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Risk Identification, Assessment and Allocation in Buying a Business
The processes and considerations involved in buying a business
are more involved than merely identifying the business that
meets the potential buyer's financial criterion, making sure
that the buyer can make money from it and then determining the
purchase price. Buying a business should also involve the
identification, assessment and allocation of risk, especially in
more complex and high value businesses. These three risk-related
processes should occur simultaneously with or very soon after
the processes of identifying the business, making sure it could
make money for the potential buyer and determining the purchase
price. Depending on the size of the target business and the
amount of money involved, a potential buyer should decide
whether to conduct the risk analyses, and if so, to what extent.
Often times, the value of the business does not justify the
expense and energy involved in identifying, assessing and
allocating the purchase risks. However, if the value of the
business is sufficiently large enough, performing these risk
identification, assessment and allocation processes can help
achieve a better purchase price for the buyer, protect it from
unidentifiable or unknown risks and/or prevent a bad deal from
happening.
The purpose of this article is to explain in general terms the
process of identifying, assessing and allocating the risks
inherent in purchasing a business from the buyer's perspective.
This article is not meant to be legal advice. It is meant to
give the readers an idea of what is involved in purchasing a
business so that the reader can consider the issues raised in
this article and ask informed questions about the processes
described. Please consult a licensed attorney for your
particular situation and transaction.
Identification and Assessment of Risk
Risk identification occurs at the very initial stage of the
business buying process, after identification of a good target
and an understanding between the buyer and seller that both can
proceed with the transaction, subject to certain conditions,
such as further investigation. Most often, this process of risk
identification is referred to as due diligence. Due Diligence
may take the form of financial due diligence or legal due
diligence.
Financial due diligence usually involves the participation of an
accountant, business broker or other financial advisor who can
guide the potential buyer through the financial analysis of the
business. It is the process of reviewing the target company's
financial records and statements to determine whether the
economic value and financial performance of the business
justifies the asking purchase price. The question should be, "is
this company really generating the revenues and incurring
expenses that the seller is claiming." Additionally, financial
due diligence may reveal whether the target's financial books
and records were properly kept. This consideration is important
because the more poorly kept the financial records, the more
imprecise the information and thus the more risk that the
information is wrong.
If during the financial due diligence process the potential
buyer discovers the target actually has only a few number of
clients or customers that make up a bulk of its business or that
its books were not properly kept or that only a certain number
of key employees generate most of the target's revenues, then
these risks should factor into the purchase price. If these
risks are deemed to be substantial enough, then the purchase
price should be reduced accordingly. Alternatively, some
arrangement should be made between the potential buyer and the
seller to factor in these discoveries.
Just as important as financial due diligence is legal due
diligence. Legal due diligence is the process of reviewing the
target company's organizational documents, contracts, compliance
records, governmental records, and other documents to determine
whether the target has complied with applicable laws, is subject
to any litigation, is exposed to any liability or obligation,
and other issues that may affect the structure, terms or
feasibility of the transaction. If the potential buyer discovers
any adverse information related to any of these matters, the
potential buyer may decide, if the
information is material
enough, that the deal should be structured differently, the
purchase price should be adjusted and/or the risks of liability,
non-compliance and other legal exposures should be allocated to
the seller. After all, the seller was running the business when
the cause of these potential issues were created.
Risk Allocation
Risk allocation is the process of determining who should bear
the financial and, some times, legal responsibilities for the
occurrence of a certain event (risk), which may or may not
happen. The risk allocation process often times is the most
contentious and detailed part of the negotiation and drafting
process. Risk is usually allocated by way of the operative
purchase agreement, most usually in the form of representations
and warranties made by the seller and the indemnification
mechanisms.
Representations and warranties are statements made by either the
buyer or seller in the operative purchase agreement as to the
status of a certain matter, situation, event, arrangement or
thing. The seller, for instance, may represent and warrant that
it has complied with all applicable governmental requirements
for its operation. This representation and warranty is
essentially a statement of fact, which if later found not to be
true, will allow the potential buyer to claim that the seller
has breached the promise and thus allow the potential buyer to
sue under the contract. Thus, when the potential buyer requests
that a seller make a certain representation and warranty, the
potential buyer in effect is allocating the risk to the seller.
If that representation and warranty turns out to be not true,
then the seller can be sued for breach under the operative
purchase agreement. The seller may deem that the risk of such
representation and warranty being wrong is small enough that the
seller may be willing to make such representation and warranty.
Alternatively, the seller may deem that it can not be very sure
that the representation and warranty is true, which will lead
the seller to try to limit the representation and warranty to
only those situations in which the seller can be more sure that
the representation and warranty are more likely to be true.
The potential buyer will not to be able to allocate every risk
to the seller. The potential buyer will inevitably have to bear
some risk of the transaction and the business being acquired.
There is always potential for mistake, confusion and lack of
knowledge on the part of the seller so that the seller's
representations and warranties may turn out to be false. The
potential buyer can reduce the effects of this situation by
requesting that if the seller turns out to be wrong about a
particular representation and warranty, then the seller will
indemnify the buyer for such mistake, confusion or lack of
knowledge. The indemnification is the seller's promise to pay
the potential buyer for a breach of a representation and
warranty. The seller's obligation to indemnify usually has
triggers and caps so that the seller is on the hook only for a
certain amount of money, and then only after certain events
occur.
Thus, with the representations and warranties backed up by the
indemnification requirement, a potential buyer is able to
minimize some of the risks associated with buying a business.
The risk allocation process is usually a good idea if the
transaction is big enough and the business value is high enough
to the potential buyer to justify the expense and energy
required to identify, assess and allocate the risks associated
with purchasing a business. So, the buyer should determine at
the outset whether the target business has inherent risks that
the potential buyer is or is not willing to bear without
engaging in the risk identification, assessment and allocation
process. Usually, the more complicated the business and the
higher the business value, the more need for this process.
About the author:
*Tri Nguyen regularly represents small businesses, start-ups and
entrepreneurs in business and real estate transactions and
counsels them on a regular basis on legal issues that affect the
growth, stability and continuity of their businesses. Please
visit his firm's website at www.trilawoffice.com or call
713.513.4808.
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