How to buy a business
We explain how the process of buying a business works for those who are considering buying out an existing business.
Why buy a business?
There are many reasons for buying a business.
For example, you may want to expand your existing business faster than by organic growth, remove a competitor from the market or acquire a supplier or distributor to bring your sourcing or distribution systems in-house.
Alternatively, you may want a presence in a new customer market or geographical area, or to diversify into new product lines.
Research has shown that many acquisitions fail to achieve their objectives and that the following elements are essential for success:
- a thorough investigation of the target business, to help ascertain its true value and identify any potential liabilities
- effective management of the acquisition process, particularly if the buyer is running its own business at the same time
- careful planning to decide how to run the business, and integrate it into any existing business of the buyer, after the acquisition.
As the buyer, you may have to pay a high price for the business (particularly if it is well established and has valuable goodwill) and incur substantial expenses and professional fees.
You may also have to spend a huge amount of management time on the process, which can distract you from running your existing business, if you have one. So you must do all you can to make the acquisition a success.
Shares or assets?
Assuming the target business is operated through a company, there are two ways for you to acquire it:
- by buying the shares in the company from its shareholders, or
- by buying the assets of the business from the company.
There are several differences between the two:
Assets and liabilities
In a share sale, the buyer buys the target company along with all its assets and liabilities. In an asset sale, you can ‘cherry pick’ the assets you want (if the seller will agree) and leave all liabilities other than employees with the seller. For this reason, buyers often prefer to buy assets rather than shares.
Form of transfer
Shares are transferred by a simple stock transfer form, whereas different assets require different forms of transfer. For example, property requires a transfer or assignment, and customer contracts must be assigned or novated.
Consents and approvals
On an asset sale, the assets have to be actually transferred to the buyer and this may require the consent of third parties. For example, customer contracts may not be transferable without the consent of the customer, and the transfer of a leasehold property will require the consent of the landlord.
If you cannot obtain consent for the transfer of a key asset, a share sale may be the only option.
On a share sale, the problem of obtaining consent will only arise if a document entered into by the target company (e.g. a bank loan agreement) contains a ‘change of control’ clause. This clause gives the other party the right to terminate the agreement on a sale of the shares.
On a share sale, you will inherit the target company’s tax liability and will therefore need specific protection from the seller against this. On an asset sale, the tax liabilities of the business normally remain with the seller.
An additional advantage of an asset sale is that you can write off goodwill acquired from the seller against profits you earn in the business over time.
Against this, in a share sale, if the target company has significant tax losses, you may be able to make some use of these to set off against profits in your existing business, if you have one.
On a share sale, you must pay stamp duty at 0.5% of the sale price. On an asset sale, you will have to pay stamp duty land tax of up to 4% of the price of any land being transferred. Generally, stamp duty is no longer payable on the transfer of other assets, such as goodwill, intellectual property or customer contracts.
On a share sale, the price is paid directly to the individual shareholders.
On a sale of assets by a company, the price is paid to the company, and then, if the shareholders want to receive the money personally, the sale proceeds have to be transferred from the company to the shareholders.
This may trigger a double tax charge, first for the selling company and secondly for its shareholders, which may make an asset sale very unattractive to the seller.
The choice for buyers and sellers
Generally speaking, for the reasons given above, buyers tend to prefer to buy assets, whereas sellers prefer to sell shares.
The choice will depend on the parties’ respective bargaining strengths and the nature of the business. For example, if the main asset of the business is a property, you may prefer to buy shares, rather than pay stamp duty of up to 4% of the price.
Finding a business
The first step is to find a business to acquire.
Often, the business will be one which the buyer has already dealt with. For example, a competitor, supplier or distributor. It can help if you already know the business.
Alternatively, businesses can be found through personal contacts, brokers, advertisements in the trade press, or websites offering businesses for sale.
Once you have chosen a business to purchase, you will need to carry out some initial investigation, with a view to valuing the business and agreeing on a price.
The valuation will cover such things as premises, equipment, stock, debtors, creditors, goodwill and other assets. Valuations are normally done with the help of an accountant, valuer or broker.
