March 6, 2023
March 6, 2023

Top 5 legal tips when buying a business

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Buying a business can be a complex and challenging process. It's important to be aware of the legal issues involved to ensure the transaction is successful and legally sound.

Tip 1: Know what you are buying  

Most businesses are operated through company structures.  This means that a buyer of the business can buy:

  • the shares held by the shareholders of the company; or
  • the assets used by the company to operate the business. 

There are crucial differences between share purchases and asset purchases that it is imperative for buyers and sellers to understand.  

  • Share purchase transaction: this involves the buyer purchasing shares in the company that operates the business.  When a buyer purchases all of the shares, they become the sole shareholder or owner of the company. Through the company, they own everything the company owns (such as plant and equipment, land and buildings, goodwill, intellectual property, and rights and benefits under customer contracts).  Importantly, the buyer is also “buying” the liabilities of the company (which are factored into the purchase price).  
  • Asset purchase transaction: this involves buying all or only some of the assets used to operate the business.  Assets may include contracts, plant and equipment, land and buildings, goodwill, and intellectual property.  In an asset purchase transaction, the buyer may prefer to purchase just the assets used in the relevant business, leaving behind extraneous assets as well as debts or liabilities.   

There are advantages and disadvantages of buying assets versus shares and vice versa. Buying just assets can provide flexibility, allowing the buyer to choose the assets they want and avoid liabilities of the target business. On the other hand, buying shares is often a simpler because the buyer takes ownership of the business in one transaction.

The decision on whether to buy shares or assets does not have to be made straight away. A preferable approach may become clearer after undertaking due diligence on the target. There may also be tax reasons to prefer to purchase shares over assets or vice versa, and professional advice should always be sought in this regard from the outset.

Tip 2:  Negotiate an exclusivity period with the seller

The buyer should negotiate an exclusivity period during which it has the sole right to conduct due diligence on the target business.  The purpose of the exclusivity period is to prevent the seller from trying to solicit other offers or negotiate with other prospective buyers.  Also known as the “no shop” period, the seller agrees to exclusively deal with the buyer during this period.  

It is natural for buyers to want to protect their interest and improve the chances of a successful completion. They do not want to have to deal with late counter offers. Most buyers aren’t willing to spend time and resources if there is little certainty of closing the deal. Your lawyer can assist you with the appropriate documentation to ensure exclusivity during the due diligence period.  

Tip 3:  Understand your funding options

Before starting the acquisition process, a buyer should understand how it will fund the proposed acquisition (cash, debt finance, vendor finance, equity). There are many ways to acquire financing, but it is vital to plan the acquisition financing structure to fit the circumstances. The cost of the acquisition financing structure must be grounded in the cash-flow generating capacity of the target and the strength of its asset base.

If a buyer needs a loan to fund the acquisition, the lender may wish to take security over the shares or assets of the target business and review the buyer’s due diligence on the target business. Large volumes of debt are more appropriate for mature companies with steady cash flows. Businesses that compete in unstable markets, that want to grow fast and need large amounts of capital to do so are more likely to seek equity financing.

Tip 4:  Undertake your due diligence

Due diligence is essentially an investigation into (and an appraisal of) the target business. It is an opportunity to assess the value of its assets and liabilities as well as the businesses’ commercial potential. 

From a legal perspective, due diligence on a business acquisition includes things like:

  • reviewing and cross-checking ownership records and corporate governance documents;  
  • analysing material contracts for provisions that may be triggered by an acquisition or which are onerous in nature;  
  • evaluating funding and borrowing arrangements, as well as any security granted over the assets of the business;  
  • considering compliance with regulatory requirements such as environmental, health and safety, or industry-specific regulations;  
  • assessing any litigation the business is subject to;  
  • examining records of employees, their entitlements, and their employment contracts; and  
  • conducting searches on any land or premises owned or occupied by the target business.

Beyond legal due diligence, a buyer will usually also conduct financial, commercial and possibly tax due diligence on the target company or business in conjunction with their financial advisors.  

The importance of due diligence should not be underestimated. This is because:

  • a buyer should ensure that it knows what it is buying so that it can better manage the risks associated with the purchase;  
  • it will assist the buyer to negotiate the terms of the purchase, for example, it may reveal certain risks in the target business which the buyer may want to protect against;  
  • issues arising in due diligence can usually be dealt with in the transaction documents either as condition precedents or completion deliverables, or via warranties and indemnities; but  
  • only the known issues and risks of a transaction can be managed to ensure an optimum outcome.  

The level of due diligence on the target business will depend on a number of factors including the value of the acquisition and the buyer’s experience in the relevant industry.  Please see our recent article for top tips when conducting due diligence (LINK).

Tip 5:  Understand what protections you may need in transaction documents as a result of due diligence findings  

If the buyer still wants to proceed with the purchase after conducting due diligence, the next step is to prepare, negotiate and enter into definitive transaction documents.  Sometimes a term sheet or heads of agreement is entered into first.  

Material issues arising from due diligence should be translated into protections sought by the buyer in the sale and purchase agreement and/or as adjustments to the purchase price.  Examples of buyer protections that are often included in a sale and purchase agreements include:

  • having conditions precedent that must be satisfied before settlement or completion of the transaction;
  • representations or warranties from the seller regarding the quality, condition, and title of the assets being sold;
  • indemnification provisions that require the seller to compensate the buyer for any damages or losses resulting from breaches of the sale agreement or other contractual obligations; and  
  • provisions that require part of the purchase price to be held back or retained until a specified action or result is achieved this could take the form of an earn out or escrow arrangement.  

If you have any questions on buying a business, undertaking legal due diligence, or would like assistance with conducting legal due diligence on a target business, please do not hesitate to get in touch with one of the Sierra Legal team.

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