EXPERIENCE. TRUST. SOUND ADVICE.
Buying a Business
A Few Things You Should Know
If you are buying a business, these are the matters that you should (at the very least) consider right at the outset of your business purchase so as to avoid creating unnecessary (and potentially costly) issues for yourself in the course of or following your business purchase.
What am I actually buying, the Business Assets or the Shares?
If you are purchasing a business, you must, right at the outset, think about whether it makes sense for you, in the context of your specific circumstances and commercial objectives, to purchase the business assets only of the vendor (which you will then run under your own legal entity) or in the alternative, to purchase the shares in the legal entity of vendor such that you become the owner of the legal entity that owns the business. There are many advantages and disadvantages to both approaches.
Purchasing the business assets only is an attractive option with many of our clients as it means that you become the owner of the business free of any encumbrances, debts and liabilities associated with the business, which will remain the responsibility of the vendor (such as any tax liabilities, for example). However, with larger businesses, it is not uncommon to have to take over the trade creditors, employee entitlements (and other debts incurred in the usual and ordinary course), which would be adjusted for in the purchase price (but definitely not tax liabilities, which could be a high risk area).
Purchasing the shares in the legal entity that owns the business has its advantages too. For example, you may not have to pay any stamp duty on the acquisition (which, for larger business asset purchases, can amount to tens, if not hundreds, of thousands of dollars). As the owner of the business remains the same (there being only a change of shareholding of the legal entity in the background) all existing supply and services agreements, leases, hire-purchases, licences and employment agreements, remain in place, without having to take steps to enter new or assign those agreements with the consent of the third parties to those agreements.
This is but the tip of the ice berg in terms of the differences between the two approaches, but getting this right at the outset may result in many obstacles and risks being avoided and thousands of dollars saved.
Should I enter a Heads of Agreement?
We always recommend (especially for larger businesses) that the parties enter a Heads of Agreement. A Heads of Agreement is basically a document setting out the key terms of the agreement, usually in principle only, meaning that the parties are not bound to proceed with the purchase and sale of the business unless and until the key terms (and any further negotiated terms) are fully and finally formalised in a business contract of sale that follows.
A Heads of Agreement (as opposed to mere and random discussions between the parties) commits the parties to a clear plan of action to completing the purchase transaction, and it gives the parties insight into what those final terms of the business contract of sale will look like (including an opportunity to iron out any issues or disagreements during this more informal stage of the proceeding).
The Heads of Agreement will tackle all the big terms, so there are no surprises, including the purchase price payable (and how the final purchase price will be determined), any retention sums to be withheld from the purchase price, are there any preconditions to the formal contract becoming unconditional (such as obtaining a new lease from the landlord of the business premises, a transfer of the material contracts and licences of the business etc), are the employees being taken over, and if so, how are there entitlements to be dealt with, and many other issues.
A Heads of Agreement should also permit, in the timetable contained in the Heads of Agreement, for the buyer to conduct legal and financial due diligence on the business. This will give the purchaser an opportunity to inspect the financial and business records of the business to ascertain whether the business is in as good a shape as it has been made out to be, or whether there are issues which could be overcome by adjustments to the purchase price, or whether there are red flags all over the place such that it is deal breaker and there is no longer a point in proceeding further with the purchase.
And lastly, whilst a Heads of Agreement is generally non-binding, there are terms contained in the Heads of Agreement which will be binding on the parties, such as the obligations of the parties to keep the negotiations and business information disclosed strictly confidential, and for there to be exclusivity between the buyer and the vendor, meaning the vendor, for a period of time, is not allowed to be negotiating further deals with other parties in the background.
Who are the Parties to the Purchase Transaction?
Only the true owner of the business assets has the ability to pass full legal title and ownership of the business assets to you. However, and we see this time and time again, the parties will not give too much thought to identifying the precise details of the legal entity/ies that own the business. The parties will simply proceed on assumptions that either this guy or that company own the business, a most of the time, they are simply innocent mistakes. But these mistakes can create big problems.
For example, the vendor selling the business (who is not a lawyer, and therefore can be forgiven) may believe that his company “XYZ Pty Ptd” owns the business, but during our legal due diligence, we may discover that it is in fact his trading trust that owns the business, being “XYZ Pty Ltd as Trustee for XYZ Family Trust” or “XYZ Group Unit Trust” and not the company. In the eyes of the law, this makes a big difference, as the company, in the first example, does not own the business assets (which are in fact “trust assets”), and therefore has no assets to pass to the buyer in the purchase transaction.
At other times the business assets will be owned by a partnership comprised of either individuals, companies and trusts, or any combination of them. So, for example, the vendor may in fact be XYZ Pty Ltd and ABC Pty Ltd, as partners of a registered partnership trading as “x”. There are instances where the trading entity may not in fact own the business assets for asset protection reasons and the assets are own by a related holding company. In this case, both parties would need to be added as the vendor to the contract.