Financing the deal
The next step is obtaining the necessary finance.
Unless you can fund the acquisition from your own resources, you will need funding from a bank or other lender.
The lender will want to see a business plan and cash-flow forecast for the business and will require security for the loan. This can be in the form of a charge over the assets of the business, or even personal guarantees from the directors or shareholders of the buyer and charges over their own homes.
If you are being asked to give personal guarantees or a charges over your own home, you need to think very carefully before doing so. If you cannot repay the funds you are borrowing, you may risk losing all your personal assets.
The legal process
Heads of agreement
Once the parties have agreed a deal in principle, they will often draw up heads of agreement (also known as heads of terms, an offer letter or a letter of intent).
The heads are designed to identify the main issues (e.g. deal structure, price and timetable) and act as a ‘route map’ for the rest of the transaction. They will be assumed to be legally binding unless stated otherwise.
If you do not want to be committed to the deal until you have signed a formal sale agreement, you must make sure the heads state that they are not legally binding.
Some provisions will normally be legally binding. For example, you may want a period of exclusivity during which the seller cannot sell the business to anyone else and must pay your costs if it does so.
In turn, the seller will often require you to keep confidential any information provided to you during the negotiations or even to pay a deposit which the seller will keep if you pull out of the deal.
It is important to avoid spending too long on the heads — especially if they are not legally binding — as you can waste time and costs negotiating them.
Due diligence and sale agreement
After the heads have been finalised, you will carry out your investigation of the target business and your solicitors will prepare the sale agreement (see below). It is generally better for your solicitors to draft the agreement because this can help your negotiating position.
Exchange and completion
When the documents have been finalised, each party will sign the sale agreement and give its signed copy to the other party (‘exchange of contracts’). The parties will be committed to the deal at this stage, although there may be a delay before completion.
On completion, you will pay the price and the seller will transfer the shares or assets.
You may need a period between exchange and completion, for example, to obtain any necessary consents from third parties, such as customers (the seller will be reluctant to tell customers about the sale until a formal sale has been agreed) or, in the case of an asset sale, to consult with employees.
In addition, in a large transaction, the acquisition could require regulatory approval under competition law. You should try to identify these issues at the outset and perhaps make the acquisition conditional on resolving them before completion.
How long does it take?
The length of the process can vary enormously between transactions, but you should normally anticipate at least six weeks from the signing of the heads of agreement until completion.
Once the parties have agreed the principal terms, you will begin investigating the target business. This process is called ‘due diligence’ and falls into three main categories:
- Financial — reviewing the accounts and the financial and tax situation of the business. This is normally done by the buyer’s accountants.
- Legal — examining the corporate structure, the contractual and other legal obligations of the business and any regulatory issues. This is usually done by the buyer’s solicitors.
- Business — reviewing the products, market position and trading relationships of the business, which is normally done by the buyer.
Other advisers, such as surveyors, environmental experts or IT specialists, may be needed to investigate specific aspects of the business.
Due diligence can help you to identify problems which need to be covered in the sale agreement, and any consents required for the transaction (e.g. from customers). Issues arising from due diligence may make you want to renegotiate the price or even pull out of the deal altogether.
What should you look for?
For example, you will be interested in:
- The trading position of the business — e.g. key contracts, debtors, creditors and capital commitments
- Onerous obligations — e.g. long-term contracts involving high payments
- Ownership and condition of assets — e.g. title to land, the terms of any leases, or the condition of stock
- Employees — e.g. employment terms, salary payments, pensions and other benefits
- Litigation — e.g. disputes with customers or claims by employees
- Taxation — e.g. tax arrears or disputes with the Revenue
- IT/intellectual property issues — e.g. computer contracts and rights to software or trademarks
If the business owns a property, you will need to carry out searches and enquiries (e.g. at the local authority) and you may want to do a survey of the property.
Due diligence is advisable for any buyer, but it can also be expensive and time-consuming. You and your advisers should identify and focus on the areas of particular interest and the specific risks in the relevant industry sector, and you must keep the exercise in proportion to the value of the acquisition.
