Structure, risk and litigation

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 parts 1 and 2 of this three part series, we:

1. discussed what is legal due diligence;
2. explained its benefits including how it can help you make better business decisions;
3. specifically explored the importance of reviewing business contracts;
4. drew attention to relevant considerations regarding the business premises including zoning and environmental compliance;
5. pointed out the importance of reviewing any lease agreements including understanding obligations and identifying risks; and
6. noted the importance of reviewing other agreements relating to the business premises such as subleases and licences including the assessment of costs and revenue of the business.

You can read part 1 here and part 2 here.

In this final part 3, we will look at business structure, risks and litigation.

Business structure

Whether you are buying the business assets or purchasing shares in the business entity, it is important to review and consider the current business structure and the entity acquiring the business or shares.

Consider:

1.  is the current business structure a sole trader operating the business, or perhaps a partnership, trust or proprietary or public company?
2.  how many people own the business including the number of directors and shareholders involved (if relevant)?
3.  are there any related entities to be considered?

The current business structure affects many areas of business operations, including legal, financial, and operational aspects.

Legal and tax implications and regulatory compliance

1. Liabilities and obligations: the business structure can largely determine how risk is allocated. For instance, with companies, liabilities are usually incurred by, and therefore limited to the company, while in a partnership, the partners can be held personally liable for the acts of the partnership, including by other partners. Trusts can be effective, but then it depends if the trustee is a company or an individual.
2. Taxation: different structures have varying tax implications. For example, companies are taxed separately from the shareholders, while in a partnership or trust, income is typically passed through to the partner’s/beneficiary’s personal tax returns. Understanding this can help in planning for tax efficiency. You should seek independent tax advice from an accountant as part of your due diligence.
3. Transfer of ownership: the ease and method of transferring ownership can depend on the structure. For example, shares in a company (or units in a fixed trust) tend to be transferred a lot easier than a transfer of the business assets or partnership interests, which can often be a more difficult/costly process. Of course, a transfer of shares/units may trigger the requirement for consent of a number of third parties like landlords, financiers, suppliers or customers and that can only be known if you have undertaken a comprehensive due diligence investigation.
4. Duty: the business structure can determine the duty you pay on the business/share acquisition and/or future transfers to those that become part of the business as part of your business growth or succession plan. To illustrate, the acquisition of shares in a company that operates the business is usually not dutiable, whereas the acquisition of the business or units in a fixed trust itself usually is. If, as part of your plan for the business, you intend to bring in new co-owners for growth or succession, it’s important to consider a structure that minimises transactional and ongoing costs.
5. Compliance requirements: different structures have different regulatory requirements, such as filing annual reports, maintaining certain records, or holding regular meetings. Understanding the structure helps ensure the business is compliant with relevant laws and regulations, avoiding potential penalties.

Financial Considerations

1. Access to capital: the structure can impact the business’s ability to raise capital. Companies, for example, may issue shares to raise funds, and trusts may issue units, while partnerships might rely more on personal investments or loans.
2. Financial health and reporting: the structure influences how financial statements are prepared and reported. The structure itself might have more rigorous reporting standards, which can provide greater transparency during due diligence.

Operational impact and risk management

1. Management and decision-making: the structure determines how decisions are made and who has the authority to make them. For instance, in a company, decisions are ordinarily made by the board of directors, while in a partnership, decisions are typically made by the partners. Decisions of trusts are largely dictated by who is the trustee, which may be a company or an individual/s.
2. Flexibility and growth: some structures offer more flexibility in terms of growth and adaptation. For instance, companies can issue new shares (and unit trusts by issuing new units) to bring in investors or expand operations, while partnerships might find it harder to scale in the same way.
3. Continuity of business: certain structures offer better continuity if an owner leaves or dies. For example, for companies, business continues even if the original owners are no longer involved, whereas a partnership would typically dissolve unless there is a partnership agreement that states otherwise. The latter point shows the importance of having a partnership agreement.

Due Diligence and Negotiation

1. Identifying issues: you can identify potential issues or areas for negotiation. For example, if the business is structured as a partnership, you might negotiate terms that mitigate the risk of partner disputes or require the seller to restructure to a company before the purchase.
2. Structuring the purchase: the business structure will also influence how the purchase is structured. For instance, buying shares in a corporation differs from purchasing assets from a sole proprietorship, with different legal, tax and duty consequences. Trusts offer another option, which will have implications if it is a fixed or discretionary trust.

Reviewing the business structure provides insights into how the business operates, its financial and legal standing, and the risks and opportunities associated with the purchase. A thorough understanding of the business structure helps in making informed decisions, structuring the deal effectively, and ensuring a smooth transition of ownership.

Risk and litigation

The legal due diligence process is the best time to uncover any potential risks and liabilities before you have purchased the business.

Potential risks, claims and liabilities can be hidden in plain sight and can arise in a variety of ways such as:

1. Outstanding debts and obligations: if the business has debts, loans, or financial obligations it could impact financial projections or require immediate payment post-purchase.
2. Regulatory compliance: if the business has not complied with relevant laws and regulations (e.g., environmental, employment, health, and safety laws), the business can face fines, sanctions, or operational restrictions, which could be costly. Even if you are not personally liable for the non-compliance by the previous business owner, it could materially affect the value of the goodwill of the business you have acquired.
3. Intellectual property rights: if the business does not have clear title to its intellectual property, there could be disputes or infringements on third parties’ rights which may affect the business viability moving forward.
4. Litigation risks: it is important to obtain details of any actual or threatened claims, arbitration, proceedings, or regulatory investigations against the business and/or business owners in the past 6 years to assess the associated risks and costs. You should be informed of the outcome of such matters including when and how they were resolved. This can assist with assessing the likelihood of future claims or issues related to the business.
5. Employment Disputes: it is also important to obtain details of any actual or threatened employment disputes, such as wrongful termination claims, which could lead to significant liabilities.

If there are specific claims or risks identified during legal due diligence, the purchase contract can include specific seller warranties and indemnities to give you further protection against identified risks.

Final thoughts

As we have outlined in this three part series, legal due diligence is crucial when purchasing a business as it helps identify hidden liabilities, ensures regulatory compliance, and uncovers ongoing or potential legal proceedings.

Having a clear understanding of the business, including potential risks involved, can assist you with making informed decisions, negotiating better terms, including the purchase price, and hopefully avoid costly surprises after you have purchased the business.

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 investigations.

Written by Sabrina Austin

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