How to find out what you are buying
Bill walks into the shop on Monday morning, he has just purchased his new take away food business from the previous owner on Friday. At around midday on Monday, after serving a handful customers in the morning, Bill is already thinking to himself, ‘I am sure that Fred (the previous owner) told me I would have 3 times as many customers. He is approached by a food business inspector from the local Council.
The Council officer informs Bill that the Council is undertaking an audit of the take away food premises compliance with a recent audit. Within an hour the business is shut down, Fred had not complied with 7 notices to rectify problems with the premises which affect the safety of the food being prepared on the premises. Bill telephones Fred and asks for an explanation. Fred tells him that well you didn’t have a lawyer so I didn’t bother to disclose the 7 notices to rectify it is your problem now, I am about to board a plane to South America and do not ever expect to return.
Bill receives a quote from 3 tradespeople that quote him $100,000.00 to repair the premises, Bill only paid $75,000.00 for the business.
This is an extreme example of problems that can crop up in what people think is just a ‘simple’ business transaction. With the previous owner on a plane to South America, Bill has no way to recover any of his money, he has the choice between paying for the repairs or shutting down his business. He is also concerned with the number of customers that came through the door, he had just taken Fred at his word and did not review the financials. Not what Bill expected on the first day of life’s next great adventure.
Unfortunately this happens all too often, people who want to save money from engaging with lawyers or accountants to undertake a proper analysis of the business, due diligence, can end up costing themselves thousands of dollars and even losing the business.
Due Diligence is the term that is given to a comprehensive analysis of a business by a prospective owner to ascertain the target businesses assets and liabilities. There are 4 main types of due diligence:
- Legal Due Diligence
- Financial Due Diligence
- Human Resource Due Diligence; and
- Operational Due Diligence.
Before undertaking any due diligence it is important that you sit down with your consultants and work out exactly what it is you are trying to achieve. What reviews they recommend, the consequences of whether or not the review is done and the cost of doing the review.
Legal Due Diligence
You undertake a legal due diligence in relation to a business that you are buying. The actual analysis that your lawyer will do will depend on the type of business that you are buying and the way that you are buying the business. Ordinarily there will be an analysis of:
- any lease that the business has for the premises that it operates from,
- if it is a franchise the franchise agreement;
- supply and distribution agreements; and
- any other agreement that is required by the business to operate.
Usually your lawyer will also recommend a number of searches such as:
- company searches;
- security register searches;
- property searches; and
- licence searches.
A search of the licence and the requirements of the food business licence should have uncovered Fred’s non-disclosure of the serious issues with the business. A simple search that would have cost a few hundred dollars would have saved Bill not only the costs of repair but he probably would not have purchased the business. A conservative estimate of the loss to Bill could be around $200,000.00 based on the above scenario.
With a proper and thorough due diligence this could have been avoided and Bill could have been protected from the unscrupulous Fred.
Financial Due Diligence
A financial due diligence will look at the finances of the business to ensure that what the buyer has been told is accurate. An analysis by an accountant will usually be able to pick up on potential financial problems within the business. This allows for you as the buyer to undertake further investigations.
In our example above we mentioned that Bill noticed that the number of customers was not what he was expecting. A further analysis of the business shows that the previous financials, which Bill look at with a glance, showed that the turnover was considerably less than what he was led to believe. An analysis of the books and records by an accountant would have easily discovered this fact.
Financial due diligence also allows you to reveal financial or tax risks and can be a great assistance in determining the right price for a business. It is a review that looks in the past but a good analysis will allow for future profitability and cash flow to be determined with a fair degree of accuracy.
Human Resources Due Diligence
This is a due diligence that you undertake when you are buying a business with employees. You need to ascertain the qualifications, technical ability and working initiative of the staff that you are taking on. You also need to determine the level of seniority of the senior management and key personnel.
Part of this analysis can also be looking into whether there are any potential staff issues or past claims that may affect the continued operation of the business.
Operational Due Diligence
This is something that is often overlooked when buying a business. An operational due diligence analysis will help evaluate the target businesses model and prospects for growth in the future. This includes identifying the existence of a market for the business, whether or not the business has an attraction to new markets and what the growth prospects and development potential are.
Buying a business is an exciting time for any business owner. Whether you are in the startup phase of the Business Legal Lifecycle or looking at using an acquisition or merger to help strengthen your current businesses position. However you have to remember that from time to time things are not as they seem. A proper and thorough due diligence of the business should reveal most if not all of the problems. There are always issues in business but as a business owner you need to consider how to minimise those risks to ensure that you are not spending time fixing other people’s business mistakes.
The team at Streten Masons Lawyers love working with businesses and referral partners such as accountants on mergers and acquisitions. It is an area that, when done properly, is an extremely rewarding part of any business. If you or anyone that you know is looking a buying a business please speak to one of our experienced lawyers today on (07) 3667 8966.