‘Investigating a business before purchase is vital as few businesses have a perfect history,’ says Louise Adams, associate solicitor in the commercial department at QualitySolicitors Parkinson Wright. ‘A business that looks great on its website or on the shopfront may be lacking in other areas, and you need to know if there are any skeletons in the cupboard.’
A thorough investigation of the business, its current owner and the assets will help you understand what you are taking on, key points for negotiation, and any actions required to secure the right to trade and maximise value.
This process is known as ‘due diligence’ and our lawyers will make enquiries on your behalf and provide a report on the replies to highlight any risks. This will help you to decide whether you wish to proceed, renegotiate or back out gracefully.
It may seem that the accounts are the most important aspect of any business. However, some buyers just want access to a customer list, a particular contract, some intellectual property, or the trading name.
The key things to consider are:
- reasons for the sale;
- the seller’s right to trade;
- financial accounts;
- major contracts; and
- intellectual property.
Reason for sale
There will be a ‘narrative’ presented to you by the seller about the reasons for the sale. For example, you may be told it is a retirement sale or a change in direction by the seller.
Exploring the reasons for a sale is important, for example:
- Is there is a lease coming to an end?
- Is a major customer in trouble?
- Is there a new competitor in the market which you do not know about?
- Is one of the relatives of the seller about to set up a phoenix operation, while assisted by the outgoing seller?
Despite what you have been told, you should always ask whether the seller is aware of any future event or reason that could impact upon the business. If the seller falsely provides a warranty that there is nothing in the pipeline that will cause any problems, and a significant loss occurs from something they knew about, you would have a claim for losses which flow from that breach of warranty.
Confirming the seller’s right to trade
You will need to understand how the seller trades; what right the seller has to operate the business; and that they have the legal right to sell it to you.
If they manufacture a product; do they have the exclusive right for production and sales? Is there a distribution or franchise agreement?
You will need to explore these arrangements and contract terms before you begin examining the business in detail, or you could find yourself hamstrung by onerous restrictions. For example, you need to check there are no restrictions on the territory you can trade within or whether certain potential customers cannot be approached.
With your accountant, you should review the trading accounts of the business and accounts going back at least three years. You should also ask for management accounts and forecasts.
There should be notes in the accounts about trading activities and any changes, but if they are not there your accountant will flag up concerns.
The accountant can:
- compare past invoices against tax returns to ensure the income and expenditure tally; and
- review the management accounts to see if the projections for the future are feasible and reflect the profits from the year before.
Things to look out for from a legal perspective include checking:
- the extent of loans and their security arrangements;
- any issues from bad debts;
- the total for salaries corresponds with the number of employees and/or disclosed remuneration of the seller; and
- any notes in the accounts that reveal historical issues that need further investigation.
To ensure a smooth transfer of the business, you will need to review the key contracts (which will usually be provided in an anonymised format). The suite of contracts will depend on the business, but some of the major contracts that you need to look at include:
The supplier will usually want your business, but some suppliers could use the change in ownership as a trigger to terminate and renegotiate terms. Things to look out for include:
- a trigger provision in the contract allowing the supplier to terminate should the owner change; or
- a discount provision that is personal to the seller which will be removed should the owner of the business change.
If you are taking over a lease, the landlord of the property will usually insist on the lease being transferred to you. However, you need to check the rent terms, liability for any repairs, and the renewal terms with your solicitor. All of these can be renegotiated immediately before the takeover, but there is a risk that these negotiations can cause delays.
If a landlord does not want you to have the lease in your name, you should proceed with caution and take advice on the risks. The landlord may:
- refuse you as a tenant altogether, forcing you to find other premises; or
- insist you only be granted an underlease, with the seller remaining as the tenant. This protects the landlord’s legal remedies against its original tenant, but you would have no security or right to renew.
Investigating customer contracts is vital.A seller will usually insist on hiding their customers’ identities, but if you are buying ongoing contractual relationships you will need to check the terms of the contracts and any restrictions on changes in ownership of the business.Most contracts will continue despite a change of owner, but some customers may choose to go somewhere else so you should ask your solicitor to check and see if there is anything that can be done to tie them in.
Look at the notice periods, and whether there are problems with complaints or any customer disputes which might come back to haunt you. Buying the assets of the business does not usually involve taking over its liabilities, but if a good customer has complained or if there is a dispute, it is unlikely that customer will continue trading with the business going forward.
Check if any one customer provides more than 10 per cent of custom, as you will need to understand how they will feel about a change of owner and consider if you need to keep the seller on for a short introductory period to smooth a transition or effect introductions. You may even consider a staggered payment structure of the purchase price.
Employment contracts are the only contracts that automatically transfer to you if you take over a business that employs people.All other contracts must be either formally transferred or adopted by conduct of implied agreement.
Our employment law colleagues will help you to review this key element of the business. You also need to investigate staff pension rights and your ongoing commitment.
The trading name of the business may be of particular value, and you will want to confirm ownership of the company name(s), trade marks and domain names.
Other intellectual property assets to review include:
- brand licensing agreements;
- databases; and
- business systems and methods.
How we can help
Buying a business is a bold commitment and these are just some of the things you will need to think about. Our solicitors will be with you every step of the way to protect your interests.
We have acted on numerous company sales and acquisitions and have standard sets of enquiries to raise with the seller on your behalf.
Taking the time to make thorough enquiries and to read the small print during the early stages will pay dividends by putting you in a well-informed position for the negotiations.
This article is for general information only and does not constitute legal or professional advice. Please note that the law may have changed since this article was published.