The Due Diligence Period in a Letter of Intent: How Long It Runs and What Each Side Must Do

Due diligence is the buyer's investigation of the business between signing the letter of intent and signing the purchase agreement. Its purpose is to confirm that the business is what the seller described, to find the liabilities the price should reflect, and to shape the representations, warranties and indemnities in the definitive agreement. The letter of intent sets the rules: how long the buyer has, what the seller must provide, and what happens at the end.

In Ontario private-company deals the diligence period and the exclusivity period are usually the same window, because exclusivity exists to protect the diligence spend. Drafting one without the other produces a mismatch: a buyer still investigating after exclusivity ends, or a seller locked up after the buyer has finished. Our guide to exclusivity clauses covers that side; this article covers the diligence terms.

The period is also where the buyer's lawyer and accountant do most of their work and where the buyer learns whether the asset or share structure chosen in the letter still makes sense. A buyer who discovers unfiled tax returns or an undisclosed lawsuit during diligence will often switch from shares to assets. The letter should allow that without reopening the whole deal.

Thirty days is a short diligence period for a private business and works best where the records are current and the buyer has already seen the financial statements. Thirty to sixty days is the usual range, at the longer end where the buyer needs bank financing. Longer periods are justified where the buyer needs a lender's own diligence, a landlord's consent to assign the lease, a franchisor's approval, a regulator's licence transfer or an environmental assessment of owned premises.

The start date matters as much as the length. The period should begin when the seller delivers the initial diligence materials, which the letter can define by reference to a request list attached as a schedule, not on the date of signing. Sellers who object to that should commit to a delivery date instead, so that the buyer is not consuming its period waiting.

Extensions should be mechanical rather than discretionary. A common approach: the period extends automatically by the number of days the seller is late in delivering a requested document, and extends by a further fixed period, say 15 days, if the buyer has delivered a draft purchase agreement and confirms in writing that only specified items remain outstanding. Beyond that, extension requires the seller's written consent.

The letter should oblige the seller to give the buyer and its advisers reasonable access, during business hours and on notice, to the books, records, contracts, premises and management of the business, and to respond to written requests within a stated number of business days. It should also list the core categories, with the detail left to the request list:

• Corporate records: articles, by-laws, the minute book, share register, shareholder agreements and the register of individuals with significant control. Gaps here are common and are the subject of our guide to corporate minute books.
• Financial and tax: financial statements for three to five years, interim statements, tax returns and assessments, HST and payroll filings, and any audit or review correspondence.
• Contracts: customer and supplier agreements, with their assignment and change-of-control clauses identified.
• Premises: the lease, amendments, the landlord's consent requirements and the state of rent. Commercial leases in Ontario are governed by the Commercial Tenancies Act and the lease itself, and most require landlord consent to an assignment or a change of control. Unless the lease says otherwise, the Act provides that consent to an assignment is not to be unreasonably withheld.
• Employees: a list with start dates, compensation, written agreements, policies and any claims under the Employment Standards Act, 2000 or the Human Rights Code.
• Intellectual property: registrations, applications, licences and the assignments from the people who created the IP. Our guide to IP due diligence explains what to check.
• Litigation, regulatory and insurance: claims, demands, licences, inspections and policies.
• Information technology and data: systems, licences, privacy compliance and any breach history.

Sellers should prepare these before the letter is signed. A well-organized data room shortens the period, reduces the buyer's findings and signals that the business is run properly. Our checklist for buying a business in Ontario doubles as a seller's preparation list.

The diligence condition is the buyer's right to walk away if the investigation disappoints. How that right is phrased decides how free the buyer is to use it.

"Satisfactory to the buyer in its sole and absolute discretion" gives the buyer the widest right to terminate. Sellers dislike it because it turns the letter into a free option, but it is the market standard at the letter stage, where the buyer has not yet seen the business. Ontario courts will generally respect a subjective condition, but even a sole-discretion condition must be exercised honestly and in good faith: the buyer must be genuinely dissatisfied, not using the condition as a pretext.

