Buying a business - legal due diligence series - Part 2 (property)

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.

In this three part series, we break down some important considerations when undertaking legal due diligence.

In part 1 of this three part series, which you can read here, we:

discussed what is legal due diligence;
explained its benefits including how it can help you make better business decisions; and
specifically explored the importance of reviewing business contracts.

In this part 2, we will look at business property. Most businesses will have a premises, whether it is a shop-front, a warehouse to stock goods, or an office to conduct business affairs. When you buy a business, you will likely need to take over the existing premises. Most of the time, the business will lease its premises whether to an unrelated third party or to a related party (like a relate trust or super fund). It may also sublease or licence part of its premises to other parties. For example, a medical practice may sublease part of its space to a pathology business.

So, let’s look at evaluating the business premises including the lease and any other agreements relating to the business premises as part of legal due diligence.

Evaluating the business premises

Before we look at the specific agreements relating to the business premises, it is important to consider the following when assessing the suitability of a business premises as part of legal due diligence:

Is the premises required: to conduct the business? If yes, is the property being sold as part of the business sale transaction or will it be leased by the buyer?
Property ownership: it might seem obvious, but it is important to confirm who owns the property. If the seller owns the premises, ensure that title is clear, with no encumbrances (e.g. mortgages) or disputes. If the seller leases the premises, check that the lease is valid and enforceable (and the landlord is happy to transfer it).
Designation and land use regulations: confirm the business activities comply with local town planning (including designation/zoning) laws and land use regulations. Non-compliance could lead to fines or even force the business to relocate or alter its operations.
Environmental compliance: assess whether the premises meets environmental regulations. Check for existing environmental issues, such as contamination, which could result in costly clean-ups or legal liabilities.
Building permits and code compliance: ensure the premises complies with building codes and all necessary permits have been obtained. Non-compliance can result in fines, required alterations, or even closure.
Premises condition: evaluate the physical condition of the premises, including the structure, plumbing, electrical systems, and any equipment. Identifying any necessary repairs or upgrades can prevent unexpected costs post-purchase.
Occupancy and tenant rights: if the premises is part of a building, it’s important to understand the rights and obligations of other tenants, including common area maintenance costs, shared utilities, and other expenses.
Access: consider any easements or rights of way that may affect the use of the premises. Ensure the business has necessary access to the premises and there are no restrictions that could hinder operations.
Outgoings, utility and services: review contracts related to outgoings, utilities and services (e.g., water, electricity, waste management, security) to understand the terms, costs, and any obligations that may continue after the purchase.
Development plans: investigate any planned or proposed developments or changes in the surrounding area or building that could impact the business, such as new infrastructure projects, designation/zoning changes, or planned construction that could affect traffic, visibility, or customer access.
Neighbouring businesses and competition: research the surrounding area for potential competition or complementary businesses. The proximity of competitors or partners can significantly impact the business’s performance.

Addressing these considerations ensures that all aspects of the premises are thoroughly vetted, minimising risks and helping to secure a smooth transition in ownership. Don’t assume that, just because the seller was conducting the business from the premises, the premises is fit for purpose or can be legally used to conduct the business.

Reviewing the lease

Reviewing leases as part of legal due diligence when buying a business is important for several reasons:

Security of tenure: consider the length of the lease, options to renew, and any conditions that might affect the security of tenure. This is essential if the location is critical to the business’s success.
Understanding obligations: understanding specific obligations for the tenant, such as bond/personal guarantees, rent (including rent increases), maintenance responsibilities, , make good obligations or restrictions on property use will help you assess future costs and liabilities.
Identifying risks: look out for unfavourable lease terms, clauses that allow the landlord to terminate the lease or restrictions that could impact business operations.
Ensuring transferability: the lease may restrict or require landlord approval for transferring the lease to a new owner. Ensuring the lease is transferable is vital to maintaining business continuity.
Negotiation leverage: identifying unfavourable terms can provide leverage in negotiations, either to renegotiate lease terms or to adjust the purchase price.
Insurance: consider the required insurance policies related to the premises to ensure adequate coverage is in place, including property insurance, liability insurance, and any specialised coverage required by the business activities.
Exclusivity: does the lease contain an exclusivity clause or can other tenants in the building compete directly with the business. This could affect profit and viability in the future.
By-laws: if relevant, review the by-laws to determine whether they adversely affect future business plans including expansion or change in business operations.
Financial: be careful to identify any periods that the tenant was required to pay less than ‘rack rate’ (e.g. reduced rent or outgoing free periods) as that would have overly inflated the profit in the business, and you could be paying ‘overs’. This is where the legal due diligence interacts with the financial due diligence undertaken by your accountant.

Reviewing subleases, licences and other agreements

Similarly, reviewing subleases, licences or other agreements related to the business premises is equally important for several reasons:

Understanding secondary agreements: these arrangements can create additional layers of obligations or rights. For example, if the business is subleasing part of its premises, the sublease needs to align with the main lease. Conflicts between these agreements can lead to legal complications which affect the security of tenure.
Assessing revenue streams or costs: if the business is generating income through subleases or licenses, these agreements are a source of revenue that needs to be evaluated. Conversely, if the business holds licenses or other agreements that require payments, these are additional costs that need to be factored into the purchase. For example, car parking may be critical to the flow of customers to and from the business and that needs to be secured by way of licence.
Transferability and consents: like leases, subleases and licenses often have clauses related to transferability. The head lease may also require landlord consent for any subleases or licenses. Ensuring these agreements can be transferred may be crucial for business continuity.
Compliance and restrictions: identify specific use restrictions, compliance requirements, or rights of the third parties involved. Any breach of these conditions could result in termination of the agreement or legal disputes.
Risk of termination: subleases or licenses may have terms that allow for termination under certain conditions (such as if the business is sold, shares in the company being transferred or any change in directors), which could impact the viability of the business post-purchase.
Impact on property rights: these agreements might affect the rights to use the premises in certain ways, including restrictions on alterations or requirements to share common areas.

In short, assessing the business premises including any leases, subleases, licenses, and related agreements ensures you have a clear picture of all the obligations, risks, and opportunities associated with the business premises and can assist with a smooth transition in ownership.

It is recommended you seek independent legal advice to review the lease including any sublease, licence or similar agreement in full and obtain advice consistent with the above considerations.

Up next: business structure, risk and litigation

Stay tuned for part 3 of this series, where we explore business structure, risks and litigation.

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.

Written by Sabrina Austin

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