Seven Key Questions When Buying a Business in Difficulty

Economic difficulties can lead to great opportunities for acquiring businesses at bargain values. But buying assets from a distressed business does have some particular risks, such as dealing with a rompala clause, and requirements, such as using a business loan broker. This article sets out seven key questions to ask yourself before doing any deal.

1 When are you buying and who from?

You may decide to buy assets from a distressed company which is not in any form of insolvency process and is still under its directors' control.

If an Insolvency Practitioner ('IP') is subsequently appointed, they will examine transactions in the period leading up to the insolvency to see if there are grounds to set any of them aside as being 'Transactions at an Undervalue'. If buying before a formal insolvency you will therefore need to ensure that you will be able to subsequently demonstrate that the transaction was at a reasonable value.

This issue is often resolved using a 'prepack' where an IP oversees the structuring of the deal, and is then appointed to execute it.

2 Who else needs to agree?

Where a business is in distress, the economic interest in its value has usually passed from the shareholders to its secured lenders. So check what security has been taken over the assets from the charges registered at Companies House. You will need to obtain these lenders' agreement to the deal (since you need them to lift their charges for you to complete the transaction and obtain title to the assets).

Where a business relies on a contractual relationship, such as a franchise, the use of some licensed intellectual property, a commercial tenancy, or has a supply contract, the other party will usually want to have some control as to who they are dealing with. Contracts will often have clauses whereby they automatically terminate in the event of an insolvency, or sometimes simply on a change in control of the company. Commercially, you will therefore need to obtain these parties' agreement to the proposed deal if you are to capture the value of the contractual relationship.

If the company has a deficit on a defined benefit pension scheme, the pensions regulatory bodies may also need to be consulted and consent to any major transaction involving a sale of the assets.

However, speaking to any third party will normally be a breach of the Non Disclosure Agreement you will have been asked to sign, so you will need to obtain permission to do so. If this is not forthcoming, or if the necessary assurances cannot be obtained from the third parties, this will need to be reflected in the price you pay and/or the terms.

3 What are you buying, and what liabilities can't you avoid?

If you are buying a business before a formal insolvency then you can either buy the share capital and acquire it with all its liabilities; or you can buy the business and assets, and in return for the cash paid, extract these items from the company shell, which is then left behind together with most of its liabilities. Purchases from an IP will normally only ever be a business and assets sale.

The key expression above is 'most of' its liabilities. Where the business has employees under the Transfer of Undertakings (Protection of Employment) Regulations 2006 ('TUPE') all of the employees' contracts of employment and accrued rights are deemed to automatically transfer across to you without any variation.

So carefully consider what TUPE exposure you are taking on and factor this into the price.

4 Are you actually buying what you think you are buying?

Neither the company, nor an IP can sell you anything that does not belong to it, so be sure that you are going to get good title to everything you think you are buying.

Raw materials for example may be held on a consignment basis, be free issued by a customer, or may be subject to retention of title ('ROT' or Romalpa after the relevant case law) claims by suppliers.

Check to ensure you are clear which fixed assets are owned outright and which are leased.

Also check the ownership of key intellectual property rights very carefully. It is not unusual for websites to be registered in the name of individual employees for example, or key brand names to be the property of a different company and just licensed for use by the trading company.

5 What legal issues might you need to consider?

Where a director or shareholder of the selling company is also involved with the buying company then some legal restrictions may need to be dealt with.

The directors of a failed company cannot, under Section 216 Insolvency act 1986, be involved with a company using the same or similar name in the five years following the failure, unless they follow a procedure for notifying all creditors that they will be doing so.

Section 190 Companies act 2006 says that where the directors of a company want to purchase substantial assets from the company, this has to be approved in advance by a shareholder resolution.

6 How much cash will you need?

You have to have enough funding with which to undertake the deal, but in addition to the sale price you also need to ensure you have sufficient to cover:

* Ransom creditors and deposits - some key suppliers may hold you to ransom, refusing to supply goods until their arrears have been cleared. If oldco's directors are involved with the new business, the Crown may require a deposit against potential future PAYE/NI or VAT liabilities.

* Working capital creditors - where you buy a distressed business you will normally find it has a backlog of creditors who will be pressing to be caught up; you may also find that you will have difficulty in obtaining credit from suppliers for some time afterwards so you may need to plan on the basis of purchasing for cash for a significant period.

* Sales performance issues - some key customers may be lost temporarily or permanently as a result of the process and your funding will need to be sufficient to cover this.

* Restructuring and reinvestment costs - there will be a reason that the business got into difficulty and if this is not to simply be repeated, this will need to be dealt with which may involve costs. The business may also have suffered from a lack of investment as cash got tight so a capital expenditure program may be required.

Using an experienced business loan broker can help with ensure you raise the appropriate types and levels of finance.

7 How much can I protect myself and how can I get a good deal?

Firstly, forget warranties.

If you are buying from a business in distress, how much value will you be able to place on any warranties given? If you are buying post insolvency, then IPs only know two words of Latin which are 'caveat emptor' (buyer beware) and will give no warranties on a sale, so don't waste time asking for them. In fact, you or your solicitor doing so is usually counterproductive as it shows the IP they are dealing with someone who does not know the ropes.

An IP sale contract will be drawn up on the basis that the purchaser has relied in their own enquiries so you will need to undertake your due diligence as quickly as possible and focus it on the most important risk issues in the business you are looking at.

An IP is looking for the best offer when selling a business. This is not simply the highest, but the one which gives the best combination of:

* Headline price, so they can demonstrate he is getting good value;

* Ability and likelihood of obtaining a successful completion, so they are not wasting their time;

* Completeness, as it is usually a much more efficient transaction if they can sell all the business and assets at one go; and

* Timing, as they will usually want to complete a process as quickly as possible, both so as to avoid the risk of running up irrecoverable costs, and because they are aware that the business's goodwill can be rapidly eroded by a period in insolvency.

So you should be prepared to move fast and having your advisers, due diligence team, funding and acquisition vehicle lined up and ready to go can give you a real advantage in getting the deal you want.

Of course the information contained in an article like this can never be a full statement of the legal position as the relevant laws are complex and liable to change. This article can only therefore be a general guide as to the issues involved and as these can have serious implications you should always seek appropriate professional advice on your own particular circumstances before taking any action.