Due Diligence When Buying a Business in Queensland: What Should You Check?

Due diligence is one of the most important stages of buying a business.

It involves investigating the business before completing the purchase so that you can assess its financial position, assets, contracts, employees, premises, liabilities and other commercial risks.

Business Queensland recommends conducting due diligence before making a binding decision to buy and identifies financial records, contracts, expenses, business operations, intellectual property, stock and equipment among the matters that should be investigated.

A business may appear profitable from its headline figures but have issues that are not immediately obvious. A key customer contract may be about to expire. Important equipment may be financed. The lease may have only a short term remaining. Employees may have substantial accrued entitlements. Intellectual property assumed to belong to the business may actually be owned by someone else.

Good due diligence is designed to identify these issues before you inherit the problem.

What Is Due Diligence When Buying a Business?

Due diligence is the process of investigating and verifying information about a business before proceeding with the acquisition.

It generally involves both financial and legal due diligence.

Your accountant may focus on matters such as revenue, profitability, cash flow, taxation and the financial assumptions supporting the purchase price.

Your solicitor may investigate matters including:

• ownership and business structure;
• assets and liabilities;
• contracts;
• commercial leases;
• employees;
• intellectual property;
• licences and approvals;
• security interests;
• disputes and litigation; and
• the legal terms on which the business will be acquired.

The scope should be tailored to the particular business. Buying a small professional services business presents different risks from acquiring a hospitality venue, construction business, retail operation or company with significant employees and equipment.

1. Review the Financial Records

Financial due diligence is fundamental to determining whether the business performs as represented and whether the proposed purchase price is commercially justified.

Depending on the business, your accountant may review:

• profit and loss statements;
• balance sheets;
• tax returns;
• BAS records;
• accounts receivable;
• accounts payable;
• bank statements;
• payroll records;
• superannuation obligations;
• loans and finance arrangements;
• cash flow;
• stock records; and
• historical financial performance.

Business Queensland recommends examining tax returns and profit-and-loss statements over multiple years to identify trends and variations in performance.

It is also worth asking why the figures look the way they do.

A sudden increase in revenue may be positive — or it may result from a one-off contract that will not continue after settlement.

Similarly, apparently strong profitability may depend heavily on the owner working substantial unpaid hours or receiving favourable supplier pricing that will not be available to a new owner.

The figures should therefore be considered in the context of how the business actually operates.

2. Understand Exactly What You Are Buying

The purchaser should establish precisely which assets are included in the sale.

Depending on the business, this might include:

• goodwill;
• plant and equipment;
• vehicles;
• stock;
• intellectual property;
• business names;
• websites and domain names;
• telephone numbers;
• customer databases;
• social media accounts;
• software;
• licences;
• customer contracts; and
• supplier arrangements.

Do not assume that because an asset is used by the business, the seller owns it.

Equipment may be leased or financed. Software may only be licensed to the current owner. A website may have been created under an arrangement that does not clearly transfer intellectual property rights to the business.

The contract should ultimately identify what is being transferred and what, if anything, is excluded.

Related article: Buying or Selling a Business in Queensland: Key Legal Considerations.

3. Conduct Business and Company Searches

Appropriate searches can assist in confirming the identity and structure of the seller.

Depending on the transaction, searches may help establish matters such as:

• the entity operating the business;
• company details;
• directors;
• registered business names;
• ownership structure; and
• other relevant registrations.

This is particularly important where several related entities are involved.

For example, one company may operate the business while another entity owns equipment or intellectual property.

Before settlement, you need to know whether the entity signing the contract actually has the ability to transfer the assets being sold.

4. Search the PPSR

The Personal Property Securities Register (PPSR) should be considered where the acquisition includes personal property such as vehicles, machinery or equipment.

A PPSR search can reveal registered security interests over property.

The Australian Government's PPSR guidance warns that purchasing personal property without conducting an appropriate search can expose a buyer to the risk that property may later be repossessed where another party has an enforceable security interest.

Depending on the transaction, searches may be undertaken against the seller as well as particular serial-numbered assets.

If security interests affect assets being purchased, the sale contract may need to require those interests to be discharged or otherwise appropriately dealt with at settlement.

5. Review Customer and Supplier Contracts

For some businesses, the real value lies less in physical assets and more in their contractual relationships.

A purchaser should identify important customer and supplier agreements and determine:

• how long they have left to run;
• whether they can be terminated;
• whether they are assignable;
• whether consent is required to transfer them;
• whether a business sale triggers termination rights;
• whether pricing can change;
• whether there are minimum purchase commitments;
• whether there are exclusivity arrangements; and
• whether there are change-of-control provisions.

