Fundamentals of limiting risk when buying a business

Buying a business typically requires a significant investment of time, human resources, and capital. Acquisitions can be demanding processes that are often critical to a buyer’s long-term strategy.

Every transaction has its own unique anomalies and intricacies, which means that there is always an element of complexity that naturally leads to buyers being exposed to risk. Considering the relative magnitude and importance of most acquisitions, it is fundamental that buyers take appropriate steps to protect themselves.

There can be serious consequences where risks are not considered and managed. We outline some of the main ways that risk can be managed when buying a business.

How to reduce risk when buying a business

1. Competent advisors

Many buyers are heavily reliant on advisors when buying a business, as they are often not familiar with the process and usually don’t have the resources or expertise in-house. Advisors can have a significant influence on any deal, and those with experience will help buyers to increase value and limit risk. As mentioned, all deals will have a number of complexities, and competent advisors will be able to identify and guide clients through these. The main advisors from a buy-side perspective are typically lead advisors (to manage all aspects of the process), lawyers (to negotiate the legal documents and for legal due diligence), and financial advisors (for financial and tax due diligence). This is not an area where a buyer should look to save relatively small amounts of money, as while choosing the cheapest advisors may lead to upfront savings, substandard advice can lead to serious issues and financial losses down the line. Buyers should ensure they invest in competent and credible advisors.

2. Due diligence

This is a process whereby the buyer engages advisors to investigate the target business. This is confirmatory in nature, meaning that the main purpose of this process is to ensure that the business is as it was presented when the original deal was agreed. There are a number of different types of due diligence that can be conducted, with the most generic categories being legal, tax, and financial due diligence. Advisors will identify the main risks in the business, and the buyer can then decide how to manage these. Where significant risks are identified, some buyers will look to renegotiate the deal, or might even pull out.

3. Warranties

Essentially, warranties are promises that a seller makes to a buyer about the state of the business. They are general in nature and cover aspects of the business such as financials, contracts, intellectual property, right to sell the shares, etc. Legal advisors will typically include a general suite of warranties in the legal document governing the acquisition, and sellers will be liable for any significant losses (there are materiality thresholds) incurred by a buyer where any of the warranties are found to be untrue within a certain period of time following completion. It is important to note that sellers can ‘disclose’ against warranties by stating any aspects of the business that contradict any of the warranties in a ‘disclosure letter’. Buyers will not be able to bring a claim in relation to anything that is considered to be ‘disclosed’.

4. Indemnities

Again these are promises by the seller, but this time in relation to specifically identified risks that may lead to losses in the future. Where a loss is realised in relation to a situation covered by an indemnity, a seller will have to compensate the buyer for the loss incurred. These are usually not subject to materiality thresholds or timing limitations, so they can understandably make sellers nervous. However, where a business has ongoing exposure to risk in relation to events that occurred prior to the acquisition, including indemnities in the legal documentation can be a great way for buyers to limit exposure.

5. Insurance

Both buyers and sellers can seek insurance in relation to the sale and purchase of a business. M&A insurance is a set of protections specifically designed to help policyholders mitigate risk and facilitate comfort in completing a deal. Policies can be tailored for specific requirements, so it’s often worth having a conversation with an insurance provider when looking to buy a business.

Summary

While buying a business can be complex and unfamiliar, there are several ways that buyers can protect themselves from deal-related risk. It is important to be aware of these factors and to engage in appropriate conversations sooner rather than later.