Fundamentals of Limiting Risk When Buying a Business

By Nick Wallis

Acquiring a business is a major decision that requires a significant investment of time, careful planning and consideration. Acquisitions can be a challenging process that are usually pivotal to a buyer’s future plans.

Each transaction has its own differences and complexities, which naturally means buyers are exposed to risks and uncertainties. Considering the scale and cost of acquisitions, it is essential that buyers take the necessary precautions to safeguard themselves. Failing to evaluate and control risks may have detrimental effects. In this article, we cover a few of the key strategies for managing risk when purchasing a company.

How to lower risk when buying a business

1. Having an adviser you trust

When purchasing a business, buyers often rely on advisers because they are not always familiar with the process and often lack the internal resources or knowledge. From a buy-side perspective, the primary advisers involved in the process are usually:

• Financial advisors – for financial and tax due diligence
• Lawyers – to negotiate the legal documents and for legal due diligence
• and lead advisers – to supervise all elements of the transaction.

When choosing your adviser, it’s important to note that a low-cost option may result in savings up front but could potentially lead to poor guidance, which could cause major problems and future financial losses. Of course, this isn’t always the case, but it’s crucial to ensure that you invest in credible advisers that fully understand you and your goals

2. Due diligence

Due diligence is the procedure by which the buyer hires consultants to investigate the potential company. The process is primarily intended to verify that the business is operating as it was when the initial agreement was reached. There are multiple variations of due diligence that can be carried out, with the most common categories being legal, tax, and financial due diligence. Advisers will determine the key risks in the business, and then the purchaser can decide how to handle and manage these. If the consultants identify any potential risks, some purchasers may try to renegotiate the deal or back out.

3. Warranties

In essence, warranties are guarantees that a seller makes to a buyer regarding the condition of the company. They are broad in scope and address various topics of the business, including contracts, intellectual property, financial contracts and the right to sell shares, etc. In the legal document governing the acquisition, legal advisers will usually include a general suite of warranties and sellers will be liable for any significant losses (there are materiality thresholds) incurred by a buyer in the event that any of the warranties turn out to be false within a specific period of time after completion. Note that sellers may ‘disclose’ against warranties by putting in a ‘disclosure letter’ any information about the company that conflicts with any of the terms. If there is anything that is deemed to be ‘disclosed’, buyers will not be permitted to file a claim.

4. Indemnities

These are also promises made by the seller, only this time they are in reference to specific risks that may lead to future losses. Sellers are required to reimburse buyers for losses they incur, where a loss is realised in relation to a situation covered by an indemnity. It is understandable that sellers may be concerned about these since they are typically exempt from time restrictions and materiality thresholds. However, where a business has ongoing exposure to risk relating to events that happened before the acquisition, including indemnities in the legal documentation can be a great method for buyers to limit exposure.

5. Insurance

In connection with the purchase and sale of the business, insurance is an option for both buyers and sellers. M&A insurance is a collection of protections created especially to protect policyholders in reducing risks and facilitating comfort when closing a deal. When looking to buy a business, it’s best to speak with an insurance provider about how they can customise the policy to meet your specific needs.

Summary

Although purchasing a business might be a complex process, there are ways for buyers to mitigate deal-related risks. It is crucial to be aware of these elements and to have the right discussions as soon as possible. For further information on any of the risks we have discussed above, or to have an initial discussion, contact our Gerald Edelman’s Deal Advisory team today.