The Importance in Conducting Proper Due Diligence during a Business Sale

Businesses come in many different shapes, sizes and structures. Acquiring an existing business can often be far easier than launching a start up from scratch, especially where the Buyer is new to the industry in which the business will operate.

Due Diligence generally

Pre-contract and post-contract due diligence are important steps that allow a Buyer to better understand the business they intend to acquire, regardless of whether they will purchase:-

1. The Company that is currently operating the business, through the acquisition of the shareholding; or
2. The assets of the Business, which will be transferred to a brand new entity controlled by the Buyer.

Typically, investigations will be made of all aspects of the business, including (without limitation) assets and liabilities, plant and equipment, stock, day-to-day operations, cash flow and financial performance, taxation compliance, lease and franchise matters (if applicable), employees and employment matters, licensing requirements (if any), supplier and customer contracts, intellectual property, pending lawsuits, debtors and creditors and goodwill.

These investigations will vary, depending on the nature, size and complexity of the business and the entity that operates same. For example, the due diligence that is undertaken in an asset sale will usually be very different (and often less complex) to the due diligence that is undertaken in a share sale (which is broader and more detailed). This is because in acquiring shares in a company, the Buyer will also inherit the liabilities and risks inherent in that trading company (such as existing liability under contracts, debts, tax liabilities and litigation exposure).

Often an asset sale to a fresh new entity the Buyer controls is a far cleaner and less risky approach than purchasing the shareholding in an entity that has been run for a period of time by someone else. It also allows the Buyer to ‘cherry-pick’ only the assets that are essential for the continued operation of the business and leave any unnecessary or unwanted assets with the Seller. It also allows (through appropriately worded contractual indemnities) the Buyer to limit any existing liabilities or exposure to the period from when the Buyer takes over the business, rather than before that time, as would be the case in a share sale.

Pre-contract and post-contract due diligence

Safeguarding the Buyer requires more than just relying on standard form contracts and undertaking a standard range of enquiries. Each business must be analysed before the contract is prepared, to understand:-

• what underpins its value and makes it appealing;
• how it has been operated to date and what structure is currently used by the Seller; and
• where the potential risks and ‘skeletons’ may lie and how severe those risks may be.

Only after the business is properly analysed can the Buyer decide whether to proceed with an acquisition. Depending on the nature, size and complexity of the business involved, a contract prepared by one of our experienced business and commercial lawyers will typically contain:-

1. An adequate due diligence period in which the Buyer will undertake recommended post-signing of the contract due diligence enquiries;
2. Specified pre-conditions to completion. Examples include (without limitation):-

1. All requisite notices and approvals having being given at corporate level, so that the transaction can proceed (applies to both share sales and asset only sales);
2. Lease and Franchise Agreement assignments, including the obligations on both parties and who bears the cost;
3. Dealing with employee entitlements. For example, whether the seller will pay out the entitlements allowing for new employment by the Buyer or whether an adjustment between the parties will occur to allow for continuity of service;
4. Arrangements for stock and whether stock is included in the purchase price or payable in addition (the latter of which requires a stocktake between the parties prior to settlement);
5. Assignment of material contracts (with suppliers, customers or otherwise) or licences that are required to continue operations (liquor, food licences etc); and
6. GST obligations – particularly where the business is sold as a going concern;

3. Tailored warranties, releases, limitation of liability clauses and indemnities; and
4. Alternative pricing structures, deferred or contingent consideration (such as vendor financing arrangements, if required) or post-settlement clawbacks.

Our business and commercial lawyers expertly assist in dealing with the above through undertaking proper enquiry (both pre-contract and post-signing) and asking the right questions of the Seller and its advisors before a properly tailored contract is drafted.

Examples and categories of risk

Our lawyers have compiled the following list of examples and common areas where gaps or issues often arise, which should be the central focus of the Buyer’s due diligence in any business sale and the subject of express provisions in any contract:-

• Corporate structuring, organisational compliance;
• Personal Property Securities Act 2009 (Cth) (“PPSA”) compliance, where the business is a secured party and ensuring the registered PPSA interest is duly registered and properly affects the assets of the grantor entity;
• Current condition of plant and equipment and stock and depreciation;
• Whether any part of the business is under a finance arrangement, goods lease, hire purchase terms, consignment etc that must be released prior to completion;
• Other finance or security aspects, including loans, mortgages, personal guarantees and indemnities;
• Poor documentation with key suppliers. For example, where agreements with key suppliers or customers are not documented property and do not protect the rights of the business with regards to payment for services rendered or enforcement in the event of non-payment or late payment;
• Employment matters and industrial relations compliance. In particular, outdated or non-existent contracts with key employees. For example, where employment roles have changed or there are no restraint clauses or clauses imposing confidentiality obligations at the end of the employee’s employment;
• Regulatory Approvals, licencing or registrations have lapsed or do not cover current operations;
• Insurance matters, including any claims history;
• Confidentiality and restraint obligations on the Buyer;
• Intellectual property matters. Specifically, failure to protect copyright or to register intellectual property rights (trademarks, patents, designs etc);
• Property ownership matters;
• Premises lease has limited time before expiry or there is a risk of lawful cancellation. For example, if the Landlord has plans to develop or refurbish the premises for which vacant possession may be required (thereby invoking demolition or relocation clauses);
• Premises lease has onerous assignment clauses or other clauses that are unattractive to a purchaser of the business;
• Deficiencies in financial reporting obligations or business accounts (particularly where cash transactions are concerned);
• Existing or threatened claims or litigation – especially where such claims have not been recorded in company minutes, balance sheets or other discoverable or searchable documentation;
• Loans by the officeholders or shareholders of the business that have not been properly documented and are incapable of proper reconciliation;
• Late or outstanding taxation or superannuation payments or compliance (particularly relevant in share acquisitions, rather than asset purchases);
• Work, health, safety, fire safety, asbestos (if any), goods services or product safety and relevant policies, procedures and compliance;
• Shareholders Agreements containing restrictions or limitations on business sales without the passing of a special resolution of members;
• Foreign Investment Review Board (FIRB) approval – applicable where the transaction involved the acquisition of 20% or more of the shareholding in a business with a value over $261,000,000.00 or, in the case of investors from a specific list of countries, a higher threshold of $1,134,000,000.00, or where a Foreign Government Official directly invests in an Australian business. As can be seen, most private company businesses or companies in Australia are likely to fall outside of these requirements.

Whilst this list is not intended to be exhaustive, it is intended to show that a Buyer’s due diligence, if undertaken properly and comprehensively, will traverse a significantly large area of business operations and will require the assistance of and cooperation between a number of legal, financial and other appropriately qualified professionals.

There is no standard path when undertaking due diligence in the context of a business acquisition. Each particular transaction needs to be carefully considered on a case-by-case basis and any contract should be expertly tailored to meet the particular nature of the business being transferred.

Our team of business and property lawyers are highly experienced in all manner of business transactions across all industries, from those businesses that operate as a side project or a part time basis, to businesses of significant financial turnover in both national and international jurisdictions. Our lawyers can assist through the entire process from the very first pre-contract steps, to drafting the contract until completion of the transaction. If you are contemplating the sale or purchase of a business, please do not hesitate to contact us today for a no obligation consultation.