Business acquisitions: The importance of due diligence to manage risk

Business risk in New Zealand

With New Zealand economic conditions improving, business confidence on the rise, and general business “picking up” some perceive understanding the risks associated with New Zealand businesses is less important than it once was.  Although there may be some truth that the level of business risk may be lower now than two years ago, the idea that prospective business purchasers can be less prudent when investigating prospective businesses is only creating a false paradigm.  When looking to purchase a business the importance of identifying the risks associated with that business and managing those risks is pivotal.

How to identify the risk

Due diligence is a term used to describe the investigation process undertaken by a purchaser or their representative before a business is purchased.  The objective of carrying out this process is to extract privileged information and knowledge from the vendor about the business.  The information gathered from a due diligence investigation can expose inaccuracies in the information provided by the vendor, as well as details of any current or impeding weaknesses of the business that may inevitably cause substantial risk and loss to the purchaser if the sale goes ahead.

The quality of the due diligence investigation will determine the quality and outcome of the information that is discovered. Therefore, it is important to engage appropriate professionals and experts to conduct the investigation to ensure all avenues are covered, minimising any unexpected surprises following settlement.

Key points to investigate

Although different industries and business structures will have different key areas that will need to be investigated, it is essential that the basic components of a business are investigated irrespective of the size or type of the business.  This includes looking into the arrangements with the employees, the value and quantity of stock/work in progress, the extent of the business’s liabilities and the nature of the existing contracts.

When purchasing shares in a business, investigating the employee matters is less important as the employees are part of the business so generally remain with the business.  Conversely, when purchasing the assets of a business, the purchaser has the option to take over all or some of the employees on the existing employment terms or new employment terms can be negotiated.  Either way, conducting  due diligence will allow a purchaser to determine whether there is any accrued annual leave or other paid leave owed to the employees.  Often the purchaser will negotiate with the vendor for any leave owed to the employees to be paid out prior to the new purchaser taking over the employees’ contracts.

Being aware of the type of stock required to run the business, how often it turns over, and whether the business turnover reflects industry standards, are all questions that will be answered when analysing the stock and work in progress of a business.  It is important that a purchaser feels comfortable with the stock they are purchasing and the value they are paying for that stock.  The extent and nature of the due diligence investigation into the stock/work in progress will depend on the industry the business operates in.  For example, a large furniture manufacturer will have more stock and work in progress to be assessed and valued than a small interior design business.

It is crucial to appreciate the importance of investigating every area of the business as minor inaccuracies such as a small accounting error when valuing each unit of stock can lead to a significant expense on settlement day.

Investigating the vendor’s liabilities is only required when purchasing shares in a business, as the liabilities remain with the business and therefore become the responsibility of the purchaser.  Conversely, when purchasing the assets of a business the liabilities of the business remain with the vendor.  Investigating the liabilities of a business can be an arduous task as the relevant information is usually not as accessible as the vendor can be less willing to provide information about what the business owes as opposed to providing a list of its suppliers.  Despite this difficulty, it is worth purchasers investing in professionals or appropriate experts such as engaging an accountant to review and analyse the financial reports to gain a clear picture of all the business’s liabilities.  A thorough due diligence investigation will minimise the risk of any unknown debt being uncovered well after settlement has taken place.

All third party contracts should be thoroughly reviewed prior to finalising an agreement to purchase a business.  This is so the purchaser is clear about the nature of the relationships, the quality of the goods or services provided, and whether the third parties intend on continuing with the existing arrangement after the business is handed over.  This part of the due diligence process can play a pivotal role in the success of the business after hand over.   For example if a key supplier terminates their contract with the business soon after settlement, there could be serious financial implications if the business is unable to find a new supplier that can supply a similarly priced and quality product.  In the event this occurred, the business may have no option but to go to a more expensive supplier or alternatively a supplier with an inferior product.

What to consider before going unconditional

It is not uncommon once due diligence has been completed, for the purchaser to negotiate some amendments to the sale and purchase agreement.  For example:

• A reduced purchase price;
• Renegotiating the values of the tangible assets and intangible assets (e.g. goodwill value to increase and tangible assets value to decrease with the overall purchase price to remain the same); or
• Adding further vendor warranties (e.g. a turn-over warranty).

During the due diligence period, if any serious issues are uncovered, it may be appropriate for a purchaser to cancel the contract before it goes unconditional, opposed to negotiating more favourable terms to mitigate the risks.  It is important, the purchaser is comfortable with all aspects of a business and understands all of the risks involved before purchasing.   Often a purchaser’s judgement can be clouded in the event a vendor responds to any issues raised by heavily reducing the purchase price.  In this situation the purchaser can overlook the strong possibility that the purchase price was significantly overpriced to begin with instead focusing solely on the "savings".

A purchaser should invest significant resources into the due diligence process before buying a business.  This will minimise the possibility of anything unexpected occurring/coming to light after the business is handed over.  A quality due diligence investigation carried out by the appropriate experts/professionals will assist with purchasing a viable and successful business.  

If you would like further information please contact Laura Monahan on 07 958 7479.