BUYING A BUSINESS. TOP 10 LEGAL TIPS FOR A SUCCESSFUL PURCHASE. Conveniently packaged by Atticus Legal, Extraordinarily Clever Business Lawyers Hamilton
There are 10 main things to consider when buying a business, and more depending on the type of business. They are:
- Pre-contract research on the business, what you are buying and the business environment (including competition and demand/supply factors).
- Profitability, price & apportionment of the price (and the assumptions on which profit forecasts are based).
- Lease terms and suitability of the premises.
- Contract conditions – due diligence, key contracts, key personnel, etc.
- Staffing (human capital) & terms of employment.
- Assets (evaluate condition/quality & return on investment) & assess likely capital replacement or improvement costs.
- Financing the purchase & working capital (and ability to service debt).
- Optimal structure for purchasing & owning the business (including tax implications) – usually a company, but what about a ‘Look Through Company’ (LTC)?
- Restraint of trade on the seller & its shareholders and directors.
- Exit arrangements – saleability of the business &/or whether the lease can be readily assigned or sublet. Is the business so unique (eg. in terms of products/services or location) as to limit the market for eventual re-sale?
All of the above factors are important. But this article comments on the first 5 only. The rest are more or less self-explanatory.
Call Atticus Legal now if you want to know more about buying a business, or selling a business for that matter. We’ve assisted many clients buying and selling businesses over the last 25 years. We know these inside-out. Our expertise and experience can really add value when buying a business.
Pre-contract research when buying a business
You should make a pre-contract investigation and initial assessment of the success or otherwise of the business. A more detailed assessment of profitability, etc will follow when you insert a due diligence condition in the purchase contract (see below). Note that the ‘buyer beware’ principle features strongly when you are buying a business or taking over a lease. You should investigate and assess as much as reasonably possible before committing to it.
Ideally this preliminary inquiry stage should be carried before signing the purchase contract, to avoid unnecessary legal and accounting fees if it becomes obvious quite early on that the business is no good. However, the seller is unlikely to give you any ‘hard’ information before you sign a purchase contract. Even so, just asking to attend at the business for a day or two will give you some insight into the business. You can see how they operate, who their customers are, how busy they are, how hard their staff work (or not), what the foot-traffic is like (for a retail business), etc.
You should also consider the competition. How strong/nearby is it? Does the business have a competitive advantage? Will that advantage endure? Are there any competition constraints/barriers to entry? Are there any constraints on expanding the business?
At this stage also give consideration to what you are buying or should be buying. Some of this should wash out as part of your due diligence condition investigation, but you need to be able to specify in the contact what business assets you are buying. These are usually listed for you by the seller, but what if a key asset is in fact not owned by the seller? For example, what if important intellectual property such as a patent or trade mark is owned by a separate entity (as is sometimes the case, depending on the type of business, where valuable intellectual property is held separately from the trading concern)? You could purchase the business (without those assets) and then be held over a barrel. It’s up to you to ensure you are buying everything you need and that all relevant assets are listed in the purchase contract.
Don’t forget that where the seller company includes the brand or trading name in its company name, you need to have a clause in the purchase contract requiring the seller to change its company name to something dissimilar on settlement.
2. Profitability, price & apportionment of the price
Is it a financially viable business taking into account the level of your intended borrowing? Or is it a failing business, which may be why it is being sold? Is there room to increase profitability? – eg. by increasing sales or reducing costs?
Is the asking price reasonable, based on current and forecast profit? An assessment of a fair price for the business by your accountant is usually based on future earnings potential. This requires various assumptions to be made. Do the assumptions on which the forecast earnings and profitability are based stack up?
Sometimes a seller bases the asking price on a multiplier of earnings before interest and tax (EBIT) or just a multiplier of annual profit. If it is based on an EBIT multiplier or similar, is there an ‘industry norm’ to compare it to? Or has the seller just plucked a number out of the air? Comparable sales prices for nearby similar businesses may not help much because businesses can vary greatly in profitability. Your accountant’s advice is essential here to avoid paying too much for the business and, in turn, putting yourself under unnecessary financial pressure by borrowing too much.
