I Am Purchasing A Business in an Economic Downturn. How Can I Protect Myself?
As a result of the Coronavirus (COVID-19) pandemic, there are very uncertain times ahead for the economy. Protective measures such as banning social gatherings and social distancing are in place, contributing to an economic downturn. If you are already in the process of purchasing a business, you may be wondering where this leaves you.
Generally, if you have signed a sale of business contract, you are legally bound to proceed with the sale. However, there are some protective measures you can take to limit any negative effects during these unprecedented times. This article will explore these measures, including:
- conducting thorough due diligence of the business, and assessing how much of its revenue is recurring revenue;
- ensuring you have written contracts for all key customers and suppliers contracts and that they still have a reasonable amount of time left on their term; and
- considering how you can reduce costs once you have taken over the business.
For any business sale, it is important to conduct thorough due diligence on the business you are looking to purchase. This will ensure that:
- you know exactly what you are purchasing; and
- whether the purchase price truly reflects the value of the business.
In an uncertain economy, it is particularly important to investigate the business’ recurring revenue, to determine the revenue projections for the next six to 12 months. Recurring revenue is revenue that continues into the future. It is usually locked in by contract (i.e. a 12-month contract) and ideally is directly-debited from the customer’s bank account. Some common examples include subscriptions and memberships.
When calculating the business’ purchase price, recurring revenue provides more value compared to revenue associated with one-off purchases. However, while ongoing revenue provides more certainty, you should review the client agreement in question to determine if it allows the customer to terminate or suspend the contract.
Also, even if revenue is recurring, the reality is that some of these clients may simply not pay. Even if they have a contractual obligation to do so, it may not be worth your time and expense to pursue these debts. You should consider negotiating a reduction in the purchase price with the seller if:
- the business you are purchasing has limited recurring revenue; or
- has recurring revenue that you may need to chase as part of debt collection measures.
Locking in All Contracts
When purchasing any business, make sure that all essential aspects of the business are contractually locked in. This includes ongoing services with clients and suppliers. In the same way that you expect that the lights will turn on when you enter your office, you want to know that the supplies you will be relying on will be delivered.
As a result, it is important to make sure that your suppliers and service providers are contractually obliged to continue providing their goods or services to you.
Consider these arrangements carefully. For example, a long-term supply contract may be beneficial to the business, but it could also mean that you are required to buy a certain amount of stock from your suppliers, even if your sales are low. Seek professional advice on all key business contracts to confirm:
- the risks in existing contracts; or
- to draft or amend new contracts to better suit your needs and the changing business landscape.
Make sure all important business contracts can be transferred to you, especially if the planned purchase is an asset or business sale (rather than a share sale). The customer or supplier contract normally will state whether you can:
- transfer the contract to a third party (a buyer) without their consent; or
- customer or supplier consent is required.
If the contract is silent on the issue, then you will need to seek consent.
Check the contracts carefully to see if consent is required, and consider what process you will follow. Negotiations to meet customer or supplier requirements and gain consent can be time-consuming and could allow them to terminate these contracts. If these contracts are essential to the business’ operation, you should consider this early in the sale process, to ensure the contracts can be formally transferred to you.
If the consent process is going to take time, there are other options you can consider, such as the seller subcontracting their business contracts to you (if the contract permits this). Your lawyer can advise you on your options. Where it is a share sale, it can be an easier transition as you are taking over control of the company and the business contracts will remain with the company.
Once you own the business, if you are expecting revenue to decline, look at ways to reduce current expenses. Build a continuity plan that allows the business to quickly adjust to a downturn, which could include cutting expenses. Some options for reducing overheads include:
- asking the landlord for temporary rent reductions;
- asking the bank to temporarily pause loan repayments;
- cutting non-essential service providers;
- using fewer resources in your dayto-day business operations;
- reducing the hours for part-time or casual employees; and
- taking more drastic measures.
Drastic Cost Reductions
In a challenging economic climate, you may need to consider drastic cost reductions. A business’ two highest expenses are usually employee salaries and its lease, so revisit these for opportunities to reduce costs.
Not Transferring Employees
During a business purchase and depending on the terms of the contract, you can elect not to take on some or all of the employees. This can reduce the business expenses for the time being.
If you do not take on certain employees, the seller may need to make their roles redundant. However, redundancy payments are not always be required. For instance,
- where there are less than 15 employees (subject to limited exceptions);
- and if the employee is casual or has been engaged for less than 12 continuous months.
Ending the Lease
There may also be the opportunity to end the lease in limited circumstances. If the lease has a long term remaining, then the landlord will be reluctant to allow the seller to exit the lease.
However, if the lease term has expired and it is now month-to-month, this typically allows the seller to end the lease on a month’s notice. If this is a retail business, you may be able to move entirely to online sales in the interim, and lease a premises once the economy returns to normal. This would drastically reduce expenses and would allow the business to continue operating.
While there are uncertain times ahead, if you are purchasing a business there are a few proactive steps you can take to help limit your risks moving forward. This includes locking in client and key supplier contracts as soon as possible. While this does not guarantee payment or delivery of supplies, it will significantly improve your risk exposure. You can also take measures to temporarily reduce costs if you expect revenue to be low when you take over the business, such as negotiating your lease with your landlord.
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