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Buying a Business - The Due Diligence Process

15 August 2016

Following on from our previous article, ‘Buying a Business: Initial Legal Considerations’ this article focuses on the due diligence investigation involved in buying a business. This is where the prospective buyer has an opportunity to thoroughly investigate all aspects of a business including its operations, financial performance, legal compliance, staff arrangements, external contracts, intellectual property, assets and other details. As with our previous article, we will use the example of Kate who is looking at buying the Flowerpot Café from Smith Holdings Limited (Vendor).

1.                       Why is it important for Kate to conduct a due diligence investigation?

Due diligence is the best way for Kate to assess the value of the Flowerpot Café and the risks associated with buying it before the purchase proceeds. In particular, Kate should check that any information presented by the Vendor is accurate. She should satisfy herself that the business is profitable and any projections as to earnings which may have been provided by the Vendor are realistic and achievable.

2.                       When should Kate conduct the due diligence investigation?

Usually, this is best done before the sale and purchase agreement is signed. However, a sale and purchase agreement can be made conditional on the satisfaction of a due diligence investigation. Kate will have a set timeframe within which she must complete due diligence. After completing due diligence, or at the expiry of this timeframe, Kate must either confirm the condition is satisfied and proceed with the purchase, or advise the condition is not satisfied and cancel the sale and purchase agreement. For a small to average size business such as the Flowerpot Café, due diligence should generally be able to be completed within a two to three week timeframe.

3.                       Who should Kate involve in the process?

Kate should get her accountant to check the financial records, including annual accounts and any management reports of the business, for the past three to five years, any potential tax implications of the purchase, and the best ownership structure for the business purchase.

Her lawyer should be consulted to review the sale and purchase agreement itself, as well as the various contracts that Flowerpot Café is party to, such as supply or lease agreements, and any employment contracts.

Kate may also choose to engage a valuer to assess the Flowerpot Café and provide an accurate value of the business.

4.                       What might Kate’s due diligence investigation consist of?

Due diligence will be different in almost every situation and should be tailored to fit the type of business. However, some of the general areas investigated during due diligence are as follows:

  • Annual accounts, financial information, and tax records;
  • Leases, employment agreements, supplier contracts, customer terms of trade and any other contractual agreements to which the business is a party;
  • Proprietary information such as copyright, trade marks, patents, and any other intellectual property rights;
  • Systems and operating procedures – This may involve spending time in the business observing the day to day operations;
  • Customer references;
  • Industry regulations, health and safety requirements and compliance issues; and
  • Inspection of the condition and value of the assets including the property, vehicles, equipment and machinery.

For the Flowerpot Café, we might advise Kate to investigate the following:

    • Furniture/fixtures/equipment and buildings – The sale and purchase agreement should include a list of all of the chattels and equipment included in the sale price. The state of repair of all of these should be examined during the investigation. The fridges, mixers, display cupboards, and whatever else is included should be in working order.
    • Legal documents – Any leases, supply agreements, and registered intellectual property rights will need to be reviewed by Kate’s lawyer. She needs to find out whether the rights under the lease and supply agreements be assigned to her as the new owner of Flowerpot Café? Will the intellectual property associated with Flowerpot, such as trade mark registrations be transferred to Kate?
    • Employees - Depending on whether the sale is by way of sale of assets, or sale of shares (as discussed in our previous article), Kate may have to offer the employees new employment agreements on her purchase of Flowerpot Café.
    • Business viability – Kate should investigate what it is about Flowerpot Café that keeps the customers coming back. Whatever it is, will it be something that is included in the sale? Something such as location, coffee type, certain staff. Or is it something that will be lost? Such as the Vendors if they were key to the success of the business? Will the cook who makes the recipes that all of the customers love, be leaving?
    • Legal requirements – Does the Flowerpot Café have all of the licences and certifications that it needs to be able to operate? Are they up to date? What are the expiry dates? What licences are required for Kate personally (if any)? For example, if the Flowerpot Café sells alcohol, the Flowerpot Café will need to be a certified premises, and if Kate is going to be one of the Managers then she will need to be certified to run the Flowerpot Café.

 

5.                        Will Kate need to sign a confidentiality/non-disclosure agreement?

Some of the information that Kate may need to access for the due diligence investigation could be highly sensitive. Where this is the case, the Vendor may require Kate to sign a non-disclosure or confidentiality agreement before she and her advisers can access it. However, Kate should make sure that she gets the non-disclosure or confidentiality agreement reviewed by her lawyer before she signs it.

6.                       What happens if Kate is unhappy with the results of her due diligence investigation?

If Kate has not yet signed a sale and purchase agreement then she can just walk away if she is unhappy with the results of the due diligence. Or, this may be an opportunity for Kate to negotiate a lower price with the Vendor, taking into account the matters that Kate will need to deal with.

If Kate has signed a sale and purchase agreement that is conditional on due diligence then Kate should be able to cancel the sale and purchase agreement by advising the Vendor that due diligence is not satisfied. Kate does not have to provide any reasons to the Vendor about why due diligence is not satisfied.

 

Chris Steenstra is an Associate in the Commercial Corporate team at Norris Ward McKinnon, specialising in IT and Commercial Corporate law.  Email Chris at:  chris.steenstra@nwm.co.nz

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