Buying a Business: Selected Due Diligence Issues

By Robert J. Hamilton & Javad Heydary

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This article is intended to give you, the proposed buyer of a small or mid-size business, practical information on some of the legal investigations you should consider conducting to ensure the business you're proposing to buy is truly the business that the Seller has described and represented to you. If you carefully conduct a thorough investigation of the business before you buy it, you will minimize the likelihood of unpleasant surprises arising after you have bought the business. You will also reduce the likelihood of spending money and time seeking compensation from the Seller for either misrepresenting material aspects of the business you bought or not adequately disclosing material information about the business that the Seller should have disclosed to you.

The type of business you are proposing to buy will dictate, to a large degree, the type and extent of the investigations you should make. As an example, if you are planning on buying a manufacturing operation, you will probably want to give consideration to, among many other issues, environmental and employee health and safety issues as they relate to the manufacturing operations of the business. On the other hand, if you are planning on buying a software company, it is less likely that the foregoing issues would need to be considered.

Moreover, if the business you are planning on buying is a franchised business, another set of issues arise such as the terms of the franchise agreement. An extremely important issue to consider in buying a business is whether you should buy the assets of the business or buy the shares or partnership interests of the entity that operates the business. Your accountant and lawyer can help you make that decision. Although this article does not deal with the issue of whether to buy assets or shares, it is important for you to realize that how you structure the transaction will impact the investigations you should consider conducting.

The value that a good lawyer or law firm can provide to you is helping you narrow down the range of relevant investigations when buying a business. With your input, your lawyer can help you determine what investigations need to be carried out and what issues should be dealt with in the legal documents that will give effect to your purchase transaction.

The following is an outline of some of the more important investigative issues you should consider carrying out before you buy a business.

Status of the Seller

One of the first things you will want to do is determine the status of the Seller. Is the Seller a corporation, a partnership or an individual operating as a sole proprietorship? Is the Seller a resident or non-resident of Canada? Once you have determined the Seller's status, various searches can be conducted to confirm the accuracy of the Seller's representation as to the Seller's status.

Having determined the Seller's status, you should obtain information on the ownership structure and related details. If the Seller is a partnership, who are the partners and what are the terms of the partnership agreement that might affect the proposed purchase? If the Seller is a corporation, who are its shareholders, is there a shareholders' agreement and do other individuals who are not shareholders have options or rights of refusal on shares of the corporation? The answers to these questions will determine if you are or will be dealing with all the parties who have an interest in the Seller and who can affect the Seller's decision to sell the business you want to buy.

Real Estate

Freehold Property

If freehold property is an asset of the business, you will want to confirm that the Seller is the registered owner of the property and that there are no charges or encumbrances outstanding against or affecting the property. If there are outstanding charges, you will want to confirm the amount owing and the duration of the charge and other terms and conditions that apply. If there are restrictions affecting the property, you will need to know what they are and how they might impact the operation of the business you want to buy, even though they may currently not appear to be affecting the business.

You will want to conduct searches to confirm that the Seller is and has been in compliance with various governmental rules and regulations that may regulate the way the business can properly be conducted. Again, compliance with some rules and regulations may not be an issue because of the nature of the freehold property and fixed assets being purchased.

Leasehold Property

You will want to review copies of all leases of real property to confirm that the terms and conditions are the same as those represented to you by the Seller and that the leases cover the property used in the business you are planning to purchase. You will also want to make certain that the leases can be transferred to you and that the business you plan to carry on in the leased premises can, in fact, be carried on therein according to the terms of the lease or leases.

Various other legal issues should also be considered. As an example, you will want to make certain that the holder of the Landlord's mortgage, if there is one, cannot force you out of the premises in which the business is carried on because of a default of the Landlord under the mortgage that has nothing to do with you. Additionally, you will have to determine if the sale of the business involves an assignment of the lease or does it involve a sub-letting of the premises. If it is a sub-let, certain other legal issues will have to be addressed.

Machinery, Equipment, Vehicles and Other Tangible Personal Property

You will want to obtain a list of all machinery, equipment, vehicles and other tangible personal property, both owned and leased and noted as such, used in the business you are planning to buy. You will want to review the terms of all leases or similar documents relating to the personal property; again, you will want to confirm that the terms of theses documents are the same as the terms that have been represented to you by the Seller.