You should also avoid spending too long on it, particularly if there is a risk of losing the sale to another buyer.
Share/business purchase agreement
The share/business purchase agreement is the most important document in the transaction, and most of your solicitors’ time will be spent preparing and negotiating it.
It will set out the key commercial terms which have been agreed between the parties, including:
If the sale is subject to certain conditions — for example, obtaining the consent of a key customer to the transfer of its contract — these will be covered in the agreement and must be satisfied before the sale can complete.
Price and payment
The buyer normally pays the price in full on completion, but you may want to hold back part of the price until a later date (a ‘deferred payment’), make the price dependent upon the business achieving certain targets in a specified period after completion (an ‘earn out’) and/or hold back part of the price in a joint account to use in settling any problems which arise after completion (a ‘retention’).
In contrast, the seller may require a deposit on exchange of contracts for the sale agreement, which may be forfeited if the buyer cannot complete the deal.
You may want the price to be dependent on the value of certain specific assets, such as stock, work in progress or debtors which are valued on completion using ‘completion accounts’, with the price being adjusted downwards or upwards if the value of the assets is lower or higher than the figures which the parties have agreed in advance.
On an asset sale, the parties will normally draw a line at completion, with the seller being responsible for all liabilities before completion, and the buyer responsible for those after completion.
Pre-payments by or to the seller will also be divided pre- and post-completion.
For example, if the seller has already paid rent for a period which straddles completion, the amount for the post-completion period will be added to the price you will be paying, whereas if the seller has received a deposit from a customer for work to be done after completion, the deposit will be deducted from the price.
The agreement will govern how book debts are collected after completion.
In a share sale, the book debts are automatically inherited by the buyer. In an asset sale, you could agree that the seller will keep them and you will collect them on the seller’s behalf, or that you will buy them and collect them for yourself.
You will probably not want the seller contacting customers for a period after completion.
On a share sale you will automatically take on any premises owned by the target company. On an asset sale the agreement will need to specifically deal with the transfer of the premises, including obtaining the landlord’s consent if the property is leasehold.
On a share sale, the employees remain with the target company which you are acquiring.
On an asset sale, the end result is similar in practice, as the regulations known as ‘TUPE’ provide that the employees’ contracts are transferred from the seller to the buyer on completion, so the employees will become employed by the buyer. This means that you cannot unilaterally change their contracts.
The seller cannot dismiss employees immediately before completion if they are surplus to requirements going forward, and nor can you dismiss them immediately after completion, without following the correct legal procedure, as either action could lead to claims against you.
If you have an existing business, you may have to select some of your own employees for redundancy, rather than making all redundancies out of the employees you inherit from the seller.
It is essential for you to get the right legal advice on all employment issues — including pensions and share schemes, which are treated differently from other employee rights on the sale of a business.
The buyer will often restrict the seller from competing with the business, and taking clients or employees, after the sale. These ‘restrictive covenants’ must be reasonable in scope, duration or geographical area, or a court may refuse to enforce them at all.
The handover period immediately after completion is a crucial phase. You will need to focus on retaining existing customers, motivating staff and integrating the target business into any existing business you are operating.
Also at this stage, if the deal involved a share sale, there may be an accounting exercise after completion, which involves the preparation of accounts for the company as at the completion date.
If the parties agreed on a target value for the next assets of the company, this exercise may result in a post-completion increase, or reduction, in the purchase price.
Discovering problems in the business
If you discover problems in the business, which existed at the time of the sale but which were not disclosed to you in the sale process, you may be able to bring a claim for compensation for breach of the warranties and indemnities in the share purchase agreement.
Your right to do so will depend on what the transaction documents say about time limits and financial limits on claims, and whether or not the issue in question was adequately disclosed in the disclosure letter and supporting documents.
Competition from the seller
Alternatively, if you discover that the seller has set up a competing business in the same sector, you may be able to sue for compensation for breach of the restrictive covenants in the purchase agreement.
In either case, you will need the right legal advice to guide you about your rights and how to bring a claim against the seller.
For support or advice on buying a business, contact our business solicitors.