This financial viability and price assessment will form part of your investigations under the due diligence condition in the contract. If you find out that the price does not represent fair value and/or there’s a problem with financial viability and the seller won’t re-negotiate the price, the due diligence condition will allow you to walk away from the purchase.
The apportionment of the price has consequences for tax deductibility and depreciation – usually the issue is the apportionment of the price between goodwill and the price for tangible assets (plant & equipment and stock). You should take advice from your accountant on this as part of your due diligence, if not earlier when the contract is prepared. Will the seller agree to modify the apportionment?
For the purpose of the above assessments by, and advice from, your accountant the due diligence condition will need to be appropriately worded to require full disclosure by the seller of financial statements, GST returns, bank statements and all financial records.
3. Lease terms and suitability of the premises
The general terms of the standard Auckland District Law Society business sale and purchase contract contain a clause making the contract conditional on the purchaser (or purchaser’s lawyer) approving the lease documents within 5 working days after copies of all lease documents are provided.
Obviously relevant lease terms are the rent, remaining term and rights of renewal and rent review dates. If the rent seems low, ask an estate agent for a rent appraisal so that you’ve got some idea what the rent may rise to on the next rent review date.
Are the remaining term and rights of renewal sufficient to allow a reasonable period for you to trade and then have sufficient remaining total lease term left to offer when you sell the business (eg. say 6 to 8 years)? If not, consider adding a condition to the purchase contract (or including within your due diligence condition requirements) making it conditional on your obtaining landlord’s written agreement to further rights of renewal.
Also consider the suitability of the premises when buying a business. For example, for retail is there sufficient foot traffic? Is there space to expand? If you need to alter the premises, add a condition (or include it within your due diligence) requiring landlord’s written consent to the alterations.
4. Contract conditions when buying a business
The most important contract condition is an appropriately worded broad due diligence condition. In addition to the investigations already mentioned above (including input from your accountant), you should also speak to key suppliers, key customers and key personnel to find out what their intentions are. If you know they are important to the business before signing the purchase contract, you should include a condition requiring their written agreement to continue their arrangements with you following purchase.
Check the terms of the contracts with those persons. Are they binding? Fixed term? Assignable? Otherwise on acceptable terms? Legal input is appropriate here. Are key assets owned by the seller? Are they subject to securities that need to be discharged on settlement? Are important contracts enforceable or are they more loose ‘arrangements’?
What ongoing liabilities (eg. product warranties) need to be addressed in the purchase contract? Will the purchaser satisfy those product warranties and recover the cost from the seller?
In addition, the purchase contract will usually need to be conditional upon landlord’s consent to assignment of the lease and your arranging sufficient finance. If land and buildings form part of the business assets being purchased, you should also have a builder’s report condition and possibly a valuation condition (which may be required by your bank).
5. Staffing & terms of employment
The human capital of the business is often the most important asset. The purchase contract will usually allow the purchaser to determine which, if any, of the seller’s existing staff the purchaser wishes to offer employment to. Usually the seller is liable for any outstanding holiday pay, severance and other entitlements to be paid out on settlement date. The purchaser enters into a new employment relationship with selected staff, so legally a redundancy situation arises for the seller.
Clearly the purchaser needs to speak to the staff, if only to gauge which of them he/she wishes to employ. Sometimes some staff are key to the continuing success of the business and buying a business without them poses a significant risk. In that case, the purchase contract should be made conditional on (or satisfaction of the due diligence condition subject to) those key personnel agreeing in writing to be employed by the purchaser on terms acceptable to the purchaser.
Buying a business is a big step. You should ensure you have great legal advice from the outset. Call Atticus Legal, Hamilton’s supremo business lawyers.
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This information sheet is copyright ©Atticus Legal, September 2016