What happens if you buy a business and it fails? Guarantees, deferred payments and set-off

What happens if you buy a business and it then fails? Do you still have to pay the seller? And might you have any claims against them? The short answer is that your payment obligations usually survive, but a well-drafted share purchase agreement can give you claims to set against what you owe. This guide covers the consequences of a failed acquisition, what happens to your obligations under the SPA, and how to avoid buying a business that fails in the first place.

The consequences of buying a business that fails

Personal guarantees called in

If you signed any personal guarantees, for example when applying for finance to buy the business, it is very possible that the lender will treat the failure of the business as a trigger event and call in the whole loan. If the company cannot repay it, the lender will enforce the personal guarantee against you personally. In other words, a debt you thought sat with the company becomes your debt, and the lender can pursue your personal assets to recover it. It may also affect your credit score.

Director duties and wrongful trading

Your actions as a director of the business that failed may be scrutinised, particularly to assess whether you complied with your duties as a director. One of those duties is the obligation not to engage in wrongful trading.

In short, wrongful trading is when a director continues to trade the business as usual, incurring liabilities and taking out loans, despite knowing the business is insolvent. What a director should be doing in that situation is the opposite: stop trading, stop taking on liabilities, and liquidate, meaning sell off the assets and pay the creditors. If you keep going in the hope that things turn around, your conduct during that period is what will be looked at.

Insolvency proceedings after an acquisition

The third main consequence is insolvency proceedings. Typically a business fails because it has creditors it cannot pay. If that is the case, the creditors are likely to bring claims against the company, and that may result in the company going into an insolvency process. The company stops trading, its assets are sold off, and the proceeds are used to pay creditors in the order in which they rank. By that point you have lost the business you paid for, and the questions below become very important.

Do you still have to pay deferred consideration?

This is the question I get asked most when a purchase has gone wrong. As part of the deal you will very likely have deferred part of the purchase price, to be paid to the seller after completion. This is often described as seller finance. Let us assume that is the case, and that when the business fails there is still money owing to the seller. Do you still need to pay it?

In short, typically yes. The share purchase agreement would not normally state that the buyer's payment obligations are conditional on the target business continuing to be profitable. A seller is very unlikely to accept such a provision, for an obvious reason: once they have sold the business to you, they have no control over how it is run or whether it stays profitable. They are not going to tie their money to decisions you make. So your obligation to pay for the asset you bought typically remains, even though the asset itself has failed. The seller sold you a business as it stood on completion. What happened to it afterwards is, contractually, your problem unless the SPA says otherwise.

Right of set-off against the seller

So if the obligation to pay survives, what can you do about it? The answer is to look at the other side of the ledger. To minimise the amount you have to keep paying, you should explore any claims you might have against the seller, and then set off the amount you are claiming against the amount you still owe.

This is why I like to include set-off rights in the SPA for my buyer clients. If there are claims to be made against the seller, I would much rather my client could deduct those claims from the money they owe than keep paying the seller in full and then try to chase the money back from them in a separate claim. Chasing money is slow and uncertain, and a seller who has already spent the proceeds may have nothing to pay you with. Deducting the claim from a payment you were going to make anyway is neither slow nor uncertain.

Breach of warranty claims

The most obvious claim for the buyer of a failing business is breach of warranty: one or more of the warranties written into the SPA turns out to be untrue. For example, say the business failed because of large debts owed to HMRC, but the seller promised in the SPA that there were no HMRC debts and that everything had been paid up and on time. If those debts contributed to the business becoming insolvent, you may very well have a claim against the seller, and with a set-off right you can deduct it from the deferred price. The warranty is what turns the seller's promise into something you can enforce. Without it, the seller's assurance about HMRC was just a conversation. You can read more about how warranties work in what is a warranty in a business sale.

How to avoid buying a failing business

• Conduct thorough due diligence. This is the very first thing that must be done. Appoint professionals, solicitors and accountants, to investigate the target business and identify the key red flags that should stop you proceeding with the deal. A business that is going to fail usually gives signs beforehand, and due diligence is where you look for them. Skipping it to save fees is the most expensive saving a buyer can make.
• Include extensive warranties in the SPA. Your solicitor will typically draft these. The effect is that the seller makes a lot of promises to you about the state of the business, and those are positive promises that are good for you to have. If any of them turn out to be untrue, you may have a claim against the seller and so be able to reduce the price you end up paying.
• Defer as much of the purchase price as possible. Pay as little as you can on completion. That puts less of your capital at risk on day one, and if claims do arise, for example for breach of warranty, there is enough money still owing to the seller for you to set those claims off against it. A buyer who has paid everything up front has nothing to set off against, and is left chasing the seller for whatever they can recover. A buyer who still owes a substantial deferred sum is in a much stronger position.

Next steps

If a business you have bought is struggling, take advice on your position as a director straight away, and have your solicitor review the SPA for set-off rights and any warranties that may have been breached. If you are still at the buying stage, build in due diligence, extensive warranties, set-off rights and deferred payment before you sign anything. For other common pitfalls, see the mistakes buyers make when buying a business.