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Legal, financial due diligence vital part of buying a business

Although handing over the funds and getting a receipt is enough to make the sale of a business legally binding, this is not an advisable way to assess the viability of a possible purchase or protect against any risks, Vancouver corporate lawyer Jonathan Reilly tells AdvocateDaily.com.

As Reilly, founder of English Bay Law Corporation, explains, when it comes to buying or selling a business, risks come in many shapes and sizes — ranging from tax issues, such as income, capital gains, property transfer, GST or PST, to hidden lawsuits, environmental liabilities, real ownership interests that are either unknown or undisclosed and regulatory restrictions.

“If disclosed and identified, most risks can be mitigated. Some can be eased by a reduction in price, a holdback, warranties, revised structure, or not doing a deal,” he says.

When considering the purchase of an incorporated business, it is important that people know both the value of what they are acquiring, and how they intend to buy it, says Reilly.

The “how,” he says, will involve whether the buyer decides to purchase assets or shares. 

“Generally speaking, for tax reasons, vendors prefer to sell shares and, for risk reasons, buyers prefer to purchase assets. On the sale of land, there may be transfer tax reasons that a purchaser would prefer to buy shares, but acquiring shares always involves more risk for the buyer and costs more for document preparation and due diligence,” says Reilly.

Due diligence, he says, is a blanket term for the process by which a buyer investigates the value and risks of a potential purchase. 

“Financial due diligence involves investigation of the financial records, cash flows, debts, income, expenses, and so forth of the target acquisition. Most of the financial due diligence will be conducted directly by the client or its accountants. This forms the basis of much of the value when the purchaser is setting the price. 

“Legal due diligence involves investigation of the ownership of the target, potential registered liabilities, lawsuits, contravention of government regulations, guarantees or other pledges that would give third parties a claim that could affect what is being purchased. Results of legal due diligence are intended to confirm that the sellers, in fact, own and are authorized to sell the assets, and they do not have any liabilities attached to them that would reduce their value,” adds Reilly.

In addition to conducting much of the legal due diligence, the lawyer will also advise the client on what is required. 

“Basic things — searches for land title, asset liens, and company registry may need to be augmented with searches for litigation, examinations for environmental (provincial and federal), municipal and fire compliance,” he adds.

The results of the legal due diligence, he says, will also help the buyer decide if they are willing to complete an asset or a share purchase.

The effort and cost of conducting due diligence on a small deal is not that different from one that is larger, says Reilly, although with modest transactions, the contract of purchase and sale has often been prepared by a broker and executed by the parties before a lawyer for either side has seen it. 

“So the amount, time to complete, and types of due diligence a buyer is allowed, may be restricted,” he cautions.

Although setting prices and determining valuation is likely the purview of accountants rather than lawyers in this type of transaction, Reilly says what the lawyers discover can put downward pressure on price or lead to a recommendation for a holdback, warranty, further due diligence, a different structure for completing the transaction, or lead to parties not completing the deal at all.

Once a client has found a business that they think is worth considering, it is time to approach the potential seller, says Reilly, which can be done directly or through an agent. This process can be informal — via a conversation to suss out whether there is any appetite to sell — or more formal, through a letter of interest or a formal offer.

Reilly says it is also a good idea to have a confidentiality agreement in place.

“If the transaction is one-sided, then the seller will likely require the purchaser to sign a confidentiality agreement that only obligates the buyer to maintain confidences. If the transaction is two-sided — a merger, or if information will be shared by both sides — then a mutual confidentiality agreement would be more suitable,” he says.

For clients buying a business, one of the most common pitfalls is falling in love with the target property, says Reilly.

“When that happens, buyers lose their objectivity and sellers can sense it; purchasers should be making decisions based on financial and risk criteria. Falling in love with a target leads to overpaying and over purchasing — that is paying too much for what you think you are getting, and taking on more risk or more problems than you thought,” he says.

Having an accountant and lawyer with whom there is a trust relationship will help a purchaser remain objective in their decision-making, both during the due diligence process and before the contract is signed, says Reilly. 

Other common pitfalls involved with buying a business include signing an agreement before having it reviewed by a lawyer, or a deal that does not provide enough time to complete due diligence or the flexibility to modify the price if due diligence is unsatisfactory, says Reilly.

“Before a client signs a purchase contract, the lawyer can advise on whether the contract allows for due diligence and whether it allows the purchaser to terminate the deal or modify the offered price if the due diligence does not meet with expectations,” he says.

For sellers, downsides can involve a requirement to reveal confidential information such as pricing methods or customer lists. Reilly cautions that a confidentiality agreement may not protect against having to disclose this type of information. 

“The seller may also be faced with legal costs before they find out for sure the sale will occur. To protect against the risk of giving out too much confidential information, a seller may refuse to answer due diligence questions, but this could affect the price offered,” he says.

For both sellers and buyers, Reilly says it is important to realize that this is a business negotiation — you can say no to a term you don’t like. 

“If you really don’t like the deal, you don’t have to take it. Sometimes clients lose sight of that and don’t try to negotiate or find out what it is that the other party needs. Sometimes it is not the price, but some other thing that makes or breaks the deal. Sometimes there are soft issues that can be addressed at a low cost, but are very important to one side or the other,” he adds.

Ultimately, he says, it may be worth taking complex transactions or those with a great amount of money at stake in stages, with a letter of intent or a memorandum of agreement — either of which can be binding or non-binding — laying the groundwork and acting as a summary for instructing the lawyers on how to draft the actual purchase and sale agreement.

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