A business may derive a substantial proportion of its revenue from one major customer.

If that customer's contract expires shortly after settlement — or cannot be transferred — that may materially change the commercial value of the acquisition.

Due diligence should therefore consider not merely how much revenue the business currently earns, but how secure that revenue is after ownership changes.

6. Investigate the Commercial Lease

If the business operates from leased premises, the lease can be one of the most important documents in the transaction.

Review matters including:

• current rent;
• outgoings;
• rent reviews;
• remaining lease term;
• options to renew;
• permitted use;
• guarantees;
• make-good obligations;
• assignment provisions;
• landlord consent requirements;
• redevelopment or relocation provisions; and
• whether the premises are suitable for your intended operation.

A profitable business can become considerably less attractive if the purchaser cannot secure its premises on acceptable terms.

Where the lease is to be assigned, landlord consent may be required. Alternatively, a purchaser may negotiate a new lease as part of the acquisition.

The business purchase contract may need to be conditional upon satisfactory lease arrangements being secured.

7. Review Employees and Their Entitlements

If employees will continue with the business after settlement, employment arrangements require careful investigation.

Due diligence should identify:

• employees and their roles;
• salaries and wages;
• employment contracts;
• applicable awards or enterprise agreements;
• accrued annual leave;
• long service leave;
• personal leave;
• superannuation compliance;
• bonuses or commissions;
• disputes or claims;
• contractors; and
• whether particular employees are critical to the business.

A sale can constitute a transfer of business for Fair Work purposes where the statutory requirements are satisfied. In those circumstances, service with the previous employer must be recognised for many entitlements, although specific rules apply to matters including annual leave, redundancy, long service leave, unfair dismissal and notice.

The sale contract should clearly address responsibility for employee entitlements and any settlement adjustments.

8. Check Intellectual Property

Intellectual property can be a significant part of the value of a business.

Depending on the business, this might include:

• trade marks;
• logos;
• copyright;
• designs;
• proprietary software;
• websites;
• domain names;
• customer databases;
• marketing material;
• confidential information; and
• other proprietary systems or content.

The buyer should establish who actually owns the intellectual property.

For example, material created by an external designer, software developer or consultant may not necessarily be owned by the business unless the contractual arrangements adequately deal with intellectual property ownership.

Registered intellectual property should also be checked to determine who owns it and what steps will be necessary to transfer it.

9. Check Licences, Permits and Regulatory Approvals

Some businesses depend upon licences or approvals to operate lawfully.

The purchaser should determine:

• which licences and approvals are required;
• whether they are current;
• who holds them;
• whether they can be transferred;
• whether a new application is required;
• how long approval is likely to take; and
• whether any compliance issues exist.

Business Queensland provides a Business Launchpad service to identify licences, permits and registrations that may apply to businesses operating in Queensland.

If an essential licence cannot be transferred, the purchase contract may need to make settlement conditional upon the purchaser obtaining the necessary approval.

10. Look for Litigation, Complaints and Disputes

A buyer should investigate whether the business is involved in existing or threatened disputes.

These could involve:

• customers;
• suppliers;
• employees;
• landlords;
• regulators;
• competitors;
• contractors; or
• former business partners.

The seller should be asked to disclose current litigation, threatened claims and material disputes.

Depending on the transaction, additional searches may also be appropriate.

The significance of a dispute is not limited to its immediate legal cost. It may reveal broader operational or reputational problems within the business.

11. Review Tax and Superannuation Compliance

Tax matters should be reviewed with an appropriately qualified accountant or tax adviser.

Due diligence may include considering:

• GST;
• PAYG withholding;
• superannuation;
• payroll tax where applicable;
• outstanding tax liabilities;
• lodgement history; and
• the taxation consequences of the proposed transaction structure.

The purchaser should understand the distinction between acquiring business assets and acquiring shares in the company operating the business.

A share acquisition can expose the purchaser to a very different risk profile because the company itself continues to exist with its historical obligations and liabilities.

The transaction structure should therefore be considered before the purchase documentation is finalised.

12. Investigate Related-Party Arrangements

Some businesses rely heavily on arrangements with entities connected to the seller.

For example:

• the premises may be owned by a related entity;
• equipment may be leased from another company controlled by the seller;
• intellectual property may be owned personally by a director;
• management services may be provided by a related company; or
• favourable supplier arrangements may depend upon a personal relationship with the seller.

