Buying a business - Identifying and managing risk

A thorough due diligence process serves as an investigative tool, enabling buyers to make informed decisions and effectively manage risk – whether you are a first-time buyer or a seasoned buyer, the risks (both actual and potential) of buying a business must be identified and carefully navigated. This article explores the vital role of due diligence and highlights three prevalent legal challenges that arise out of this process.

Business structure

Even before the buyer and seller engage in initial negotiations, the buyer should consider the structure of the proposed acquisition.  The structure will usually take one of two forms:

•   Share purchase – this involves the acquisition of shares in the relevant entity that owns and controls the business.  In this case the buyer will acquire, through its acquisition of the target entity, both its assets and liabilities; or

•   Asset purchase – this involves the transfer by the seller to the buyer of the assets that are used to conduct the business. Sometimes an asset purchase will also involve the assumption of agreed liabilities. Buying a rent roll is commonly conducted as an asset purchase. 

It is necessary, at a very early stage of the transaction, to decide which structure to adopt. The structure adopted will have important implications on the nature of the due diligence process that is conducted, the terms of the sale, and the steps necessary to transfer ownership from the seller to the buyer.

Due diligence

Due diligence is the process by which the buyer, through a focused review and analysis of the target entity and its operations or the target assets, seeks to identify and mitigate actual or potential risks.  

Due diligence is therefore both ‘forward looking’ – that is, to assess whether the proposed transaction is a strategic and financially sound investment – and ‘backward looking’ – that is, to confirm that the shares or assets which are the subject of the acquisition have a traceable history that accord with the law.

A buyer’s due diligence will typically involve:

•   commercial and operational due diligence of potentially broad scope: this involves an assessment of the target’s management, infrastructure, systems (e.g., IT, software), processes (including risk management), culture, customer and supplier relationships, strategic positioning; 

•   financial due diligence: to confirm the historical financial position and performance of the target and the prospects of growth; and

•   legal due diligence: to review the legal arrangements, identify existing or potential legal and assess its impact on commercial and operational issues.

A buyer’s advisors (legal, accounting, taxation and business advisors) will typically work together to compile a due diligence questionnaire.  The due diligence questionnaire will be provided to the seller’s advisors, who will work with the seller to answer the questions and table documents that corroborate the seller’s answers.

Transactions that carry little to no risk, although desirable, are few and far between.  A well-structured due diligence process will bring all risks (both actual and potential) out into the light.   Recently, buyers are paying particularly close attention to three issues arising the due diligence process – intellectual property (IP) rights, regulatory compliance and existing contracts.

1. Intellectual Property

IP can comprise trademarks, patents, copyright, trade secrets and propriety software.  For some business, IP is their primary and only asset.  In such cases, the due diligence process should include an IP audit to check:

• the ownership and validity of the IP assets, whether registered or unregistered;

• whether IP is the subject of existing licencing arrangement; and

• whether the IP is freely transferable.

The findings uncovered during an IP audit will inform the drafting of draft IP-related provisions under the transaction documents.

2. Regulatory compliance

Buyers should consider whether regulatory requirements may affect the acquisition, and if so, whether the satisfaction of these requirements should be dealt with in the transaction document.  

The due diligence process will assess historical compliance and the target’s ability to remain compliant.  If there is evidence of non-compliance, a buyer may insist that completion of the transaction is conditional upon regulatory compliance, which may include:

• applications and approvals for essential licenses and permits; and

• employee and labour-law compliance (including settlement of any outstanding workplace issues or claims).

Regulatory non-compliance can negatively affect the business' valuation, operations and reputation.  Where a seller has not properly managed regulatory compliance, buyers must have regard to any potential litigious risks and revisit the purchase price that it is willing to pay.

3. Contracts and agreements

A business may have existing contracts and agreements with suppliers, customers, employees, landlords or lenders.  

In a share sale context, these contracts and agreement may contain provisions whereby a party cannot undergo a change of control without the consent of (or notification to) the other party. In an asset sale context, these contracts and agreements may contain provisions whereby a party cannot assign the contract or agreement, or transfer or sell the assets under the contract or agreement, without the consent of (or notification to) the other party.

In a rent roll context, the buyer should execute a new Form 20a with their new clients to supersede the previous agreement with the former property manager. Buyers should also ensure that they only use the Form 20a documents available on Realworks as these are updated regularly to comply with the current legislation and provide the best level of protection to the buyer. 

Further, a rent roll buyer should review each existing contract to ensure that the management of these properties are managed in the same (or similar) way as the buyer’s current practices.  Buyers should check Part I of the Schedule to ensure they have full particulars of the seller’s insurance policies. Buyers, in conducting their due diligence inquires, should also check the property management file to verify that copies of the seller’s current insurance policy schedules are on file.

In such cases, the transaction documents must contain conditions that oblige the seller to gain the consent of (or notify) the other party to the contract or agreement.

4. Inspection 

A buyer of a rent roll should perform, during the due diligence period, an inspection of each property to be acquired. It is recommended that the seller and tenants are both present at these inspections so that any outstanding maintenance or repair issues can be attended to prior to the completion date. 

Photographs should be taken at each property and a detailed report provided to the seller regarding the condition of the property. Approval to effect any repair and maintenance items identified during the inspection should be requested in writing.

Contact us

A thorough and well-structured due diligence process will seek to uncover risks that must be brought to the negotiation table and effectively managed by way of considered contract drafting.  

Carter Newell’s Corporate & Commercial team has experience advising buyers and sellers of businesses and companies and can help you successfully structure and complete a transaction.

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