The purchase of a business, especially for first time buyers, can be a complicated process. There is no substitute for extensive background work as part of negotiating and signing of the Agreement of Purchase and Sale. As everyone knows, an ounce of prevention is worth a pound of cure, and therefore we recommend that you get help early to ensure the target business is worth the price you agree to pay. Important components of this background work involve a detailed review of the financial statements of the business to be purchased, a detailed investigation into the operations of the business, and the arranging of financing to complete the transaction.
The purpose of this Lawletter is to provide a brief overview of matters to consider during what is often called the “due diligence period”.
Reviewing the Financial Statements of a Business
It is extremely important to review in detail the financial statements of any business intended to be acquired. If you do not have training in reading financial statements it would be wise to have them reviewed by an accountant, as differing accounting practices can influence the presentation of the figures on the statement.
There are several types of reports that may accompany the financial statements:
- Auditor's Report: This provides the highest degree of assurance one can obtain from an accountant. This report is provided after the accountant has conducted an in depth review of the bookkeeping practices of the business, has physically counted inventory, and has applied numerous check and balance tests to the figures. The report of the accountant will specifically state that the statements are based on a full audit of the business.
- Review Engagement Report: This report does not arise from an audit but does provide a moderate degree of assurance. It involves a limited review of the business, by doing checks on certain risky areas of the financial statements. This report will generally state that the accountant's review was conducted in accordance with generally accepted standards for review engagements which include inquiry, analytical procedures and discussion related to the information supplied by the business. It will advise if anything has come to the attention of the accountants which causes them to believe the financial statements were not prepared in accordance with generally accepted accounting principles.
- Notice to Reader: This is usually provided in the case of small businesses, and no assurances are given respecting the information given in the financial statements. In this circumstance the statements have been assembled and prepared by the accountant based upon information provided by the business, without any independent verification. If financial statements are provided to you without any type of communication from an accountant, it is very likely they are financial statements generated by management of the business without any input from an accountant. You should be very careful to ensure that any such statements provided to you are professionally reviewed.
Notes to Financial Statements
It is very important that any notes to the financial statements be reviewed with care. These notes are provided to give the reader information which is not otherwise apparent from the statements. There may be a note on economic dependence; that is, the business may be greatly dependent upon one large customer. The loss of this customer would, obviously, impact substantially upon the value of the business.
You should be looking for some type of trend in sales or income generated by the business. Is the percentage of gross profit reasonable considering the nature of the business? It is important to review discretionary, or onetime expenses, as well as any expenses which appear to be unusually low. You may find that certain expenses are low due to non arm's length relationships; for example, the rent being paid is below market because a relative of the principal of the business owns the building. In that case, it would be prudent to review the particular arrangement and factor in the true expense for the purposes of your projections.
This portion of the financial statements shows what the company owns (assets), and what the company owes (liabilities). The difference between the two is the equity in the company. Certain of the asset values included on the balance sheet may not reflect actual value, as the balance sheet values are determined according to generally accepted accounting principles. There may be no recognition on the balance sheet of any upward changes in the value of an asset. As with the income statement, you must always look closely at any transactions which involve related parties. In addition, you should always determine that the liabilities are specifically related to the business in question.
Tax Implications - The Income Tax Act is a very complicated piece of legislation, which has a bearing on every business acquisition. It is very important that you obtain professional advice from a tax expert respecting the structuring of your acquisition and financing. There may also be substantial HST implications related to the business acquisition, and advice should be obtained respecting the structuring of your business acquisition to minimize the impact of these taxes. Failure to receive such advice may mean unexpected tax liability for you and can mean the difference between success and failure of your business.
Operational Due Diligence
In addition to understanding the financial health of a business, it is important to learn as much as you can about operations. This can be done by examining standard business agreements, customer and supplier information, occupational health and safety records, and workers compensation experience. Depending on the type of business, it may be important to conduct environmental due diligence, particularly where there is real property or an industrial undertaking. We can help you decide on the scope of required operational due diligence, and have access to various sources of information that can facilitate a thorough operational exam. When negotiating your purchase agreement, it is important to insist on the right to conduct your due diligence prior to an irreversible commitment to purchase.
What do the banks look for?
In the majority of cases, whether or not you will be able to purchase a business depends upon obtaining financing from a bank or other lending institution. When it comes to borrowing money for the purchase of a business, the factors the Bank will consider are much more detailed than those for a personal loan. It is extremely important that prior to approaching the bank you give serious consideration to the present financial status of the business and how you intend to improve it. Banks do not like to prepare projections for you; therefore, after a detailed review of the financial statements of the business, you should prepare, with the assistance of your accountant, projections to show the bank the growth you hope the business will achieve. If you are intending to add the target business to a current business, then of course you will want to prepare models that show the benefits of integrating the two businesses together, referred to by lenders and business valuators as potential “synergies” that should lead to improved financial results. There are a number of important aspects of the transaction which the bank will review and wish to discuss prior to providing any financing, including:
Review of the Industry
The bank must be satisfied that the business is one which has a reasonable chance of success in light of the status of the industry and the competitive landscape. The potential for your business may often depend upon your intended different approach or innovative proposal , and that was not considered by the present business owner. The banks are always interested in looking at any such unique idea, provided there is a reasonable basis for believing that this unique idea can increase the profitability of the business. It is simply not enough to believe you can increase revenues; you must have a convincing plan to satisfy the bank.
Review of Management
The bank will closely review how you plan to conduct the operations of the business. It will want to know where your management skills fit in the industry, particularly as they relate to experience in the same or related businesses. The bank will be particularly interested in reviewing your proposed management structure to determine whether there is a succession plan in place, in the event that experienced management is temporarily unavailable to the business.
Access to Additional Funds:
In most cases, you must expect to put cash into the acquisition of the business. The bank will look at your personal financial circumstances to determine whether you are in a position to make a sufficient advance of funds to the business. In addition, the bank will look at whether or not there will be any immediate cash needs of the business once the acquisition has been completed. This could be in the form of new products or equipment which may be immediately required, and will in most cases, involve the provision of credit to cover operating expenses. And most importantly, many lenders will require owners of small businesses to personally guarantee loans to the business. These guarantees can be onerous, and should not be undertaken lightly or before getting objective advice.
This information has been provided for general reference only. For advice on an actual matter, you should consult a lawyer. To contact a member of our team call us at 902-469-9500 or 1-866-339-3400 or contact us online to make an appointment.