Buying an existing business means relying on someone else's numbers, contracts and operating history.
Before you commit, you need to answer two questions: what exactly are you buying, and do the numbers justify the price?
That is why legal and financial due diligence should usually happen together. A problem uncovered by your accountant may also be a legal issue, and a problem in a contract or lease may directly affect what the business is worth.
If you have found a business you are serious about buying, start both due diligence processes before entering into an unconditional contract.
If you have found a business you are serious about buying, start both due diligence processes before entering into an unconditional contract.
Book a Free Client Assessment →Start With What You Are Actually Buying
The first question is whether you are buying the assets of the business or the entity that owns it.
In an asset sale, the buyer usually acquires specified assets such as equipment, stock, goodwill, intellectual property and contracts. The agreement should clearly state what is included, what is excluded and which liabilities, if any, the buyer is taking on.
In a share sale, the buyer acquires the company itself. The company continues to own its assets, employ its staff and carry its existing liabilities.
That distinction affects almost every part of the due diligence process.
The Legal Due Diligence Checklist
1. Confirm the assets being sold
Check exactly what is included in the purchase. Depending on the business, this may include equipment, stock, goodwill, business names, trade marks, websites, domain names, customer databases, telephone numbers and key contracts. Do not assume that an asset used by the business is actually owned by the vendor.
2. Check ownership and security interests
Appropriate searches of the Personal Property Securities Register, or PPSR, should be conducted to identify registered security interests over relevant assets. Any security interests affecting assets you are acquiring should be investigated and, where necessary, released at or before settlement. Importantly, the PPSR records security interests. It is not proof that the vendor owns an asset.
3. Review the important contracts
Review the contracts the business relies on, particularly major customer, supplier, franchise, distribution and equipment agreements. Check whether contracts can be transferred and whether third-party consent is required. In a share sale, also check for change of control clauses. A contract may remain with the same company but still give the other party rights if ownership of that company changes.
4. Check the lease
If the business operates from leased premises, review the remaining term, options, rent reviews, outgoings, permitted use, make-good obligations and guarantees. Also confirm whether the landlord must consent to an assignment or whether a new lease will be required. For some businesses, losing the premises can materially affect the value of the business.
5. Check licences and regulatory requirements
Identify the licences, permits and registrations needed to operate the business. Do not assume an existing licence automatically transfers to the buyer. Some licences require consent or a fresh application. Also investigate any regulatory notices, compliance issues or previous breaches relevant to the business.
6. Check for disputes and liabilities
Ask about current and threatened litigation, customer complaints, employment claims, regulatory investigations, tax disputes and other material claims. This is particularly important in a share acquisition because historical liabilities generally remain within the company being purchased.
7. Check whether a Victorian section 52 statement is required
For certain small business sales in Victoria, the vendor must provide a prescribed statement under section 52 of the Estate Agents Act 1980 (Vic). If a section 52 statement is required, check it against the financial information provided during due diligence. It is an important disclosure document, but it should not replace independent financial due diligence.
The Financial Due Diligence Checklist
1. Verify the financial records
Do not rely only on a broker's sales memorandum or summary accounts. Where appropriate, compare the financial statements against tax returns, BAS lodgements, bank statements, payroll records and accounting records.
2. Scrutinise the add-backs
Add-backs can materially increase the profit used to justify the asking price. Some may be legitimate. Others may represent costs the buyer will still need to incur after settlement. Each material add-back should therefore be supported and tested.
3. Review debtors and creditors
Check whether debtors are actually collectible and whether there are overdue, disputed or doubtful accounts. Also identify unpaid creditors, tax obligations and other liabilities that may not be obvious from a simple profit and loss statement.
4. Look at cash flow, not just profit
A business can be profitable on paper but still require significant cash to operate. Consider working capital, stock requirements, customer payment terms, payroll, tax, loan repayments and upcoming capital expenditure.
5. Check payroll, superannuation and employee liabilities
Review wages, leave balances, superannuation, payroll tax, workers compensation and compliance with applicable awards or enterprise agreements. These issues can become particularly significant in a share purchase because historical liabilities remain in the company.
6. Independently test the valuation
Do not assume that the vendor's asking price or broker's multiple represents market value. Consider maintainable earnings, industry benchmarks, customer concentration, dependence on the existing owner, recurring revenue and future capital requirements.
What Happens to Employees?
Employee issues require careful attention when buying a business.
In an asset sale, employees who move to the purchaser may be affected by the transfer of business provisions in the Fair Work Act 2009 (Cth). Different rules apply to different entitlements, including annual leave, redundancy and recognition of prior service.
Victorian long service leave requires particular care. Where a business is sold or transferred and an employee continues with the business, their previous service may remain continuous and the new employer may become responsible for the employee's long service leave entitlement.
The sale agreement can allocate the financial cost of employee entitlements between buyer and seller, but it cannot remove an employee's statutory rights.
In a share sale, the employing company usually remains the same, so employment continues with that company. The buyer should still investigate accrued entitlements and historical employment compliance before purchasing the shares.
Earn-Outs and Vendor Finance
An earn-out can bridge a gap between the vendor's asking price and what the buyer is prepared to pay upfront. Part of the price is then linked to the business's performance after settlement.
If an earn-out is proposed, the contract should clearly state how performance is measured, who calculates it, what accounting rules apply and how disputes are resolved.
Vendor finance also requires careful drafting. The parties should agree on repayment terms, interest, security, guarantees, defaults and enforcement rights.
From the buyer's perspective, particular attention should be given to any security the vendor requires and whether it interferes with bank finance or the future operation of the business.
Make Due Diligence Count
Finding a problem is only part of the process.
The sale agreement should deal with the risks identified during due diligence through appropriate warranties, indemnities, conditions, price adjustments, employee entitlement adjustments, security releases and settlement requirements.
If due diligence has not been completed before signing, the contract may need to be expressly conditional on satisfactory due diligence. The wording of that condition matters. Simply writing “subject to due diligence” may not give a purchaser the protection they expect.
How Phan Campbell & Associates Can Help
At Phan Campbell & Associates in Footscray, our commercial lawyers and accounting team work together on a proposed business purchase.
Our lawyers review the sale agreement, assets, leases, contracts, employees and legal risks, while our accounting team examines the financial records, cash flow and assumptions behind the purchase price.
If you are considering buying a business, speak to us before entering into an agreement.
Book a Free Client Assessment →
Frequently Asked Questions
1. What is the difference between legal and financial due diligence?
Legal due diligence checks what you are buying and the legal obligations and risks that come with it. Financial due diligence checks whether the financial performance of the business supports the price.
2. Do I need a lawyer and an accountant?
There is no general requirement to engage both, but independent legal and accounting advice is strongly recommended for most business purchases because each adviser considers different risks.
3. What happens to employees when I buy a business?
It depends on whether you are buying the business assets or the company itself. Different rules can apply to continuity of employment and employee entitlements, so these liabilities should be identified and addressed before settlement.
4. Can I sign a contract subject to due diligence?
Yes, but the protection depends on how the due diligence condition is drafted. It should clearly state the scope of the investigation, the time allowed and what happens if the purchaser is not satisfied.
This article contains general information only and does not constitute legal, accounting or tax advice. The appropriate structure and due diligence process will depend on the particular transaction.