Legal Red Flags That Can Make Your Business Harder To Acquire

A business being acquired can be a great opportunity for both the business and the buyer.

However, buyers look at much more than revenue before making an offer. They will want to understand who owns the business and its assets, how secure its key relationships are and whether there are any legal problems sitting beneath the surface.

Missing contracts, unclear ownership or unresolved compliance issues can quickly raise questions about the value and risk of the deal. Whether you are thinking about an acquisition now or further down the line, it is worth knowing which legal red flags could make your business harder to acquire - and what you can do about them first.

The Business Doesn’t Clearly Own What It’s Selling

This might sound obvious, but ownership can get messy surprisingly quickly.

A business may use a trade mark, piece of software, design, website or other valuable asset every day without actually owning all of the rights to it. For example, intellectual property created by a contractor may still belong to the contractor if it was never properly assigned to the business.

Even where work was created by an employee, it is worth checking that ownership is clear and properly documented. Third-party software, templates or licensed materials can create another layer of complexity, as the business may only have permission to use them rather than own them outright.

There can also be issues where intellectual property was created before the company existed and never formally transferred into the business. Where ownership needs to move from a founder, contractor or another entity, an IP Assignment Deed can formally record that transfer.

If a buyer is paying for your brand, technology or other key assets, they will want confidence that the business actually has the rights it says it does. Sorting out any ownership gaps before due diligence starts can avoid an awkward problem later in the deal.

The Revenue Looks Better Than The Contracts Behind It

Strong revenue is obviously a good sign, but a buyer is likely to look at what is actually holding that revenue together.

For example, your biggest customer might have worked with you for five years but never signed a proper agreement. Another customer might bring in a large portion of your revenue but be able to terminate their contract at any time. On paper, both relationships are valuable. Legally, they may offer the buyer much less certainty.

This does not mean every customer needs to be locked into a long-term contract. It does mean the agreements behind your important relationships should reflect how the business actually operates.

Buyers may also look at supplier, distribution and other commercial agreements the business relies on. If a key supplier can stop providing an essential product at short notice, that can matter just as much as the customer side of the business.

A buyer is likely to look beyond how much revenue the business is making and ask how likely that revenue is to continue. Making sure your key commercial agreements are signed, current and reflect the real relationship can make that picture much clearer.

Too Much Of The Business Depends On The Founder

A founder being important to their business is hardly unusual. The problem is when the business cannot really function without them.

Perhaps the founder personally manages the biggest customers, holds an important licence or is the only person with access to certain systems. Some contracts or business assets may even sit in the founder’s personal name rather than the company’s.

Customers may also associate the business so closely with the founder that it is unclear whether those relationships will continue once they leave.

This can become particularly important during an acquisition because the buyer is paying for a business that should be able to continue after ownership changes.

Think about what would happen if the founder stepped away tomorrow. Could the team manage the main customer relationships? Does the business control its own accounts, records and important assets? Is key knowledge documented somewhere other than the founder’s head?

The founder can still be an important part of the business. The question is whether the business could continue operating if they were no longer involved day to day.

There Are Liabilities A Buyer Could Inherit

Some legal problems are obvious. Others can sit quietly in the background until someone starts asking questions during due diligence.

An employee may have been underpaid, a contractor arrangement may need another look or there could be an unresolved complaint from a customer or supplier. A threatened claim does not need to have reached court before it becomes relevant to a potential buyer.

Employment issues can be particularly important. Underpayments, incorrectly classified contractors or unresolved workplace complaints may represent liabilities that a buyer needs to understand before taking on the business.

There may also be disputes about unpaid invoices, defective work, supplier arrangements or intellectual property that have never been formally resolved.

How much of that risk ultimately sits with the buyer can depend on how the acquisition is structured. Either way, an unresolved problem is likely to become part of the negotiation.

A buyer might ask for stronger warranties or indemnities, seek to reduce the purchase price or require the seller to remain responsible for a particular issue after the acquisition.

A problem you already understand and can explain is generally easier to deal with than one the buyer unexpectedly discovers halfway through due diligence.

The Business Has Compliance Gaps

A business can grow much faster than its legal setup.

A licence that made sense when you started might have expired. Your privacy practices may have changed while the privacy documents stayed the same. The business could have expanded into a new service, location or industry without considering whether different rules now apply.

These gaps matter because a buyer is not only interested in what the business has done in the past. They also need to know whether they can continue operating it without immediately inheriting a compliance problem.

Privacy is a good example. If the business collects customer information but its privacy practices, notices or security processes have not kept up with how that information is actually being used, a buyer may inherit something that needs to be fixed.

The Privacy Act does not apply to every Australian small business, but there are important exceptions. The business should understand which obligations actually apply to it rather than assuming its size automatically puts it outside the rules.

If your business is required to have a Privacy Policy, it should also reflect how the business actually collects, uses and handles personal information today.

The same applies to industry-specific licences, registrations and approvals. Something held by the wrong person, allowed to expire or never obtained in the first place can become much more noticeable when a buyer begins checking the business.

The exact requirements will depend on what the business does. The important thing is that its legal and compliance setup reflects the business it has become, rather than the much smaller version that existed several years ago.

Something Could Get In The Way Of The Acquisition

Even where the business looks attractive, there may be people or arrangements that need to be dealt with before a buyer can actually complete the acquisition.

A landlord, lender, major customer or other third party may need to consent. Important agreements may contain change-of-control clauses that are triggered when ownership of the company changes.

The ownership of the company itself can create complications too.

Perhaps equity was promised to someone years ago but never properly documented. There may be different classes of shares, options or other arrangements that need to be understood before anyone can work out who needs to approve or participate in the deal.

The company’s constitution and any Shareholders Agreement should also be checked for approval requirements, restrictions on transferring shares or other rights that could affect a sale.

Existing finance and registered security interests over business assets may need to be cleared or otherwise dealt with before the transaction can complete.

None of these issues necessarily means the business cannot be acquired. However, discovering late in the process that another person needs to consent, an important asset is tied up or the ownership position is unclear can slow down a deal that otherwise looked straightforward.

What Happens When A Buyer Finds A Red Flag?

A legal red flag does not automatically kill an acquisition.

Some issues can be fixed before completion. A missing agreement might be signed, ownership of an important asset could be clarified or an outstanding compliance issue may be resolved.

Other problems can affect the deal itself. A buyer might negotiate a lower price, ask for stronger warranties or indemnities, make completion conditional on the issue being fixed or require the seller to remain responsible for a particular risk.

Where the problem is significant enough, the buyer may decide the acquisition is no longer worth it.

This is why it helps to find these issues before the buyer does. Your business does not need to be legally perfect, but understanding its weak spots gives you more time to fix what you can and explain what you cannot.

If an acquisition could be on the cards now or further down the line, a Legal Health Check can help identify gaps in your contracts, ownership arrangements and wider legal setup before due diligence begins.

If you would like a consultation on getting your business acquisition ready, you can reach us at 1800 730 617 or team@sprintlaw.com.au for a free, no-obligations chat.