Today we talk about the element of misrepresentation and how it can potentially occur in the sale and purchase of a business and how it can hold risks for both buyers and sellers. To give depth to this discussion, we brought back our resident expert in this area of law, Elizabeth Lee.
- Why are we talking about this?
- Where misrepresentations occur and are most dangerous in a transaction
- Case Example 1 – Inflating the revenue by including a one-off asset sale
- Case Example 2 – Incorrect trading stock figures
- Debunking a myth in business sales transactions
- Case Example 3 – License versus Lease
- Case Example 4 – Misrepresenting the business turnover
- Snapshot of lessons that can be learned in this space
- Employee entitlements in relation to a business that’s been sold
- Protections you can set in place
Why are we talking about this?
Often when parties engage in buying and selling a business, in the beginning their relationship is always the sweetest. The parties are best friends. They talk about everything in a positive light. They just can’t see anything going wrong. Understandably, the buyer is really excited.
The tendency of an excited buyer is to not look at things critically. This is where they start to get into quite dangerous territory, because they believe everything that they are told.
Rightly or wrongly, the vendor may not be deliberately misrepresenting because they truly believe the information that they have passed on. But without it being tested and verified independently, buyers stand to lose more than they gain in this type of scenario.
Ultimately, there is risk on both sides of the transaction:
- For the buyer, a misrepresentation could result in a loss of the investment money used to purchase the business.
- For the seller, there’s the possibility of the transaction being voided due to the misrepresentation and the buyer may demand for the money back.
Where the misrepresentation was not picked up until after completion, and losses flowed to the new owner because of the misrepresentation, you might have the situation of either:
- reversing the deal; or
- seeking damages from the guilty party.
Where misrepresentations occur and are most dangerous in a transaction
Where it occurs that have been most commonly reported is in the presentation of financial information. This is why it’s very important to make sure you involve the right advisors to help you understand the financial information that you have been given. You need to be able to verify and check those figures and the expert advisors usually know how to do this.
Quite often, buyers don’t want to spend a lot of money on due diligence because they feel there’s a level of trust. They feel that they have enough of a handle on the business themselves and they don’t need detailed due diligence to confirm what they believe they already know. But that’s exactly where the issues come into play.
Majority of the cases that we see reported often are dealing with a situation where the financial performance isn’t as expected. Of course, understandably that’s where you will sue the seller because you paid a lot of money for the business and it’s not delivering you the financial returns that you thought you were going to get based on the figures that have been presented to you as a buyer. – Elizabeth Lee
Case Example 1 – Inflating the revenue by including a one-off asset sale
The seller of a printing business included a one-off asset sale in their financials, which artificially inflated the figures of their revenue for a particular period of time. When the buyer didn’t achieve the financial performance expected when it took over the business, it started to question the correctness of the profit and loss statement. They found out much later that the seller hasn’t been truthful in declaring the one-off transaction as not part of the usual repeatable day to day trading of the business.
The court found that the amounts alleged to have been included in profit and loss statement were falsified, and that there was some deliberate action on the part of the vendor in inflating the financial performance of the business.
Here is an interesting lesson for sellers who might not be thinking about what they need to disclose and how to properly disclose it. Be careful not to give a misleading view of the inherent financial status of the business itself.
Buyers also have to be careful that they’re asking the right questions in the right way so that if a seller has done a bit of a tricky and included these sort of one off items that this is picked up in the due diligence process or at least that the right questions are being asked throughout the due diligence process so that if an issue is picked up in the future, then there’s enough to go back on to claim this element of misleading and deceptive conduct or misrepresentation. – Joanna Oakey
Case Example 2 – Incorrect trading stock figures
In the sale of a pharmacy, there was incorrect trading stock maximum figures disclosed in the contract. Normally, a regular sale and purchase business contract would specify maximum trading stock figures so that if there was more stock than that amount, the purchaser didn’t have to purchase the excess stock and end up with too much stock.
When this happened, and because the pharmacy actually had more stock on hand that they had disclosed, the court reversed the transaction on the grounds that there was an incorrect amount of stock figures disclosed.
Because the court ordered the reversal of the transaction, it meant that the party had to go back to resettle the transaction. Due to the delay, the vendor had actually run the business down and the goodwill of the business had depleted by the time the buyer took over the business again after getting the court to order a reversal of the original transaction. The value of the business had been destroyed by that time. – Elizabeth Lee
Debunking a myth in business sales transactions
There is some sort of belief in the market that where there’s a low value purchase price, there should be less need for due diligence because less money is spent. But these case examples suggest otherwise.
A printing and pharmacy business typically fall under the small business category. This just shows that no matter what the size of the business that’s being sold, being really tight in your contract and tight in your due diligence process is absolutely imperative. Otherwise, you can be throwing loads of money away even if the business sale that you’ve been looking at is only a low value purchase.
The value of the business should not be the indicative element as to how much due diligence you do because although you might not pay a lot of money for a business, your financial exposure could be huge if you didn’t undertake the proper due diligence required. You simply cannot rely on the representations made by the vendor because let’s face it, the vendor will say anything to sell the business because that’s what their motivation is.
