Do You Inherit Debt When Buying a Business in the UK? Key Insights

When you buy a business as a going concern, what is it that you actually get for your money? As with so many things, the answer is, ‘It depends.’ It depends on what the business has, how it is structured and what you actually want out of the deal. Maybe you want the client contracts – or even just one key client contract – and have no interest in the rest. Maybe you don’t want all the staff. Maybe the business owns the premises it operates from and you would rather rent the property instead.

All these things and more can be sorted out in deal structures. Potential buyers just need to make sure they understand any legal issues and legal obligations that might be involved.

If an existing business has outstanding debts, especially if they are substantial, that needs to be carefully considered. Debt payments cut into cash flow and profit, which might inhibit investment and growth, and ruin your business planning. However, there are ways to deal with this too.

In this article, we’re looking at debt in a business you might be interested in buying, and in the process considering what you buy, how you buy it, and how you protect yourself in a deal.

Inheriting Business Debts

When you buy an existing business, the seller might offer a share sale or an asset sale.

With a share purchase, you buy everything, debt included, and you get the business and all its history and secrets. You will undertake thorough due diligence and use warranties and indemnities in the sale and purchase agreement to protect yourself against potential legal and financial issues.

With an asset purchase, you buy the bits you want and leave the rest behind – and that can include loans, debts and HMRC liabilities. You make a clean break with what has gone before. Due diligence is less involved, but you will likely want to call in an asset valuer to confirm the price of the assets you are buying.

A share purchase typically takes longer to complete than an asset purchase.

Which type of business purchase is best? That needs to be decided on a case-by-case basis.

Dealmaker Andy Doyle was faced with the choice between share and asset purchase when he made his second business acquisition, a digital agency that was struggling to make money. His first acquisition had been the share purchase of an e-commerce company, which had gone well, so after due diligence he made the decision to go down the same route.

The deal took about three months to complete, and soon after things started to emerge that showed the previous business owners had violated some of the warranties in the sale and purchase agreement. Because those warranties had been included, Andy was able to challenge them on it and they reached an agreement. Unfortunately, the additional debt those actions had piled on the business proved to be too much and the business went into liquidation.

Andy says: ‘After that, we brought in the administrators. It just wasn’t saveable because of the extra debts. In hindsight, we should have bought the assets, and not the shares. An asset purchase would have made it really good.’

You can read the full story of Andy’s experiences here: https://deal-makers-acf.webdevnow.uk/case-studies/andy-doyle/

Due Diligence

We talk about due diligence a lot, because of how important it is. It feeds into valuation and can affect purchase price and terms. Even if you are buying an existing business for a ridiculously small sum of money, you need to carry out due diligence. That bargain business – and Jonathan Jay once bought a company for £1 – can hide a lot of outstanding debts, and that debt might not be immediately visible.

Financial due diligence is key here. The process includes reviewing historical financial records to identify things including existing debts and current liabilities and to ensure the business isn’t insolvent. It looks at a lot more besides, but this is what we’re interested in here. If anything looks dubious or raises a red flag, that’s when appropriate warranties and indemnities are written into the sale agreement.

Warranties are promises that things are as they have been stated to be. Indemnities are typically a pound for pound reimbursement – if, say, a £10,000 debt to HMRC should emerge, you can claim that £10,000 back.

In practice, any claim you can make against the seller of the business is limited to the amount you paid for the business. Say the business cost £500,000: the most you can ever claim is £500,000, and to get that you’ve got to go to court and be successful. If a £1 million financial problem were to emerge, you’d be £500,000 down.

An alternative option would be to include a right of offset in the SPA. This would allow you to reduce the deferred consideration by the amount of the claim. Downsides include that you are only able to claim as much as remains outstanding on the deferred element of the purchase price, and the seller’s solicitor typically wouldn’t want you to include that and would push back.

And of course, if the things unearthed by due diligence look especially bad, you can cut your losses and walk away. At this stage you will have signed a non-disclosure agreement and heads of terms, but neither of those obliges you to buy the business (or the owner to sell it, for that matter). There’s nothing to be gained by doing a deal at all costs; it has to be a deal that works for you, at your price and on your terms.