You will also want to develop a list of all security interests, liens and encumbrances that affect the personal property of the business you are about to buy. You want to do this for a number of reasons. As an example, you will want to confirm the accuracy of what the Seller has told you in terms of tangible personal property used in the business. You will also want, for example, to confirm the lease payments that remain to be paid on the equipment or confirm which equipment can be sold, either because it is not under lease or because it is not encumbered by a lien.

In addition to compiling the list of security interests and encumbrances, you will want to conduct searches under the Bank Act to see if any banks have an interest in the assets of the Seller and under the Ontario Personal Property Security Act to determine if any other parties have interests in the tangible personal assets of the Seller. Because some equipment may cease to be personal property by reason of being affixed to the real property, you will want to see if notices of a third party's personal property security interest has been filed in the appropriate land registry office. Additionally, searches should be conducted under Ontario's Execution Act to see if there are any outstanding Writs of Execution in the hands of the Sheriff in the district or county where the Seller's business has assets.

Intellectual Property

Every business has some sort of intellectual property rights. Such rights can be as limited and as simple as the business's name or in the case of most technology companies, intellectual property rights can be the biggest asset of the company. As a result, regardless of the business you are purchasing, you must deal with intellectual property rights.

As a starting point, you should obtain from the Seller, a list of all of its intellectual property rights. This list may include patents, copyrights, trade-marks, computer software licenses, trade secrets or other intellectual property rights. Great care must be taken when drafting this list because there are many intangible assets that a business might have which might not look like intellectual property at first glance. For example, if you are buying a restaurant, unique food recipes are intellectual property rights that you must ensure are included as part of the assets that are listed in your purchase agreement.

Employee-Related Matters

If the business you are proposing to buy has a significant number of employees, you will want to consider investigating a number of employee-related issues. The starting point is to determine whether you need to concern yourself with employment and labour relation matters. If you are buying shares of a company, the entity employing the employees continues and all of the employer's obligations to its employees will continue to exist. You will therefore have to concern yourself with these employee-related matters. If you are buying assets, the Seller's obligations to its employees may or may not be transferred to you, the Buyer. A number of issues will have to be considered before you can come to a conclusion as to whether or not you will be obligated toward the Seller's employees as a continuing employer, even though you only bought the business's assets.

Following are some of the employment and labour relations matters that you may have to consider:

Will federal or provincial legislation apply? Even though this is generally determined by the nature of the businesses operations, a provincially regulated company may have contractually bound itself to complying with federal rules because of the contract it signed to supply goods or services to a federal agency.

If a union is involved, you will want to determine the status of matters. Is there a pending application for certification or has certification taken place? Is there a collective agreement in place binding on the Seller? What are its terms? As an example, you will want to know if the collective agreement restricts your ability to manage the business in any way.

You will want to determine all issues percolating on the labour relations front: complaints, proceedings, orders, grievances or arbitration awards.

Compliance with employment standards legislation is another issue to investigate. Are there outstanding issues such as outstanding orders, claims or complaints?

You will want to consider compliance with a number of statutes: human rights, pay equity, health and safety and workplace safety and insurance legislation.

You will want to learn the terms of the various employee programs, such as employee health benefit programs, registered pension plans, group retirement savings plans and profit sharing plans.

You will want to determine the status of all of your employees: active, laid-off (subject to recall) and disabled. Do any employees have contracts? If so, you will want to know the terms of employment.

Tax matters

In a share purchase transaction, the Buyer will want to make certain that the Seller's business has made all necessary source deductions and remittances to Canada Customs and Revenue Agency ("CCRA") for purposes of the Income Tax act, the Employment Insurance Act and the Canada Pension Plan. In an asset purchase transaction, the Buyer need not be concerned with this issue as the Seller will remain liable to CCRA.

Possible income tax arrears, at both the federal and provincial levels, should be of particular concern to a Buyer of shares. You will want to insure that all past tax returns have been filed on a timely basis and you will want to review all assessments and reassessments and any objections or appeals filed in connection therewith. You will want to insure that all taxes have been paid, including any required instalments.

You will also want to see that all Goods and Services filings and taxes have been paid. The same applies for Ontario Retail Sales Tax, even in the case of asset-based transactions.

As mentioned at the outset of this article, the foregoing are merely examples of the kind of investigations you should consider when considering buying a business. Constraints, such as time and money, may prevent you from conducting every search you might otherwise like to conduct. Because of this, your lawyer can help you decide the appropriate investigations for the particular business you are planning to buy and help you cover off any remaining exposure in the legal documentation that will be used to implement the transaction.