Sometimes, the most complex transactions are actually of this the smaller ones, which is a bizarre thing. But I think, quite often when business owners are trying to save money they sometimes do it in the wrong way and end up costing themselves more than they actually save. I guess that’s the take home message here. – Joanna Oakey
Talking Law – A sister podcast!
If you’re interested in hearing smart legal tips for business, The Deal Room sister podcast – Talking Law is perfect for you! These two podcasts are now among the top legal podcasts in Australia.
In our Talking Law podcast, I dissect a different topic each week that I have seen impact businesses and then provide actionable tips for you to avoid that risk or to use that legal area to your advantage. We release new episodes every 10 days and you can listen to our episodes through www.talkinglaw.com.au or subscribe to our Talking Law podcast on iTunes to be the first to know when a new episode is out.
Now back to the show!
Case Example 3 – License versus Lease
In the sale of a beauty salon, we have a seller who thinks they’ve got a lease. They’ve actually got a license. They don’t understand the difference between the two.
At the end of the day, the sale was reversed because the vendor hasn’t provided what they said they had, which was the lease.
Both parties lose in this scenario, all because of failure to get the technical information correct. Once again, we’re coming back to the misplaced approach to savings in these instances, for not doing it properly and not getting the right advice. This can backfire and end up in large costs for everyone.
Case Example 4 – Misrepresenting the business turnover
There was a case reported where a water cooler and filter business was sold and the seller misrepresented the turnover of the business.
In that case, the court found that the information that had been misrepresented was actually quite easily detectable from the bank statements of the business. By not doing adequate due diligence, the buyer overlooked the incorrect information that was provided in the financial statements.
Whether you’re a broker or an accountant assisting in passing over information during the sales process, you have to be really careful. There can be a suggestion of responsibility on your end if you’re the conduit of financial information and the financial information is later found to be incorrect or at worst fraudulent. There are some questions that should be asked by advisors, like accountants and brokers, in this space to make sure they’re protected as well.
Snapshot of lessons that can be learned in this space
- From a seller’s perspective, be really careful about how you represent information to buyers. Make sure that whatever you’re telling the buyers can be supported independently.
- From the buyer perspective, it’s really important to seek advice and not just rely on how you feel about the seller personally. Be critical of all the information that you’re given and be absolutely critical about how it might impact what you want to do with the business after the purchase.
- Don’t take things at face value and don’t base your review of these areas on a perceived relationship or your perception of the truthfulness of the person that’s providing the information.
- Be careful not to fall into this trap of believing that a smaller value sale has less risk involved and therefore have less money dedicated to it. Think about the value of the risk, not the value of the transaction.
- Ensure that you are using the right professionals who understand what they’re doing in terms of going through the due diligence process to verify the accuracy of the information that you’re receiving.
- Even though in many of these cases that we talked about the sales were reversed and the cases were found for the buyer. There’s time and money that’s been wasted in getting to that outcome. Certainly, there’s no place where the maxim of prevention is cheaper and better than the cure is truer than in this area.
Employee entitlements in relation to a business that’s been sold
Sometimes, some of the risks in a business can extend past the purchase price. There’s certainly some areas where even in purchasing a business you can be exposed to the historical performance of the organisation.
The issue of employee entitlements in relation to a business that has been sold is not something that’s widely documented. But we’ve certainly seen this happen in our experience.
Even though a buyer has said to an employee that they’re not recognizing their period of service with their past employer. The Long Service Leave Legislation in NSW and in other states requires the purchaser to recognize continuity of service. This means that the buyer bears the risk post settlement. Irrespective of whether they’re buy a company or the business, that liability continues with the business.
It is a common misconception out there and many brokers and accountants don’t fully understand this.
Protections you can set in place
Other than making sure the right processes are followed in relation to the sale, buyers can protect themselves through personal guarantees, Often, parties will push back on accepting a personal guarantee.
You certainly see that often from a selling entity because they want to move on with their life after they sold the business. They don’t want any ongoing liability relating to the sale of business.
And from the buyer’s perspective, it is absolutely necessary to make sure their ongoing liability is somehow protected especially if they’re buying from a company that could potentially be wound up. Personal guarantees are certainly one of the safeguards that can be implemented.
This is why deferred payments can be a good option or earn outs, however you structure it. Because there’s some sort of protection built into the future where issues like this can be identified and dealt with.
But if you don’t have a deferred payment sitting there in the background, then personal guarantees are a very sensible thing for a buyer to think about and look to be included in the contract. Unfortunately, sometimes we see that sellers are advised by brokers and accountants that this is not appropriate in the situation.
Disclaimer: The material contained on this website is provided for general information purposes only and does not constitute legal advice. You should not depend upon any information appearing on this website without seeking legal advice. We do not guarantee that the contents of this website will be accurate, complete or up-to-date. Liability limited by a scheme approved under Professional Standards Legislation