Buying a business can be an exciting prospect, however it involves a lot of work and careful consideration to ensure you are buying the right business, at the right price, at the right time.
This is where due diligence comes in. Without undertaking thorough legal and financial due diligence, you could be paying too much for a business that is risky, unprofitable or simply not suitable for you and your business goals.
Think of buying a home – you wouldn’t want to pay top dollar for a house infested with termites. If you had known the house had a termite problem, you probably wouldn’t have paid top dollar (or you might have walked away altogether). Buying a business is no different.
The saying ‘you don’t know what you don’t know’ rings true here. You want the facts laid out to help you make an educated and commercially sensible business decision. Legal due diligence is a critical step in the business buying process.
In this three part series, we will break down some important considerations when undertaking legal due diligence, namely:
- Contracts – internal and third party contracts;
- Property – leases, sub-leases and licenses; and
- Business structure, risk and litigation.
Benefits of legal due diligence
Before we jump in, some of the main benefits of undertaking legal due diligence are that it:
- assists in identifying potential risks and liabilities to make informed decisions;
- strengthens your negotiating position – if due diligence investigations uncovers potential risks and liabilities, those findings can be used as a bargaining tool to reduce the purchase price or strengthen your overall position; and
- enables your legal team to draft precise and appropriate seller warranties and indemnities to specifically address any issues uncovered during legal due diligence.Top of FormBottom of FormTop of Form
Extent of legal due diligence
Of course, the extent of legal due diligence investigations will often depend on the specific circumstances of the transaction including:
- your appetite for risk;
- the commerciality of the transaction (e.g. the purchase price and whether you are buying the business assets or shares in the business); and
- the nature of the business.
Before you conduct legal due diligence, it is important to seek independent legal advice to understand the nature and extent of the investigations and when to start (hint: the earlier, the better!).
Let’s explore the first consideration in this three part series, contracts.
Types of contracts & benefits of reviewing them
Most businesses will have entered into a range of contracts (some verbal and some in writing, some long term, some short term) with suppliers, contractors, employees, customers etc. that you may wish to continue after your purchase. In most business transactions, these contracts are the very essence of what you are buying. If you would like these existing contracts to continue, you should satisfy yourself that the terms are acceptable to you and that they will, in fact, continue after you buy the business.
Internal contracts
The business has likely entered into contracts with internal people such as employees or contractors. It may also have a range of internal policies and procedures that people engaged by the business must comply with. Some internal contracts and documents you should review include:
- internal policies and procedures;
- employment contracts;
- independent contractor agreements;
- services and facilities agreements; and
- licence agreements.
Depending on the type of business, you should also review any accreditations, licenses, permits and certificates required to lawfully carry on the business.
External contracts
Contracts with third parties can have a significant impact on the business’s operations, financial stability, and overall value. Some third party contracts and documents you should review include:
- supplier agreements;
- service agreements;
- customer agreements;
- leases and licences to occupy (which often are to related entities of the seller so care needs to be had if they are truly ‘arm’s length’ terms and conditions);
- patient/client consent forms; and
- loan and finance agreements.
Benefit of reviewing contracts
Some main benefits of reviewing business contracts include identifying and assessing the following:
- Customer relationships: contracts with key customers define revenue streams and business relationships. Understanding these agreements helps you assess the stability and sustainability of the business’s income. Pay particular attention to terms like renewal, exclusivity, and pricing structures.
- Supplier reliability: supplier contracts affect the cost and reliability of goods and services. Identify long-term commitments, pricing terms, and conditions for termination or renegotiation. This helps assess the business’s flexibility and potential costs.
- Security interests/encumbrances: identifying security interests (like liens or mortgages) or encumbrances (which may restrict the use of assets) that affect the business’s assets is crucial for understanding financial or operational liabilities that impact the value or usability of assets.
- Potential liabilities: contracts might contain clauses that result in liabilities or financial obligations. For instance, long-term supply agreements with fixed prices might expose the business to future cost increases.
- Potential legal and financial risks: understanding problematic clauses, such as liquidated damages (or penalty) provisions, indemnities, or limitations on liability, helps evaluate risks and how they might impact the business.
- Compliance and legal standing: ensuring contracts comply with relevant laws and regulations is crucial, especially in light of the application of the Australian Consumer Code. Non-compliance can lead to legal issues or penalties, which could affect the business’s operation and value.
- Termination and renewal clauses: knowing the conditions under which contracts can be ended or renewed helps you understand any potential future liabilities or operational impacts.
- Change of control clauses: many contracts include clauses that require third party consent before there’s a change in ownership or control of the business. These clauses may affect the continuity of key agreements and may need to be dealt with before you purchase the business.
- Confidentiality and IP rights: reviewing confidentiality agreements and intellectual property rights associated with third-party contracts helps protect proprietary information and understand the implications of IP-related agreements.
- Financial implications: assess financial terms to determine their impact on the business’s profitability. Look for any clauses that might affect cash flow, like payment terms, penalties for non-compliance, or price adjustment mechanisms.
By thoroughly reviewing the business’s contracts, you gain a clearer picture of the business’s obligations, relationships, potential risks and liabilities, or opportunities, which allows you to make a more informed assessment of the overall value and viability of the business.
Up next: property
Stay tuned for part 2 of this series, where we explore business property.
If you would like further guidance on conducting legal due diligence, or you would like assistance with your next business purchase, contact Sabrina Austin or Antony Harrison (07 3007 3777 or saustin@mahoneys.com.au or aharrison@mahoneys.com.au.
The commercial team at Mahoneys helps take the stress out of the buying process, including by providing you with detailed guidance and assistance as you work through your legal due diligence.
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