Everything you need to know about handling debt in a business acquisition — share vs asset purchases, due diligence, warranties, indemnities, negotiation strategies, and real-world case studies from successful dealmakers.
When you buy a business as a going concern, what is it that you actually get for your money? As with so many things, the answer is, 'It depends.' It depends on what the business has, how it is structured and what you actually want out of the deal. Maybe you want the client contracts — or even just one key client contract — and have no interest in the rest.
All these things and more can be sorted out in deal structures. Potential buyers just need to make sure they understand any legal issues and legal obligations that might be involved.
If an existing business has outstanding debts, especially if they are substantial, that needs to be carefully considered. Debt payments cut into cash flow and profit, which might inhibit investment and growth, and ruin your business planning. However, there are ways to deal with this too.
When you buy an existing business, the seller might offer a share sale or an asset sale. The type of deal determines whether you inherit the business's debts.
Which type of business purchase is best? That needs to be decided on a case-by-case basis.
DEALMAKER INSIGHT — ANDY DOYLE
Dealmaker Andy Doyle was faced with the choice between share and asset purchase when he made his second business acquisition — a digital agency that was struggling to make money. His first acquisition had been a successful share purchase of an e-commerce company, so after due diligence he made the decision to go down the same route.
The deal took about three months to complete, and soon after things started to emerge that showed the previous business owners had violated some of the warranties in the sale and purchase agreement. Because those warranties had been included, Andy was able to challenge them and they reached an agreement. Unfortunately, the additional debt those actions had piled on the business proved to be too much and the business went into liquidation.
We talk about due diligence a lot, because of how important it is. It feeds into valuation and can affect purchase price and terms. Even if you are buying an existing business for a ridiculously small sum of money, you need to carry out due diligence. That bargain business — and Jonathan Jay once bought a company for £1 — can hide a lot of outstanding debts, and that debt might not be immediately visible.
Financial due diligence is key here. The process includes reviewing historical financial records to identify things including existing debts and current liabilities and to ensure the business isn't insolvent. If anything looks dubious or raises a red flag, that's when appropriate warranties and indemnities are written into the sale agreement.
Promises that things are as they have been stated to be. They give you recourse if the seller misrepresented the business.
Typically a pound-for-pound reimbursement — if a £10,000 debt to HMRC should emerge, you can claim that £10,000 back.
In practice, any claim you can make against the seller is limited to the amount you paid for the business. Say the business cost £500,000: the most you can ever claim is £500,000, and to get that you've got to go to court and be successful. If a £1 million financial problem were to emerge, you'd be £500,000 down.
An alternative is a right of offset in the SPA — allowing you to reduce deferred consideration by the amount of the claim. But you can only claim as much as remains outstanding on deferred consideration, and the seller's solicitor would typically push back.
And of course, if the things unearthed by due diligence look especially bad, you can cut your losses and walk away. There's nothing to be gained by doing a deal at all costs; it has to be a deal that works for you, at your price and on your terms.
If there is debt in a target business, you need to understand where it came from. That doesn't just mean knowing who the creditors are, it includes getting to grips with how the debt came about.
DEALMAKER INSIGHT — CHRIS STONE
Dealmaker Chris Stone and his brother run a healthcare company. During an acquisition phase, they had the opportunity to buy a chain of nine clinics, which the owner just wanted rid of. The company was £120,000 in debt to the bank, and had a turnover of £460,000. Contributory factors included the premature opening of a London clinic and payment of a £60,000 director's salary. Without those costs, the company could have earned a net profit of £120,000.
When it comes to buying a business with debt, there are different ways to approach the deal.
Pay the seller a higher price on the understanding they will settle the debts before completion.
Negotiate a lower price based on you taking responsibility for debts. Caution: debt repayments plus deferred consideration can squeeze cash flow, and having debt in the business might prevent further borrowing.
Have the seller settle some debts while you take on others. Also, if due diligence reveals the business holds a lot of inventory, a stock sale might raise funds to help clear debt.
DEALMAKER INSIGHT — MARTIN LIGHTBOWNE
Martin attended the Mergers and Acquisitions FastTrack programme and changed his entire business plan on day two. His aim was to buy fifty small businesses, safe in the knowledge that by integrating them into the group, a loss could be turned into a profit.
One acquisition, a bookkeeping business run by a sole trader, had £10,000 in the bank and company debts of £24,000 when Martin took over. He says: "We took on the debts and, on day one, ripped out the costs."
Debt in a business can be sold to a third party by the lender. It's possible that you, as the buyer, might be able to buy the loans the company has taken out, and so keep control. Be sure to take both financial and legal advice before pursuing this route.
If things are really bad, then calling in an insolvency practitioner might be the solution.
Information about debts and liabilities in target small businesses will come out of your due diligence process. When you are exploring options and deciding how to handle this kind of issue, remember to lean on your deal team. You hired experts for a reason, so use their knowledge and expertise to get clarity.
If your accountant and solicitor — and any other experts involved — don't have the depth of knowledge needed for the kind of issues you are facing, find someone who does. The final decision is yours, but you owe it to yourself to ensure that decision is made on the back of a thorough investigation and understanding of the facts, and sound, expert advice.
Buying a business, whether sole trader or limited company, has a lot riding on it. You can get advice from professionals and peers, either formally or via sites like LinkedIn, but ultimately the decisions made are yours.
Jonathan Jay has helped more than 3,000 people buy successful businesses and become acquisition entrepreneurs. Download the most comprehensive FREE package of business buying resources available today.