How to minimise risk when buying a business: due diligence, warranties and covenants

What should you do to avoid legal problems when buying a business, and what are the common mistakes a prudent buyer can avoid? To buy a business without getting burnt, you need to do three things. First, make an informed decision, which means due diligence. Second, hedge against the issues you could not find by planning for them in the sale and purchase agreement, through warranties and a right of set-off. Third, stop the seller using their superior knowledge and relationships against you after completion, through restrictive covenants. Here is how each works in practice.

Legal due diligence when buying a business

To make an informed decision you need to conduct due diligence. Put simply, due diligence is when you, as the buyer, investigate the business you are looking to buy. You request documents from the seller, the seller uploads them to a virtual data room, essentially an online folder, and you access and investigate them from there. The contracts, accounts, employment records and correspondence in that folder are the raw material for every decision that follows, including the price.

You need to do this because of the legal concept of caveat emptor: let the buyer beware. In practice it means that you, the buyer, are responsible for satisfying yourself as to the state of the business. You need to make sure you are happy with what you are buying. It is not like a consumer product ordered online that you can return within 14 days. Once you have bought the business, it is yours.

Due diligence case study: supplier exclusivity

A story about why this matters. A client came to me wanting to buy a business that he believed benefited from an exclusive relationship with an important supplier. That exclusivity was a large part of why he wanted the business, and a large part of the price.

Once I had conducted due diligence and analysed the contract between the target and that supplier, it transpired that the target did not benefit from any exclusivity at all. That finding enabled my client to negotiate a reduction in the purchase price. The valuation was reworked on the basis of the asset value of the balance sheet, rather than an exclusive supplier relationship that did not exist. Without due diligence he would have paid a premium for something he was never getting. The lesson is not that the seller was dishonest; it is that the buyer's belief about the business and the legal reality were different, and only reading the contract revealed it.

Practical due diligence tips

Due diligence can be overwhelming, particularly on a business with a lot of contracts and history. My top tip is to keep a written record of everything: the documents you have asked for, the questions you have put to the seller, the answers you have received, which documents have actually arrived and when you reviewed each one. It sounds mundane, but it is the difference between a process you control and one that controls you. It also leaves you with a clear trail of what you were told, which matters later if a warranty turns out to be untrue. For the kinds of questions to put to a seller, see Due diligence questionnaire when buying a business.

Warranties in a share purchase agreement

The second step is protecting yourself against issues you did not spot during due diligence. Typically we do this by including extensive warranties in the SPA.

In M&A, warranties are promises the seller makes to you as the buyer about the state of the business. For example, a warranty might state that the target business has always paid all of its taxes to HMRC. A well-drafted SPA will include numerous warranties across many different subject areas: finance, accounting, tax, health and safety, contracts and so on. The broader the warranties, the more of the unknown is covered. Each warranty is in effect a question you no longer have to answer for yourself, because the seller has answered it and is on the hook if the answer is wrong.

A client of mine once bought a business, and it later transpired that many of the warranties given by the sellers were untrue. Because those warranties were in the SPA, my client was able to make claims against the sellers and, in effect, reduce the purchase price to reflect what the business actually was. There is more on how warranties work in What is a warranty in a business sale?.

Breach of warranty and the right of set-off

Here is a tip that makes warranties far more useful in practice. Make sure the SPA gives you the right to set off your claims against any money you still owe the seller.

Why does that matter? If part of the purchase price is deferred, a right of set-off means that when a warranty is breached you do not have to chase the seller for compensation. You simply do not pay the seller a portion of what you owe them. Chasing a seller through the courts for money they have already received is slow and expensive. Withholding money you have not yet paid is neither, and it puts the burden on the seller to argue about it rather than on you to recover it. The set-off right turns a warranty from a claim you might one day bring into a deduction you can make immediately.

Restrictive covenants on the seller

The third step is stopping the seller abusing their position of power and knowledge against you. Think about what the seller has. They know the business, the clients, the suppliers and the employees very well. They will have built personal relationships with all of them, and they will have their direct phone numbers and possibly their personal email addresses.

As a result, a seller could sell you the business and then, shortly afterwards, poach the key employees, the clients and the suppliers, leaving you with an empty business and your newly acquired obligation to keep paying them for it. The way to prevent that is to include restrictive covenants against the sellers in the sale and purchase agreement. Restrictive covenants are restrictions on what the sellers can do after they have sold you the business, and in this context the point of them is to stop the sellers taking the employees, clients and suppliers with them.

One expert tip on drafting them. Consider not making the restrictive covenants last for more than two years after the sale of the business. If they run for longer than that, it may be quite difficult to justify the reasonableness of the provisions, and if they are not reasonable they may not be enforceable in a court. A covenant that is too ambitious can end up protecting you less than a modest one that holds up. The aim is a restriction the seller will sign and a court will uphold, not the longest restriction you can think of.

Pulling it together

Each of the three steps covers a different kind of risk. Due diligence deals with what you can find out before you buy. Warranties, backed by a right of set-off, deal with what you could not find out. Restrictive covenants deal with what the seller might do afterwards. Skip any one of them and the other two cannot fully compensate: the best warranties in the world do not help if you never checked the supplier contract, and the best due diligence cannot stop a seller walking off with the client list.

Next steps

If you are preparing to buy a business, start by organising your due diligence properly and keeping a record of everything you ask for and receive. Then make sure your solicitor builds comprehensive warranties, a right of set-off and reasonable restrictive covenants into the sale and purchase agreement. Part of minimising risk is also choosing the right structure, so look at Share purchase vs asset purchase before you agree the heads of terms, and speak to a corporate solicitor before anything is signed.