Does a Business' Debt Matter When Buying a Business?
Does a Business' Debt Matter When Buying a Business?
Short answer: YES!
But that’s not the end of the story. Read on to get the whole picture.
Every business owner knows that debt can cripple a business, so when buying a business, avoiding existing debt is the best outcome.
A buyer can acquire a business in 1 of 2 ways. You can buy the business or buy the entity that owns the business.
Buying the business is the best way to avoid existing debts. You can control which debts you will take over and avoid those you won’t - a reasonably straightforward, precise outcome.
However, if you buy the entity, you acquire all the debts of the entity, including any unknown or future debts. Unknown debts arise from unexpected events - think a failed ATO audit of prior returns or a sexual harassment/bullying claim.
While it is possible to insure against some of these events, the cost of disruption and brand damage could be a significant penalty.
Buying the entity means your due diligence task becomes an infinitely harder and critical part of your purchase decision.
But, however you are acquiring a business, understanding the existing debt structure is important. If you are buying the business, you will appreciate the amount of finance required (debt or equity), while equity buyers will (hopefully) understand what they are signing up for.
Let’s consider the different types of debt and how they may influence your purchase decision.
Types of Business Debt
1. Short-term Debt
These debts must be repaid within 12 months. These include suppliers, short-term loans, or lines of credit. Unpaid employee entitlements and principal repayments on long-term debt may also be included here.
2. Long-term Debt
These are debts due for repayment after one year. Typically, these will be bank loans.
3. Operating equipment leases
These commitments show up as debt on the balance sheet apportioned between short and long-term debt, and the corresponding asset is also recorded (even though the leasing company is the legal owner). Trust accountants to complicate things!
As a buyer, you can agree to take over the lease or require the seller to pay out the lease liability so you acquire the asset free of debt, depending on your plans for financing the business purchase.
4. Premises lease
Assuming you plan to continue operating the business from the existing premises, you (and the seller) will need to convince the landlord to agree to an assignment of the existing lease or grant a new lease.
If you take over the existing lease, there could be hidden liabilities. For example, most leases require the tenant to maintain the property to a certain standard, so if the seller hasn’t been diligent in doing this, the responsibility (and cost) will be yours.
So, what does that mean?
Well first, you now know where to look for those “hidden” liabilities that can/will bite you further down the track.
But once you have a clear understanding of all debts, you can consider how these affect your business valuation and the cash flow impact on the business in the future.
This information will also guide you in deciding the amount of working capital the business will require initially.
All vital information if you are thinking of acquiring these debts.
Final Thoughts
So, when buying a business and you are asked, “Do you want debt with that?” try to say, “No, I’ll arrange my own finance”. You will know precisely what you are signing up for, thus eliminating one source of business uncertainty. Every businessperson should aim for less uncertainty.
Tags: buying business owner small business tips
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