These arrangements may not continue after settlement.

Due diligence should identify them and determine what needs to be replaced, transferred or formally documented.

13. Examine the Business's Key Customers

Customer concentration can create substantial commercial risk.

If one customer represents 40% of the business's revenue, losing that customer after settlement may dramatically affect profitability.

A purchaser may therefore want to understand:

• the largest customers;
• revenue concentration;
• length of customer relationships;
• written versus informal arrangements;
• contract expiry dates;
• termination rights;
• recent customer losses; and
• whether customer relationships depend heavily on the seller personally.

The same analysis can apply to key suppliers.

A business that appears diversified at first glance may in reality depend heavily on one or two relationships.

14. Verify Rather Than Rely Solely on Representations

A seller may provide information about the business during negotiations.

That information is important, but due diligence should involve independent verification where reasonably possible.

For example, rather than simply being told that:

“The business owns all of its equipment,”

appropriate searches and documents may be used to investigate ownership and security interests.

Rather than accepting:

“The lease has another five years,”

the lease itself should be reviewed.

Rather than relying on:

“All employees will stay,”

their contractual arrangements and the proposed transfer process should be considered.

Warranties in the eventual sale agreement can provide important contractual protections, but they are not a substitute for appropriate investigation before the purchase.

15. Make Sure the Purchase Price Is Supported by the Business You Investigated

Due diligence may identify information that affects the price a purchaser is prepared to pay.

For example, you may discover:

• equipment requires replacement;
• stock is obsolete;
• an important contract is expiring;
• employee liabilities are greater than anticipated;
• substantial capital expenditure is required;
• a lease has limited tenure;
• a licence needs to be obtained;
• revenue is heavily dependent on the seller; or
• the financial results contain significant one-off items.

Business Queensland specifically recognises that information uncovered during due diligence can affect both the purchaser's decision and the price or terms negotiated.

Due diligence is therefore not simply a process for deciding yes or no.

It may also provide a basis for renegotiating the purchase price, altering the transaction structure, requiring additional warranties or imposing conditions before settlement.

Should the Contract Be Subject to Due Diligence?

Ideally, significant due diligence should occur before a purchaser becomes unconditionally bound.

However, commercial circumstances sometimes mean a contract is signed before the investigation has been completed.

In those circumstances, the purchaser may seek an appropriately drafted due diligence condition.

Business Queensland notes that a sale contract can include a due diligence period allowing the purchaser to investigate the business and potentially terminate where relevant issues are identified, depending on the contractual terms.

The wording of the condition matters.

A clause should not simply be assumed to give the purchaser an unrestricted right to withdraw from the transaction.

It should clearly address matters such as:

• the due diligence period;
• what investigations can be undertaken;
• the purchaser's rights if it is dissatisfied;
• any notification requirements; and
• what happens to the deposit if the contract is terminated.

A purchaser should obtain advice about the clause before signing the contract.

Confidentiality During Due Diligence

Due diligence often requires the seller to disclose commercially sensitive information.

This can include:

• customer lists;
• pricing information;
• financial records;
• supplier arrangements;
• intellectual property;
• employee information; and
• business strategies.

A seller may therefore require the purchaser to enter into a confidentiality or non-disclosure agreement before access is provided.

Business Queensland recommends considering an NDA because of the sensitive information commonly disclosed during a business-sale due diligence process.

This can be particularly important where the potential purchaser is a competitor.

What Happens When Due Diligence Identifies a Problem?

Discovering a problem does not necessarily mean the transaction must end.

Depending on the issue and the contractual position, the parties might:

• renegotiate the price;
• exclude an asset from the sale;
• require a liability to be discharged;
• obtain additional warranties;
• negotiate an indemnity;
• make settlement conditional upon the issue being resolved;
• change the transaction structure; or
• decide not to proceed.

The appropriate response depends on the significance of the issue and the terms of the transaction.

The purpose of due diligence is ultimately to enable the purchaser to make that decision with the relevant information available.

A Due Diligence Checklist Is Only the Starting Point

There is no single checklist suitable for every business acquisition.

A café, professional services firm, online business, construction company and manufacturing operation each present different risks.

A good due diligence process should therefore ask:

What makes this particular business valuable?

What does it depend upon to continue operating successfully?

What liabilities could the purchaser inherit or become responsible for?

Are the important assets and relationships capable of being transferred?

Does the information provided support the price being paid?

Those questions help determine where the investigation should focus.