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29 July, 2014 | Peter Smith
Purchasers can acquire a business either by buying the assets of the business, or by buying the shares of the company that owns the business. Both methods have their attractions and their pitfalls. This is yet another time when lawyers and accountants work together to get the right deal for their mutual client.
This is not just about the right price. It is also about minimising the risks involved in buying any business.
With the asset approach, a purchaser buys the assets, that’s the plant and equipment, plus the stock and the goodwill associated with the business.
For smaller businesses that is the most common route, because the buyer is then not buying any historical issues, or claims that might be made against the business. For example, there might be tax problems which the vendor hasn’t spoken about.
Buying the assets of the businesses avoids that. Any issues of that sort stay with the seller.
The other way is to buy the shares in the company that owns the business.
For the seller that’s very clean and tidy. They get their money and that’s the end of the matter. A sale of shares is generally a tax free transaction, and that’s important because in New Zealand we are very much driven by tax considerations in most commercial transactions.
The possible downside for the buyer in using the share approach is that the buyer is then inheriting any undisclosed liabilities associated with the business.
As lawyers we work with a buyer’s accountant to arrange the transaction in ways that minimise risk and tax. Due diligence, however well performed, won’t discover every possible wrinkle. Warranties about critical matters are often sought and usually given.
The lawyers for each side will work through a long list of warranties. A major one would be that the balance sheet is a true and correct statement of the business’s financial position. The seller will be asked to give an undertaking that this is so and the buyer then has a legal comeback if it turns out not to be the case.
Buying a business by the asset method, or the share method, shouldn’t make any difference to the ultimate value of the business, or to the price paid.
There is no black and white guide to what is the right or wrong option, but taking the wrong option can be costly. For example, in a share sale, the money in the current account is sometimes overlooked. It looks like working capital, but really the current account is profits of the business that the shareholders haven’t yet withdrawn from the business.
More than one purchaser using the share route has received a letter from the former shareholders demanding the money in the current account – and in law it is properly theirs, and purchasers have had to pay up. In effect the price paid to buy the business has gone up. It’s an unwelcome shock, but experienced advisors know to avoid that trap.
Another pitfall is that the new owners get a nasty letter from the IRD advising that inspectors plan to investigate the business.
The owner now has to take the time to deal with the matter, and pay the costs involved, and then seek to get these, together with arrears of tax, back from the previous owner.
Small businesses acquiring other small businesses usually take the asset option.
Often business owners selling up have been preparing for a sale over several years – as part of the owner’s exit strategy. So they have been careful about the standards of accounting, and maintaining reliable systems capable of audit.
Buyers can get comfort from that. They can see that the business has been properly managed.
Bigger companies looking at other sizeable businesses know that these businesses have systems that smaller businesses can’t afford. If a buyer is confident about the seller’s financial systems then such a buyer is more likely to purchase using the share purchase route.
Typically in the sale of a larger business – for example one with a turnover of more than $2 million – there will be a pre-purchase conference of the lawyers and accountants for the various parties to discuss all these matters.
It’s worth remembering that these legal costs are part of the cost of the purchase. The purchase price isn’t just what you pay the seller.
As a buyer you need to know and be comfortable about the business you are buying, and that’s where as experienced professionals Smith and Partners can help. Good advice is essential in choosing the best option for the circumstances, and to minimise your risks. There is no substitute for experience in this game.