Quick answer: Employment due diligence is the buyer’s review of the people side of a company: whether workers are classified correctly, whether pay and hours practices and benefit plans follow the rules, which agreements bind employees, and whether the people who matter will stay. Findings become price deductions for past exposure, corrected costs in adjusted EBITDA, special indemnities, or retention agreements signed before closing.
Key points
- Classification is tested first, because a contractor who should be an employee creates a past exposure and a higher run-rate cost, and the two reach price by different routes.
- The IRS weighs behavioral control, financial control and the type of relationship together, so a buyer reads how contractors actually work and not only the label on the agreement.[1]
- Pay practices, benefit plans and accrued pay are reviewed through records and sampling, and amounts that belong to past periods become debt-like items.
- Key employees matter as much as the owner: buyers ask who holds customer relationships and technical knowledge, then look for retention agreements and restrictive covenants.
- A seller who tests classification, accruals and covenants before launch can show a buyer a fixed problem instead of an open one.
What an employment review settles
A buyer reviews the people side of a company for two kinds of cost: liabilities from past periods, which come off the price, and expenses that will continue, which lower adjusted EBITDA. In a stock purchase the employer is the same entity, so wages, payroll tax, benefits and claims travel with it. In an asset purchase the buyer chooses whom to hire and which liabilities to assume, and counsel confirms what still follows. The review begins with a census of every employee and contractor, then tests samples against pay records and agreements. The legal side of the same file is covered in the legal diligence overview, and the full sequence is mapped in the guide to due diligence in a business sale.
Review areas, the risk each tests and the fix
| Area | What the buyer reviews | Risk it looks for | Fix before launch |
|---|---|---|---|
| Worker classification | Contractor agreements, payments made outside payroll, how the work is directed | Contractors who work like employees | Counsel review, then convert or restructure |
| Pay practices | Time records, overtime treatment, roles treated as exempt from overtime | Unpaid wages for past periods | Counsel audit and a corrected process |
| Accrued pay | Vacation, bonus and commission plans, deferred pay, severance promises | Earned amounts not on the books | Accrue monthly and document plan terms |
| Benefit plans | Plan documents, filings, test results, who was offered coverage | Late filings, failed tests, uncovered workers | Benefits counsel review and correction |
| Agreements and covenants | Offer letters, employment agreements, non-competes, invention assignments | Change-of-control payments, covenants that may not hold, missing assignments | Catalog and update with counsel |
| Key people and turnover | Organization chart, tenure, pay, who holds relationships, turnover by role | Revenue that leaves with a person, unexplained departures | Retention agreements and a documented successor |
| Claims and complaints | Charges, demand letters, settlements, internal complaints | Open or repeating matters | A one-page log per matter with insurer letters |
Contractors, employees and the cost of correcting
The IRS sorts the evidence about a working relationship into three categories: behavioral control, financial control and the type of relationship. It weighs all of the evidence together, and no single factor decides.[1] A buyer’s counsel applies that approach to what the work looks like in practice. Who sets the schedule and methods, who supplies the equipment, whether the person serves other customers and whether the arrangement is open-ended all matter more than the word in the contract. Other agencies and states may apply their own tests, so employment counsel decides how an arrangement would be treated.
A finding reaches price twice, once for the past and once for the future. A staffing firm, which employs placed workers by design, faces this test across its whole workforce, as the valuation page for staffing and recruiting firms describes.
Illustrative example: How four people findings reach price
A buyer offers 5.0x adjusted EBITDA of $2,400,000, which is $12,000,000. Its review makes four findings.
| Finding | Route | Effect on price |
|---|---|---|
| Vacation and bonuses of $150,000 earned but not recorded | Debt-like item | $150,000 |
| Correcting overtime pay adds $80,000 a year of payroll | Adjusted EBITDA, multiplied by 5.0x | $400,000 |
| Contractors who must become employees add $60,000 a year | Adjusted EBITDA, multiplied by 5.0x | $300,000 |
| Back payroll tax and related amounts of $90,000 on the same workers | Debt-like item | $90,000 |
| Total | $940,000 |
Adjusted EBITDA falls by $140,000 to $2,260,000, which at 5.0x is $11,300,000, and the two deductions take another $240,000, so the price falls from $12,000,000 to $11,060,000. The same reclassification is counted once as a bill for the past and once as a cost for the future, and it is not double counted. The numbers are invented to show the mechanics and are not benchmarks.
Key employees, covenants and retention
Buyers ask who holds the customer relationships, the technical knowledge and the supplier contacts, then compare that list with pay, tenure and what each person has signed. The owner is only one name on it. The guide to key-person risk explains how dependence is priced. A gap draws one of four responses:
- Retention bonuses. Paid after a set period, often funded in part by the seller through the price.
