Risk Identification Assessment And Allocation In Buying A Business

Writen by Tri Nguyen

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.

*** 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 http://www.trilawoffice.com or call 713.513.4808.