This article will explain the reason why a due diligence should
be undertaken in the sale and
purchase of a business.
Why do a due diligence?
There are a few reasons why a due diligence is important
- Risk assessment-conducting a successful and profitable business involves many aspects. Checking that each of the key aspects means that you satisfy yourself of the integrity and strengths/weaknesses of those aspects. In some businesses, this may simply means obtaining copies of relevant documents and reviewing it to properly evaluate the Vendor's business. In some situations, those documents may lead to more questions and indicate that a more thorough investigation is required. In some cases-the information disclosed or obtained, may result in a decision to terminate the contract.
- Determining Value-Due diligence is a critical element in determining value of a business. Any factors which affect the future earnings of the company or the value of any underlying assets may have a positive or negative impact upon the price for the business. For instance, any impending litigation against the company could seriously impact upon sales and reputation and diminish the financial viability of the business. Alternatively-a projected increase in sales because of a new significant customer could mean a better profit and increased value.
- Identifying the assets of the business- in some cases, certain aspects of a business may be owned by third parties-such as intellectual property rights or real property, and the terms upon which the business has a right to use those assets can impact upon control of stock sales and profit margin.
- any risk minimisation strategy for both the vendors and purchasers, although each party will have different objectives. It typically includes a legal, financial and physical (eg building and environmental) investigation. It may require the assistance of accountants, lawyers and other experts to produce the necessary information.
Who should do one?
Purchaser. Obviously, any intending purchaser should undertake a due diligence before moving to purchase a business. Usually this will be a term of a purchase contract.
Seller. In most instances-a seller should also undertake a due diligence before listing a business for sale. Making sure that all of the key aspects of a business are sound, and clear to enquiry can mean that a seller gets maximum value for their business and that any contractual due diligence can be quickly and easily satisfied. In some cases-a thorough business due diligence by a seller and rectifying any issues discovered can result in a significant increase in value.
What is a business due diligence?
This depends upon the nature and size of the business. However-common investigations involve:
- Who owns the assets and who should be parties to the transaction? It is common for family businesses to own some of the business assets in a mix of companies, trusts and the names of individuals. It is also common for third parties to own intellectual property rights if the business is conducted under a franchise or licence. It is important to firstly identify the key assets which make up the business and then to identify the relevant owners of the business assets and the contractual documentation should accurately reflect this.
- Deciding whether a more tax and risk effective transaction will be to buy all the company shares, rather than the assets themselves.
- Identifying any statutory or government licences, permits or consents and other requirements and the conditions attached to those requirements. In some cases- these aspects may determine purchaser entity-and may impact upon value and risk.
- Identifying any third- party consents required such as from landlords or mortgagees for leased premises.
- Identifying any key staff and the integrity of their employment contracts. Retaining or removing key staff can have a significant impact upon future profitability, and business/corporate culture.
- Identifying current or future risk factors and eliminating or minimising them.
- Identifying and negotiating any terms and preconditions of the contract of sale of the business. For example, what licences, permits and statutory consents are required to operate the business. There may also be other requirements that a purchaser must satisfy under competition and consumer laws, stock exchange rules, foreign acquisitions and take over laws, depending on the nature of the business and the parties involved.
- Identifying any restrictions on the ability to sell and transfer all of the assets of the business- matters such as securities held on the business assets which a seller should discharge (eg mortgages on business land or securities on personal property registered on the PPSR).
While it is ultimately a vendor's decision to sell and the purchaser's decision to buy, a thorough and comprehensive due diligence will assist both parties to make informed decisions about whether to transact at all.
For a vendor, this may involve taking the results of a pre-sale due diligence, and implementation of remedial steps to ensure that any buyer risks are eliminated to maximise the value.
Seeking advice on such issues at the outset might impact the sale price you are willing to settle on.
For a purchaser, obtaining the necessary financial information and business advice to be comfortable with the risks and financial viability of the business will not only be comforting, but can be critical, particularly if you are seeking to acquire bank finance and using that business as well as your own personal assets as security.
Due Diligence in Contract Terms
It is common for a due diligence clause to be included in a business sale contract. Important common procedural aspects might include:
- Time for due diligence
- Method of notification of satisfaction of due diligence
- Obligation on seller to deliver all required information and documents
- Extensions of Due diligence if any delays in providing documents
- Termination or price renegotiation rights
- Warranties as to the truth and completeness of information provided
- Confidentiality and return of information provided if sale does not proceed
What's the cost?
Cost will vary depending upon the nature size and type of business. There is no "fixed price" that can be applied to all due diligence, and there may be additional unexpected costs to investigate any issues revealed.
Due diligence may be an additional cost, as it does involve engaging financial, legal and technical expertise.
However-a good and thorough due diligence will be well worth the cost when measured against the failure or loss involved in a failed business because of a factor which should or could have been identified and dealt with before settlement .
Identifying and dealing with critical issues either at the outset before a binding contract is entered into or before a due diligence is satisfied is often far cheaper with better prospects of an outcome, compared to litigation to enforce rights.
If you are thinking of selling or buying a business, we can assist you.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.