Understanding where the debt has come from

If there is debt in a target new business, you need to understand where it came from. That doesn’t just mean knowing who the creditors are, it includes getting to grips with how the debt came about.

Dealmaker Chris Stone and his brother run a healthcare company. During an acquisition phase, they had the opportunity to buy a chain of nine clinics, which the owner just wanted rid of. The company was £120,000 in debt to the bank, and had a turnover of £460,000. Contributory factors included the premature opening of a clinic in London and payment of a £60,000 director’s salary. Without those costs, the company could have earned a net profit of £120,000.

Chris revealed: ‘We were able to purchase the assets of the business rather than the shares, which was quite a good move. It meant that the owner could wrap that business up. We’ve just merged all of his assets into our bigger business.’

Read about Chris’s full acquisitions journey here: https://deal-makers-acf.webdevnow.uk/case-studies/chris-stone/

Buying the business

When it comes to buying a business with debt, there are different ways to approach the deal.

Negotiating

If your target company has debt there are different ways you can handle that. For example, you might pay the seller a higher price on the understanding they will settle the debts. Alternatively, you might negotiate a lower price based on you taking on responsibility for those debts as the new owner.

The second option might seem like the better option as you will pay out less and, in theory at least, be able to make repayments for those debts out of profits. There are caveats, however. If you are also paying an amount of deferred consideration out of profits, that might not leave much for you to invest in the business, and the capital saved by making a lower payment might not be enough to offset this. Also, having debt in the business might prevent you from borrowing money with which you might make improvements or look to grow the business. It depends on the business, obviously. If it’s asset-rich, whether physical assets of intangible ones such as intellectual property, it will be less of an issue.

An alternative method when considering how to handle the sale of the business might be to look for a middle path, and have the seller settle some debts while you take on others.

Also, if due diligence reveals the business holds a lot of inventory, then a stock sale might raise funds to help clear debt.

When Martin Lightbowne attended the Mergers and Acquisitions FastTrack programme, it was an eye-opener. He already had big plans for his four companies, but they were based on organic growth. Jonathan Jay introduced him to the process of growth by acquisition. He says: ‘I went on the course, and thought that it was great stuff. And so, I changed our entire business plan on day two.’

His aim was to buy fifty small businesses of varying size, safe in the knowledge that by integrating them into the group, a loss could be turned into a profit, and a small profit into a bigger profit.

One new company, a bookkeeping business run by a sole trader, had £10,000 in the bank and company debts of £24,000 when Martin took over. He says: ‘We took on the debts and, on day one, ripped out the costs.’

Another acquisition, an accountancy practice, was making a profit of £30,000. He went on to tell us: ‘I knew that if we integrated our services, we could turn the £30,000 profit into £300,000 pretty much overnight.’

You can read Martin’s acquisitions story here: https://deal-makers-acf.webdevnow.uk/case-studies/martin-lightbowne/

Selling debt to a third party

Debt in a business can be sold to a third party by the lender. It’s possible that you, as the buyer, might be able to buy the loans the company has taken out, and so keep control. Be sure to take both financial and legal advice before pursuing this route.

If things are really bad, then calling in an insolvency practitioner might be the solution.

Seeking Professional Advice

As mentioned earlier, information about debts and liabilities in target small businesses will come out of your due diligence process. When you are exploring options and deciding how to handle this kind of issue, remember to lean on your deal team. You hired experts for a reason, so use their knowledge and expertise to get clarity. If your accountant and solicitor – and any other experts involved – don’t have the depth of knowledge needed for the kind of issues you are facing, find someone who does. The final decision is yours, but you owe it to yourself to ensure that decision is made on the back of a thorough investigation and understanding of the facts, and sound, expert advice.

Conclusion

 Buying a business, whether sole trader or limited company, has a lot riding on it. You can get advice from professionals and peers, either formally or via sites like LinkedIn, but ultimately the decisions made are yours.

Having someone with years of experience in business mergers and acquisitions on your side can be a huge advantage. Jonathan Jay has helped more than 3,000 people buy successful businesses and become acquisition entrepreneurs, and he has put together the most comprehensive FREE package of business buying resources available today. To get started on your acquisitions journey, download your FREE Business Buying Toolkit now.