Once a business has been identified as one that a would-be purchaser would like to buy, a flurry of activity usually follows. It is easy to make mistakes at this time in the transaction process. Our experience indicates that these errors are not made in the little ticket items, but in the big ones.
Many accountants and planners alike are not aware of the issues. We point out nine of the most common mistakes in this article.
Who is the purchaser?
1. John Smith as trustee
Often the purchaser (let’s call him John Smith) has no intention of buying the business in his own name and has briefly spoken to an advisor who has suggested setting up the John Smith Family Trust, but John is unsure as to how to describe this in the contract and so he simply inserts “John Smith as trustee”.
Unfortunately, John will now pay double stamp duty on the transaction – once for the actual contract for the transfer of dutiable property – s11(1)(g)(i) of the Duties Act 1997 (NSW) and once again for the declaration of trust which appears in the contract – s9(2) of the Duties Act 1997 (NSW).
2. John Smith as nominee
Alternatively, John might write “John Smith or nominee” as the purchaser. He then sees his lawyer and agrees that the nominee ought to be a company, John Smith Pty Ltd. This company is set up by John’s accountant, and it eventually funds the purchase.
However, in the absence of a properly drafted ‘novation clause’ in the original contract, John again faces potentially two rounds of stamp duty – once on the contract and once on the entity nominated in any subsequent ‘transfer’ document – for example if the transaction includes a sale of shares or real property, then a separate ‘transfer’ document will be required.
Moreover, Courts have held in some circumstances that the nominated purchaser has no contractual rights against the vendor in respect of issues arising under the contract. Similarly, the vendor may have no contractual rights against the end-nominated purchaser. This is because the nominee was not a party to the original contract. That makes it impossible for the nominee to enforce any of the vendor’s promises if problems arise. Warranties in relation to IP ownership and restraint of trade undertakings, are usually the first casualties in such a scenario.
3. John Smith Pty Limited
Alternatively John simply writes the purchaser’s name as “John Smith Pty Ltd”, knowing that the company has not yet been formed. Fortunately for John, s131 Corporations Act 2001 partially saves him and provides for the company to be able to ratify the pre-incorporation contract, but unless the ratification takes place before completion, the sale is likely to be a nullity, exposing all manner of financial, tax and accounting problems for the vendor and the supposed company purchaser. This leaves aside the problems of getting the GST exemption for ‘a going concern’. At what stage do you insert the ABN of the purchaser on the contract? It will have to be after exchange. And if the vendor does not agree to its insertion without a quid pro quo, then the purchaser’s position can be further weakened of course.
What are you buying? What you see is not what you get.
A business can be made up of many things including goodwill, tangible assets, intangible assets and financial property.
With the impact of the Personal Property Securities Act 2009 (PPSA), it is important for the purchaser to understand where all the tangible property is located.
4. Tangible property – plant and equipment
If the tangible property is on site – for example equipment used in cancer treatment for doctors’ patients – it is now not enough to simply ask ‘who owns it, and is it under a lease or licence or hire purchase agreement?’ The purchaser must now ask: ‘Is the equipment the subject of a perfected third party security interest?’
This question was not asked recently by a purchaser of a strata property. It was leased to a doctor’s surgery (‘cancer clinic business’), and the purchase was just about to settle.
The purchaser had been told that the $9m cancer treatment equipment, which had been bolted and grouted to the concrete floor of the surgery, was a fixture and therefore it was included as part of the purchase.
Just before settlement, the vendor of the strata property and the cancer clinic business were both sued by the supplier of the cancer treatment equipment. The cancer clinic business had not kept up repayments. The vendor argued that the equipment was a fixture. The equipment supplier argued that its perfected security interest, registered on the Personal Property Securities Register (PPSR), prevailed against the strata owner and the Court agreed with it.
Had the strata property purchaser checked the PPSR, he would have become aware of the problem and moved on to buy something else. The oversight cost him $180,000 in legal fees as he had to defend the action of the equipment supplier – unsuccessfully.
