17 January 2006
It is often said that the most significant investment a person will make during their lifetime is the purchase of a home, but for many people this isn’t true. The purchase of a business often involves more money and will always involve more risk.
When buying a house it is common to check council records to make sure that ‘what you see is what you get’. No one wants an unexpected motorway being built 50 metres from the back door, or to find out that their new house has been built on an old rubbish dump. The same sorts of checks, and more, need to be made when purchasing a business.
The term ‘due diligence’ refers to the process of making sure that the business being considered is what it appears to be and that there are no surprises waiting for a new owner. There is very often a clause in business sale and purchase agreements providing a time frame for these checks to be done. Due diligence will generally involve both a chartered accountant and a lawyer obtaining and reviewing information on the business and reporting to the purchaser on their findings. However, regardless of who is performing the due diligence, important items that need to be reviewed include the following:
Historical Financial Statements. These should be reviewed for trading trends, changes in margins and for unusual or inconsistent expense items. The financial results should also be compared against financial benchmarking data for the particular industry.
GST Returns and Tax Returns. These should be reviewed to ensure that the information provided in the Financial Statements matches with the information being provided to the Inland Revenue Department. While this method of checking isn’t foolproof, generally people won’t tell the IRD that they are making more money than they really are! If there are discrepancies, they need to be investigated. The GST returns filed by a business are also a good way to identify any seasonal fluctuations in trading, particularly if monthly financial statements are not available.
Accounts Receivable and Customer Lists. It is often important to determine how many customers a business has and what reliance there is on key customers. The purchaser should identify the top 10 to 20 customers and determine what percentage of the total turnover each of these customers represents. In addition, a review of the outstanding accounts receivable will quickly show if the business is having trouble collecting payment from its customers, which can signal deeper problems within the business.
Accounts Payable and Supplier Lists. As with customers, it is also important to determine what reliance there is on key suppliers. Would the business suffer if a particular supplier ceased to exist? By reviewing the accounts payable it is possible to see how up to date the business is with payments to suppliers. If the business is behind in payments, why is it behind? Are there cash flow issues that need to be investigated further?
Employee and Payroll Records. It is vital to review the employment contract of each staff member and discuss the role they play in the business with the vendor. Are the employees likely to stay on if the current owner is no longer involved? Are there restraint of trade clauses in their current contracts? Do they have strong relationships with key customers? In addition, recent payroll records should be compared to the other financial information provided to ensure that the current wage cost is as expected. Full details should be obtained of current hours of work, job description, experience and the qualifications of each staff member. In most cases there is no requirement to take on all the staff currently employed within a business so you can pick and choose who you take on.
Plant and Equipment. A complete list of the assets offered for sale with the business needs to be thoroughly reviewed. Are all the assets that the business requires to operate included or is other equipment being leased? Are any of the assets being used as debt security? If the value of the assets is significant it is often wise to get an independent valuation.
Stock. Often a purchaser will need to attend a stock take on the evening before the day of takeover to verify the level of stock on hand. It is important to check for obsolescent items or items that have reached their use by date to ensure that you are not paying for worthless stock.
Licenses, Regulations and Industry Specific Issues. Businesses often need council permission to operate and it pays to check any conditions attached to council permits granted. Will the permit easily transfer to new owners? Sometimes a business will also need a specific licence to operate, such as a liquor licence for premises serving alcohol. It is also prudent to check that the business is meeting local fire regulations, OSH requirement and the like. Certain industries can also have specific legal requirements that need to be investigated.
Gift Vouchers and Warranty Claims. This is an area that is quite often overlooked and should be addressed directly in the sale and purchase agreement. If items previously sold by the business require repair of replacement under warranty, who is responsible for the costs involved? Have gift vouchers been sold that will need to be honoured by the purchaser?
The Sale and Purchase Agreement. While this is generally an area left to the lawyers, it pays to review this document thoroughly and consider the commercial impact of any special conditions. In particular, the extent of restraint of trade clauses agreed to by the vendor should be reviewed, as should the terms and conditions of any vendor assistance period. The breakdown of the purchase price between goodwill and plant and equipment should also be considered as this will have tax implications.
Lease Details. Again, this is an area generally left to the lawyers but it is important to become familiar with the terms and conditions of the lease. Often the business premises are a key component of the success of the operation and a good lease will also make the business easier to sell again in the future. If the business is located in a mall, issues such as the landlord’s right to rent space to a competitor needs to be investigated.
The Purchase Price
While the Due Diligence process does not usually involve a full business valuation, it makes sense to get an independent assessment of what the business is worth. To justify the risk of going into business, a good level of return needs to be made on the investment. How do the expected returns compare to less risky investments such as term deposits? There is generally data available on what similar businesses have sold for in recent times and this can be invaluable when considering the reasonableness of the asking price.
It is far easier and cheaper to get efficient business structures in place from day one rather than changing your structure after you have commenced trading. Getting professional advice regarding how to structure both business and personal assets will help to minimise the risks involved with being in business while also keeping tax to a minimum.
What is Being Purchased?
The most common way of purchasing a small to medium sized business in New Zealand is to buy the goodwill and plant and equipment of the business. The accounts payable, bank loans, tax obligations and other liabilities associated with the business generally (but not always) remain the responsibility of the vendor. By comparison, the other less common and often less desirable option is to buy the shares in a company that operates a business. In this instance, often all liabilities associated with the business are taken over by the purchaser. While the issues discussed above relate to both purchasing options, there are far more complex issues associated with the share purchase approach and therefore more detailed professional advice is essential.
Purchasing a business will often be the most important financial decision that a person makes in their lifetime and as such it is vital that a thorough due diligence process is conducted before committing to the purchase.
While it can be an expensive exercise to use professionals to assist with the process, the costs associated with buying a business that isn’t what it appears to be can be huge. Our advice is to approach a business purchase with caution and use a combination of a chartered accountant and a lawyer to ensure that you end up with the business that you want.