There are also situations (which usually comes out during legal due diligence) where it is discovered that certain assets used by the business are owned by the directors personally, so they too would need to be added as parties, if these assets are business assets intended to pass to you.
The other equally important consideration is the legal entity that you, as the buyer, will use to buy the business and the business assets. The choice is usually made in close consultation with your accountant and lawyer, as there are advantages and disadvantages to using certain legal structures. For example, there may be accounting and scaling advantages to using a company as opposed to a trust to purchase and conduct the business.
On the other hand, there may be tax (especially income streaming and capital gains) advantages to owning the business in a trust (particularly if you plan on growing and then selling the business one day). You may wish to purchase the business with a partner and conduct the business under a partnership.
These are all important considerations that should not be overlooked, as undoing or unwinding or changing to a different legal structure later on may have significant stamp duty and capital gains implications.
Should I conduct legal and financial due diligence on the Business?
The short answer is yes.
If you are buying an existing business which you will depend upon to generate a return revenue for you for the sums you believe it already generates (usually as represented to you by the vendor, or the vendor’s agent), then it would be unwise to proceed with the purchase without having verified the legal and financial position of the business. It is not uncommon for a buyer to purchase a business only to find out after settlement that the financial information provided to the buyer more generally (in the course of completing the purchase transaction prior to settlement), contained incorrect, incomplete or misleading information.
Of course, the business contract of sale will contain certain warranties from the vendor as to the accuracy and truthfulness of the financial information provided, but once you hand over that money at settlement, that money is as good as gone and if you wish to recover damages for a breach of warranty, you will have expend further money on what may be significant legal costs to pursue an action against the vendor (who, by that stage, may have disposed of the money, been placed into liquidation, become a bankrupt or simply left the country).
Yes, instructing your lawyers and accountants to conduct legal and financial due diligence, respectively, will be an additional expense to you associated with the business purchase, but it may well save you a lot of money in the short and long term.
So what does legal due diligence involve.
Ideally, you want to undertake this step under the Heads of Agreement, prior to outlaying legal costs on having a formal business contract of sale prepared. But if you are buying a small business where the vendor’s commercial agent, for example, has already put together a standard and simple form business contract of sale, then you must ensure, prior to signing the contract, that it contains special conditions permitting you to conduct legal and financial due diligence on the business, that impose positive obligations of disclosure on the vendor, and that give you the right to lawfully terminate the contract (with a full refund of your deposit, without deduction) if you should pull the pin on the contract as you are not satisfied with the results of your legal or financial due diligence investigations.
With these sorts of standard form contracts, it is not uncommon for the buyer to have 14 to 21 days during which to conduct legal and financial due diligence following the date that the contract is signed by the parties. Your lawyers, depending on the nature of the business, will conduct investigations into the following matters regarding the business:
- corporate books, records and organisation details;
- business assets (including plant and equipment, motor vehicles, stock and inventory);
- software and information systems;
- leased assets (including hire purchase agreements);
- debts and liabilities (including advance payments, deposits, unfulfilled orders, purchase orders, trade debtors and trade creditors);
- business licences and regulatory compliance (including compliance with environmental laws);
- employees and employees wages, benefits and entitlements;
- contractors, consultants and agents;
- material contracts with suppliers, customers, creditors, partners, joint venture partners, franchisors and financiers;
- intellectual property (including trade secrets, know-how, confidential trading information, copyright, trade mark, business names, domain names, patents and registered designs);
- workplace health and safety procedures, processes and compliance;
- insolvency; and
- other relevant matters.
Your accountants will usually investigate the following matters regarding the business:
- final and interim financial statements and related financial information;
- income tax returns, tax assessments, business activity statements and integrated ATO accounts;
- accounting records and software;
- accounts receivable;
- accounts payable;
- compliance with employee taxes and superannuation requirements;
- trading information and records;
- stock and inventory values;
- market and sales information; and
- other relevant matters.
The essence of conducting legal and financial due diligence is therefore to look behind the curtains (i.e. the representations made to you regarding the financial, asset, debt and other positions of the business) in order to verify that the statements made are true and correct before you part with your money.
If you need legal advice or assistance with buying a business, please contact AdviiLaw today to speak to one of our experienced lawyers. Contact us on 07 3088 7937 or email us at [email protected]. This commentary is of a general nature only, containing some general information for the reader.
It is not intended to be legal advice, nor can it be relied upon as legal advice, as each case will depend upon its own specific facts, matters and circumstances. To this end, please kindly read our Website Terms including the disclaimer contained therein carefully. Laws, rules and principles may be subject to sudden and unexpected changes and you should always consult a lawyer about your specific circumstances before committing to a course of action.