Four risks to be wary of when buying a business

- October 7, 2022 4 MIN READ

Buying a business is an exciting time, but can quickly become a nightmare if you don’t mitigate these common risks, writes Joanna Oakey, commercial law expert and author of Buy, Grow, Exit.

It is imperative to identify and understand the risks when you are acquiring a business, so you can control and minimise the damage. To identify these risks effectively, you need a thorough understanding of both common risks and risks specific to the industry and target business you are assessing.

Once risks are identified, we can control and minimise them in the deal-making process through due diligence, contracts, commercial approaches and the structuring.

Four common risk areas to examine when buying a business

1. Transaction risks

Several risks arise out of the transaction itself. These include employment transfer risks, tax risks and privacy, confidentiality and contract breaches.

Ultimately, these transaction risks are controlled by your lawyer; therefore, it’s important to engage a lawyer who understands and controls them properly (this requires experience in mergers and acquisitions of similarly-sized businesses and in your industry).

Landmine risks don’t always blow up a deal, but can cause loss or value leakage which is important to factor into your planning, as well as the deal itself. For this reason, it is important to ensure your due diligence stage investigates the strength and quality of the business as well as the facts, documentation and risks.

2. Due diligence

Through due diligence, you identify risks from legal and operational perspectives. When you decide to go ahead with the deal, it should be based on price, negotiated commercial terms, and a deep understanding of the business.

Generally, due diligence happens once the price and commercial terms have been agreed and a terms sheet has been signed. There is complexity in deciding the appropriate level of due diligence. Too little and you may not have enough information, too much and you may risk over-complicating it.

Stand back and ask yourself: What am I looking to achieve in the purchase? What is the risk level in the business I am purchasing? This is, of course, balanced against the size of the acquisition and how much time, energy and money should be poured into the due diligence process.

It is vital not to be flippant about the role of due diligence.

Legal contract or form of agreement

3. Contracting and warranties

The purchase contract is an integral part of your risk minimisation – and can also be a breaking point for even the best deals.

The contract will enable you to control and minimise the risk through the interaction of warranties and indemnities from the seller (and any relevant guarantors). These are ‘promises’ made by the seller about the ownership of the assets, the accuracy of the material they have provided in due diligence, and liabilities and risks in the business.

Security for warranties is an important consideration to ensure there is someone for the buyer to turn to for a warranty claim; for example, if the selling entity has been stripped of cash post-sale.

Warranties and indemnities in the sale contract can seem daunting for both sides, and for an uneducated seller without full trust in their deal team, it can create many sleepless nights as they balance the desire for an exit on their terms against the fear of post-sale risks coming back to bite them. It can also hamstring the deal process – leading to both sides getting cold feet.

One way to reduce concerns at this stage is to take out a buy-side warranty and indem­nity insurance policy, or for the seller to take out sell-side insurance (which is likely to be more cost effective). This type of insurance allows a buyer to claim directly against the insurer for any breach of warranty. In the context of a deal, both sides can rest assured that there is coverage should an unexpected skeleton emerge from the closet post-transaction.

4. Commercial approaches and deal structure

While the contract can be used to control some of the risk, it is not the full answer. Protection through commercial approaches is an additional consideration in risk minimisation and control.

The information drawn through your investigations of the business in due diligence should provide a good outline of the risks. For each risk, determine the best method of control outside of the contract. For example, setting up systems and processes to minimise the risk, setting up proper documentation to fill any gaps, and putting appropriate insurance in place – which can cover transaction and general risks in the business moving forward.

Protection can also be achieved through decisions made on how you structure the deal. A share sale over a business sale may reduce the risk of value transfer leakage, but potentially increase the risk to the buyer in taking over the history of the business.

You can also structure the payment so it can be withheld until a period after completion, to protect against various risks. A good deal team will help you ensure you are choosing the best structure given your objectives and in the context of your overall position.

It is essential to understand the methodology of the sale process and to understand the potential speed bumps you may encounter. It’s also important to understand the levers you can pull, and ultimately, how to control the deal and the risks so you can maximise the pot of gold at the end of that business rainbow.

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Now read this:

How to prepare your business for sale