5. Tangible property – inventory
What about tangible assets that are inventory of the vendor? The inventory might be sold on a ‘buy now pay later’ basis, or on a ‘retention of title’ basis, or the inventory might be leased to third parties – for example, a company might be in the business of leasing furniture to builders who use the furniture in their show homes until the homes are sold. In all these circumstances, the provisions of the PPSA need to be complied with.
If there is no compliance with the PPSA, then the ownership of the vendor’s inventory, which is in the possession of the vendor’s own customers, will pass to those customers if the customers become bankrupt or liquidated. Possession really now is 9/10ths of the law.
Since the PPSA was introduced – now over three years ago – a number of business purchasers have found themselves instantly broke because they have paid for inventory in the possession of third parties and did not check whether the vendor had ‘perfected’ security interests in their own property.
6. Intangible Property
These can include book debts, intellectual property, rights to sue third parties, cash, electronic documents of title (e.g. share certificates), shares, options, other derivatives and negotiable instruments.
Just focusing on the sale of shares for a moment, the question arises – who has possession of the share certificates [if a private company]? Which stock broker’s permission is required to deal with the shares [if a public company]? These are both examples of ‘control’ which has a special meaning under the PPSA.
Many times, these questions are not asked before the contract is signed. If the shares are ‘controlled’ by a third party under s 27 of the PPSA then on completion, the purchaser may get good title to the shares from the vendor, but have no rights whatsoever to the share equity. The problem is that the PPSA applies independently of title.
What about the ex-wife of the director of the vendor?
7. Interaction with Family Law
Recently, a purchaser of a business selling bathroom appliances and appurtenances (towels, racks, tiles, curtain rings, taps etc) undertook all the PPSA checks and found them all clear: all the security interests of the vendor were in place. All the vendor’s inventory was protected. All their retention of title clauses had the highest level of perfection the PPSA provided.
But he forgot to search for security interests against the vendor. As it turned out the director of the vendor had just completed a property settlement with his ex-wife and had agreed to pay her out over 5 years. This obligation was secured by way of a security interest that he granted her over the vendor company. That included the business. The security interest was not discharged on settlement of the sale and the PPSA provides in such circumstances that the purchaser buys the business subject to the security interest (ss 32 and 46 of the PPSA could not assist him). The ex-wife did not even know about the sale at the time. Immediately after the sale, the director of the vendor defaulted on his payment obligations to her. The ex-wife then exercised her rights and re-sold the business to a third party. The purchaser had paid $700,000 for a business and had got nothing in return.
Restraints of Trade have to match the goodwill
8. The relationship between types of goodwill and the restraint of trade clause.
These are often misunderstood. The type of restraint that should apply is dependent on the type of goodwill that is sought to be protected. There are at least 4 types of goodwill – site goodwill, personal goodwill, brand goodwill and monopoly goodwill. Many purchasers and vendors get these confused and find to their chagrin that the restraint does not match the type of goodwill that is sought to be protected. Even when they get it right, the use of interposed entities in the contract (or outside the contract) can render restraints useless unless an ‘aid, encourage, advise or procure’ clause is used.
Employee’s Social Media Accounts
9. Don’t forget Social Media Accounts
The sale and purchase of a business is a great opportunity for the purchaser to introduce a written employment agreement for each transferring employee, if the vendor does not have any.
The written employment agreement can include references to the new employer having rights to survey the transferring employee’s desktop computers, laptops & smart phones.
In the absence of such clauses, any alleged breach of confidentiality by a wayward employee may not be able to be proved. Gardening leave clauses can also be inserted. They give added strength to restraint of trade clauses.
The Australian Courts are also yet to focus on who has rights to a transferring employee’s social media accounts. However, recent decisions in New York State indicate that failing to deal with such issues, particularly if the employee has business contacts on their LinkedIn account, can be fatal to an otherwise robust restraint of trade clause.
If you require legal guidance regarding this matter, please contact the Sydney business lawyers at Owen Hodge Lawyers today on 1800 770 780.
Here at Owen Hodge Lawyers we are always striving to deliver the legal advice and guidance you need. Read our recent post about social media used as evidence in court and more on the Owen Hodge blog today!