Key Issues in Buying a Distressed Business

Periods of economic difficulty can be good times for strong businesses as, not only do weaker competitors go to the wall, but they may present great opportunities for acquiring businesses or assets at bargain values. But buying assets from a business in difficulty does have its 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.

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1 When are you buying and who are you buying from?

You may decide to buy assets from a company which is in difficulty, but before it goes into any form of insolvency process, while it is still under the control of its directors.

If an Insolvency Practitioner (‘IP’) is subsequently appointed, part of their duties will be to 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 otherwise the deal may be open to attack.

This issue is often resolved by undertaking the deal through a ‘prepack’ where an IP is brought in to oversee 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 you will need to establish what security has been taken over the assets by checking the charges registered at Companies House, and you will need to obtain the holders agreement to the deal (as they will need to lift their charges in order for you to complete the transaction and obtain title to the assets).

Where a business relies on a contractual relationship, such as a franchisee, 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. Such contracts will therefore often have clauses whereby the contract will automatically terminate in the event of an insolvency, or sometimes simply on a change in control of the company. Commercially therefore, you will therefore need to speak to these parties to obtain their agreement to the proposed deal if you are actually 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, in which case you are acquiring it with all its liabilities; or you can buy the business and assets, in which case, in return for the cash paid, you are extracting these items from the company shell, which is then left behind together with most of its liabilities. If you are buying out of an insolvency this will normally only ever be a business and assets sale.

The key expression above is ‘most of’ its liabilities. In particular, where the business has employees, even if the business is bought through an insolvency, under the Transfer of Undertakings (Protection of Employment) Regulations 2006 (‘TUPE’) all of the employees’ contracts of employment and accrued employment rights are deemed to automatically transfer across to the new business owner without any variation. And employees for this purpose could, for example, include employees with recent claims for unfair dismissal from the ‘oldco’.

You therefore need to carefully consider what exposure to such claims you are taking on and take this into account in the price.

If employee claims are a significant issue it may be possible to compromise these by using a Company Voluntary Arrangement, but this is an area where you would need to take specialist advice.

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

Neither the company, nor an IP can sell you anything that isn’t the company’s in the first place, so you need to be sure that you are in fact going to get good title to everything you think you are buying.

Raw materials stock is a particular risk as it may be held on a consignment basis, be free issued by a customer, or may be subject to retention of title (‘ROT’ or Romalpa clause after the relevant case law) claims by suppliers. Many ROT clauses are ineffective and IPs will have extensive experience in challenging them so you may want to agree that the IP deals with these, and that you will be refunded the relevant part of the purchase price if ROT claims succeed.

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?

The key legal restrictions that you may need to take into account only generally come into play where a director or shareholder of the selling company is also involved with the buying company.

There is a restriction on the reuse of a company name in that 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.

There is also a general provision under section 190 Companies act 2006 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 will obviously need to have sufficient cash with which to undertake the transaction, but in addition to the sale price you will also need to ensure you have sufficient cash to cover:

Ransom creditors and deposits – some key suppliers may hold you to ransom, refusing to supply goods until their arrears have been cleared. Where the oldco directors are involved with the new business, the Crown may seek payment of a deposit in respect of potential future PAYE/NI or VAT liabilities.
Working capital creditors – where you buy a business that has been in difficulty prior to insolvency, 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.

When selling a business an IP will be looking for the best offer, which is not necessarily the highest, but the one which represents 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.