- New employment agreements. Signed before closing, sometimes as a condition of closing.
- Restrictive covenants. Non-solicit and non-compete terms, whose enforceability depends on state law and the facts, so the seller’s attorney reviews them.
- Invention and confidentiality assignments. Signed by anyone who built something core.
Timing matters. Telling a key employee too early risks a leak, and telling one too late risks a refusal at the last week, a sequence the guide to telling employees and customers about a sale covers. The owner’s own post-closing role is set separately, as the guide to transition periods and post-closing roles describes.
Benefits, accrued pay and plan files
Benefit plans carry their own paper: plan documents, annual filings, testing results and records of who was offered coverage. A failure is often fixable, but the fix has a cost, so benefits counsel puts a number on it. Buyers sometimes ask the seller to end a retirement plan before closing so employees can move to the buyer’s plan, and benefits counsel advises whether and when. Earned but unpaid vacation, bonuses and commissions are the usual debt-like items in this area, and sellers aim to show a monthly accrual policy that was applied consistently.
Preparing before launch
- Build a census of every employee and contractor with role, pay, start date and what each has signed.
- Have employment counsel review contractor arrangements and decide which to convert.
- Confirm that accrued vacation, bonuses and commissions are booked every month.
- Collect plan documents, filings and test results in one folder.
- List the people customers and suppliers rely on, and decide who will be asked to sign retention terms.
- Write a one-page summary for each open claim, with the insurer’s letter.
Fixes made before launch, with the date and the cure on record, give the buyer a closed item instead of a question. The overview of red flags buyers find shows how people findings read beside financial and operating ones. This guide is general education and not legal advice.
Frequently asked questions
What does a buyer review in employment due diligence?
Buyers review the census of employees and contractors, offer letters and employment agreements, restrictive covenants, pay and hours records, benefit plans and their filings, accrued compensation, claims and complaints, turnover, and reliance on specific people. The goal is to find liabilities that belong to past periods and costs that will recur after closing.
How do buyers test whether workers are contractors or employees?
They look at how the work is actually done. The IRS sorts the evidence into behavioral control, financial control and the type of relationship, and weighs all of it together, with no single factor deciding.[1] Buyer counsel reads the contracts and asks who directs the work, who supplies the tools and whether the person serves other customers. Other agencies and states may apply their own tests.
What happens if a buyer finds misclassified workers?
The buyer prices two things. The past exposure is deducted from the price, covered by a special indemnity or held in escrow. The higher cost of treating the workers as employees from now on lowers adjusted EBITDA, which the multiple scales up. Some buyers also require the workers to be converted before closing. Employment counsel advises on the exposure.
Do buyers require key employees to sign agreements?
Often, when a few people hold customer relationships or technical knowledge. Buyers ask for retention bonuses, employment agreements or non-solicit terms from those people, sometimes as a condition of closing. Whether covenants are enforceable depends on state law and the facts, so the seller’s attorney reviews them before the buyer relies on them.
How can a seller prepare for employment diligence?
Build a current census of employees and contractors, review contractor arrangements with counsel, confirm that accrued vacation, bonuses and commissions are booked, collect benefit plan documents and filings, and list the people customers depend on. Fixing a gap before launch, with a record of the date and the cure, leaves the buyer a closed item.
Preparing a company for sale or a buyer's diligence?
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Related guides
- Staffing and recruiting firms: How buyers value staffing and recruiting firms: temporary versus permanent placement, gross profit, payroll funding, compliance and client concentration.
- Legal Due Diligence Checklist for a Business Sale: Contracts, IP, Litigation and Records: What buyer counsel reviews in a sale: ownership records, change-of-control clauses, IP assignments, permits, litigation and insurance, plus a seller clean-up list.
- Key-Person Risk: How Owner Dependence Affects Valuation: How buyers measure owner dependence, why it lowers value and shapes deal structure, and what an owner can change in the years before a sale to reduce it.
- Due Diligence in a Business Sale: What Buyers Examine and in What Order: Due diligence in a business sale: the workstreams buyers run, their order, who does each, what each can change in price or terms and how sellers stay ahead.
- Debt and Debt-Like Items in a Business Sale: What Reduces Your Proceeds: Which debt-like items reduce proceeds in a business sale, such as deferred revenue, deposits, accrued bonuses and owner loans, and how each side argues them.
- What Happens to the Owner After a Business Sale: Transition, Consulting and Employment Terms: After closing, the owner’s role is set by contract: a short transition, a consulting agreement, employment or a board seat. See the terms that move pay and price.
Sources
- Independent contractor (self-employed) or employee?. Internal Revenue Service. Accessed October 13, 2026.
This guide is general education. It is not a valuation opinion, appraisal, investment advice, or legal or tax advice. How these guides are made.