"Satisfactory to the buyer, acting reasonably" obliges the buyer to have a diligence-based reason. It gives the seller an argument if the buyer walks for reasons of its own, such as a change of strategy, but the argument is expensive to run, and most sellers get more protection from a short period, milestones and a cost-reimbursement clause than from the standard of satisfaction.

Whatever the standard, the letter should require the buyer to give written notice of satisfaction, waiver or termination by the end of the period, and should say what silence means. The usual rule is that the condition is deemed not satisfied if no notice is given, so that the deal ends rather than continuing by default. Buyers who want the opposite rule should ask for it expressly.

The letter can also provide for what happens if diligence reveals a problem that is fixable. A short cure mechanism, under which the buyer identifies the issue and the seller has a stated period to fix it or agree a price adjustment, keeps a deal alive that a bare termination right would end.

Diligence rarely ends in a clean bill of health. What it produces is a list of findings, and the letter of intent should anticipate what each kind of finding does to the transaction.

Price findings. Revenue that depends on one customer with a contract about to expire, inventory that is obsolete, equipment that needs replacement, or earnings adjusted by owner expenses that will not continue. These lead to a price reduction or a restructured payment, such as a larger earn-out. A letter that fixes the price without a diligence-based adjustment mechanism makes every price finding a renegotiation of the whole deal.

Structure findings. Unfiled returns, an unresolved tax assessment or a lawsuit push a buyer from shares to assets, because an asset purchase generally leaves those liabilities with the seller's corporation. An environmental issue on owned premises is different: Ontario's Environmental Protection Act allows orders against the current owner of the property, so a buyer that takes the land takes that risk, and will want to exclude the real estate, lease it instead, or price and insure the problem. The letter should allow the buyer to elect an asset structure on written notice, with the price allocation to follow.

Consent findings. Contracts that terminate on a change of control, a lease that requires the landlord's consent to an assignment, licences that are personal to the seller. These become conditions to closing and items on the closing agenda, and they can lengthen the period.

Record findings. A minute book that has not been kept, share issuances that were never documented, directors who were never properly elected. These are fixed by rectification resolutions before closing, at the seller's cost, and are a reason sellers should put their corporate records in order before marketing the business.

Deal-breakers. Occasionally diligence reveals something that cannot be priced: a regulatory investigation, a key licence that will not transfer, or financial statements that do not reconcile to the bank records. The diligence condition exists for this case, and the buyer should exercise it promptly and in writing rather than letting the period lapse.

The letter cannot resolve findings in advance, but it can say how they are handled: a written findings notice from the buyer, a short period for the seller to respond with a fix or a proposed adjustment, and termination with return of any deposit if no agreement is reached. That process keeps a repairable deal alive and ends an unrepairable one cleanly.

While the buyer investigates, the seller keeps running the business, and the letter should say how. The standard covenant is to carry on in the ordinary course, consistent with past practice, and not to make distributions, incur debt, enter long-term commitments, change compensation, hire or dismiss key staff or settle claims above a threshold without the buyer's consent. This protects the buyer from buying a different business from the one it investigated, and it should be binding.

Everything the buyer learns is covered by the confidentiality obligation, which should restrict use to evaluating the transaction, prohibit contact with customers, suppliers and employees without the seller's consent, require return or destruction of materials if the deal fails, and survive the letter. Sellers should disclose in stages, keeping the most sensitive information, customer pricing and employee files, for the end of the period when the buyer's commitment is clearer.

At the end of a successful diligence period the parties sign the purchase agreement, and what the buyer found becomes the seller's disclosure schedule, the exceptions to the representations and warranties. Diligence that is thorough makes that schedule accurate and the post-closing relationship quiet. If you are drafting or reviewing the diligence terms of a letter, we can help.