The scenario: a man and a woman decide to buy a business, and agree to pay the owner what seems to be a fair price based on the audited accounts.

When they start running the business some problems appear: a dispute over who owns key intellectual property, a long-running argument with a major customer, a consultant's report raising serious doubts about a new product, a claim by the IRD for large amount of unpaid tax. None of these were disclosed by the former owner.

The couple's lawyer says they may be safe because they can probably sue the former owner for breaches of warranty in the sale and purchase agreement. Five years later, exhausted by inconclusive court hearings while trying to run the rather unprofitable business, they agree to settle for barely half the amount they have lost or overspent. It has also cost them many thousands in legal fees.

This outcome was avoidable. The problems were evident at the time the business changed hands. They should have been uncovered by due diligence before the purchasers agreed to buy. Then the purchaser could have worked out the likely cost of these problems to the business, and whether they could in fact be fixed.

With the benefit of that information the purchasers would have several choices: make the seller fix the problems, reduce the purchase price, or walk away from the deal.

The moral is that it's all very well having the right to sue on the agreement when unforeseen problems arise, but it's far better to find out about the problems and deal with them before going ahead.

The story cited above may seem a little unreal. Surely no one would be foolish enough to go into that transaction without doing their homework? And yet, daily, lawyers see many examples of purchasers who don't do any real due diligence, or do it incompletely, or too late, or fail to understand the significance of what they uncover.

So what is "due diligence"? It seems to have come about in the United States in the 1930s. Share brokers would provide their clients with information about the companies their clients were investing in. A new law excused the brokers from liability if they did not pass on relevant information, so long as the brokers had exercised due diligence in their research.

The idea behind a due diligence exercise is that careful checking will uncover the truth, so both parties have the same information and can bargain on a level playing field.

Due diligence is now very commonly used in business and investment. It is applied to a wide range of situations and transactions. For staff recruitment specialists, due diligence includes a careful checking of qualifications, referees and employment histories; for new company directors, it means an independent audit of the risks of the company and of the governance practices of the board.

This article concentrates on due diligence in the purchase of assets or shares in a business. Here, due diligence is a planned exercise to review material information and documents about the business and to get answers from the seller on important issues, so the purchaser can evaluate the risk of going ahead with an offer and what that offer should be.

Important points in this context:

* The goal is to identify and reduce the risks of the purchaser before becoming committed.

* The purchaser must prioritise the list of issues to look at. Otherwise, the exercise can get bogged down with trivia, and important questions may be missed. Due diligence will confirm whether the purchaser's initial assumptions and objectives have survived intact.

* The purchaser gets an understanding about the way the business is being run and whether profit improvements can be made. This may lead to the purchaser proposing that the seller or other key people stay involved in the business for a period after settlement, or to a potentially higher purchase price through a profit earn-out formula.

* Due diligence gives the best possible view of the value and condition of the assets and the ongoing levels of maintenance and reinvestment that may be needed.

* Any skeletons can be discovered, such as a negative report on the new product, tax liabilities not brought to account, patterns of customer complaints, or persistent failures to meet health and safety, environmental or advertising standards.

* An assessment can be made of the invisibles - such as staff skills, morale and commitment levels, the extent to which important relationships will be affected by the change of ownership, how much the success of the business has depended on the outgoing owner.

* The seller will be aware of the problem areas, and may have done their own due diligence. The seller will be hoping the purchaser does not uncover the problems, so there could be a need for some determined prodding by the purchaser.

Armed with the results of the due diligence the purchaser can fine-tune the offer, perhaps by adding specific warranties, making adjustments to the price and sale terms, or by leaving the seller with some of the risks that have been identified.

John Shaw is a consultant with the Auckland law firm Lowndes Associates. He specialises in commercial law with particular reference to company and business acquisitions, securities, legal compliance and corporate governance. He has extensive experience in private practice and as general counsel of public companies.