligations and specify that accessing documents in the data room constitutes acceptance of the NDA terms. This provides an additional layer of enforceability
10 Red Flags to Watch For
The following red flags, when encountered during due diligence, warrant heightened scrutiny and may justify a price reduction, additional indemnities, or a decision not to proceed with the transaction.
Inconsistent Financials
Significant discrepancies between audited financials, management accounts, and VAT returns — or unexplained variances in revenue between periods — suggest accounting irregularities or financial misrepresentation.
Qualified Audit Opinion
An auditor's report containing a qualification, emphasis of matter, or going-concern uncertainty is a serious red flag. It indicates that the auditors were unable to obtain sufficient evidence to support the financial statements without reservation.
Key-Man Dependency
Where the business is entirely dependent on one or two individuals — typically the founder — and those individuals are departing post-sale or are not subject to meaningful restraints, the core value of the business may evaporate on day one.
Undisclosed Litigation
A seller who initially claims there are no pending or threatened proceedings but later discloses matters during due diligence has breached the initial representation. Undisclosed litigation is both a liability and an indication of the seller's willingness to be candid.
SARS Debt or Non-Compliance
A SARS tax compliance status certificate showing non-compliance, or evidence of outstanding SARS assessments, payment plans, or compromises, signals significant potential tax liability. The full quantum of the SARS debt may not be apparent until SARS conducts an audit.
Change-of-Control Gaps
Key contracts that contain change-of-control clauses which the seller has not identified — and which the buyer discovers during legal due diligence — suggest either inadequate disclosure or a deliberate attempt to conceal transaction risks.
Customer Concentration Risk
Where more than 30% of revenue comes from a single customer — particularly one without a long-term contract — the business is exposed to catastrophic revenue loss if that customer relationship does not survive the change of ownership.
HR Non-Compliance
Evidence of underpaid overtime, non-compliant employment contracts, employees classified as independent contractors who are in fact employees, or undisclosed CCMA referrals — all indicate potential labour law liability that may crystallise post-closing.
Deferred Maintenance
A business where capital expenditure has been deferred for several years to improve reported profitability will require significant investment post-acquisition. The due diligence should include a physical inspection and an independent assessment of the condition of plant, equipment, and IT infrastructure.
Non-Transferable Licences
Discovery during due diligence that the core licence required to operate the business (FSCA licence, NCR registration, liquor licence, environmental authorisation) is not transferable in the proposed deal structure — and that re-licencing will take months or may be refused — can be a fundamental deal-breaker.
The Due Diligence Report
At the conclusion of the due diligence process, each workstream advisor prepares a findings report for their area. The buyer's lead attorney or transaction coordinator consolidates these into a single due diligence report presented to the buyer's decision-makers. The report serves two purposes: it informs the go/no-go decision, and it provides the basis for negotiating price adjustments and protective mechanisms in the sale agreement.
Deal Breakers vs Price Adjusters vs Indemnity Requests
| Finding Category | Description | Buyer Response |
|---|---|---|
| Deal Breaker | Material fraud, non-transferable licence, fundamental misrepresentation | Walk away or completely restructure |
| Price Adjuster | Quantifiable liability, normalised EBITDA lower than represented, working capital shortfall | Reduce purchase price; deferred consideration; escrow |
| Indemnity Request | Known but unquantifiable risk — SARS investigation, pending litigation, section 197 claims | Seller provides specific indemnity; backed by security |
| Warranty Strengthening | Areas where seller's disclosure was incomplete or generic | Require specific, detailed warranty; longer survival period |
| Condition Precedent | Regulatory approval required; third-party consent outstanding; licence transfer pending | Close only after condition is fulfilled |
The due diligence report should be shared with the buyer's legal team immediately — it forms the factual foundation for drafting the sale agreement warranties and indemnities. Every significant finding should be reflected either in a warranty (seller represents the position is as disclosed), an indemnity (seller agrees to indemnify against a specific risk), or a condition precedent (closing does not occur until the risk is resolved). A finding that is identified but not addressed in the sale agreement documentation offers the buyer no protection.
Due Diligence Timeline
The duration of due diligence depends heavily on the size and complexity of the target business, the quality and completeness of the data room, and the responsiveness of the seller's team to information requests. The following table provides indicative timelines.
Due Diligence Timeline by Deal Complexity
| Deal Size | Typical Duration | Key Drivers | Indicative Fees |
|---|---|---|---|
| Small (<R10m) | 2 – 3 weeks | Simple structure; limited contracts; few employees | R50,000 – R100,000 |
| Medium (R10m – R100m) | 4 – 6 weeks | Multiple contracts; SARS review; HR complexity | R100,000 – R200,000 |
| Large (>R100m) | 6 – 12 weeks | Competition Act notification; sector regulation; multi-entity structure | R200,000 – R300,000+ |
What Causes Delays?
- Incomplete or poorly organised data room requiring multiple rounds of information requests
- Delays in obtaining SARS tax compliance status certificates or SARS correspondence records
- Third-party consent processes (landlord consent, change-of-control consents from key counterparties)
- Competition Commission merger notification (intermediate mergers typically take 40 business days from notification)
Need a Due Diligence Team?
Conducting effective due diligence requires a coordinated team of legal, financial, and tax specialists working in parallel to a clear scope and timeline. MJ Kotze Inc provides legal due diligence services as part of a full-service business acquisition mandate — reviewing contracts, leases, intellectual property, regulatory licences, and employment arrangements, and coordinating with your financial and tax advisors to produce a consolidated findings report that protects your position in the transaction.
Related Topics
- Share Sale vs Asset Sale in South Africa
Understanding the legal and tax differences between acquiring shares and acquiring assets — and how the structure affects due diligence scope
- Sale of Business Agreement
How due diligence findings are translated into warranties, indemnities, and conditions in the sale of business agreement
- Selling a Business in South Africa — Overview
The complete guide to the legal process of selling or buying a business in South Africa
Speak to an Attorney About Your Transaction
Every transaction is different. We will advise on the appropriate due diligence scope for your specific deal, coordinate the legal workstream, and ensure your interests are properly protected in the sale agreement.
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