Financial Due Diligence for a Business Purchase

Business purchases can take two forms—an asset purchase or a share purchase.

In an asset purchase, the buyer is only buying certain assets and, generally, none of the liabilities of a target company. The assets can include any of the assets on the balance sheet, such as accounts receivable, inventory, prepaid expenses, and property, plant, and equipment. The buyer is not buying the shares of the business and will generally incorporate a new company to purchase the target’s assets. An agreement to sell assets of a company is typically referred to as an Asset Purchase Agreement.

In a share purchase, the buyer is buying the shares of the target company, meaning that it is buying all of the assets and liabilities of the target company (including off-balance sheet and unidentified liabilities). A buyer may wish to exclude certain assets and liabilities, creating the need for a corporate restructuring prior to the share sale transaction. An agreement to sell shares of a company is typically referred to as a Share Purchase Agreement.


Sellers Like Share Purchases; Buyers Like Asset Purchases

Sellers generally prefer share sales because they get a ‘clean break’ from the target company as the assets and liabilities are being sold in whole. Furthermore, the capital gains on the sale may be eligible for the lifetime capital gains exemption, substantially lowering the tax bill on the sale.

Buyers generally prefer asset purchases because they are not assuming the company’s financial liabilities, and they’re not exposed to any undisclosed or unknown legal issues or threats. Furthermore, they get increased depreciable ‘cost basis’ on the individual assets, which can be depreciated to reduce current taxes. In a share sale, rather than increased cost basis in the asset the buyer gets increased cost basis on the shares purchased, which can generally not be used against current taxes; the buyer must wait until they sell the shares to realize the benefit of the increased cost basis.

Prior to an asset purchase or a share purchase, we recommend that buyers perform due diligence to gain comfort over the value of the assets or shares being purchased. Due diligence typically begins when a letter of intent is signed by the buyer and the seller, well in advance of the closing of a transaction.

Financial Due Diligence

Financial due diligence is necessary regardless of the type of purchase, although the scope will vary depending on the size and nature of the business. Financial due diligence is not an audit of historical information as it does not result in the accountant performing the due diligence to provide an opinion. The purpose of the financial due diligence is to analyze the quality of the financial information being provided as a basis for valuing the asset or the shares being purchased. The financial information that is analyzed can include:

  • Historical earnings before interest, taxes, depreciation, and amortization (EBITDA)
  • The quality of the assets being purchased
  • Financial forecasting and budgeting
  • Capital maintenance and spending requirements for the foreseeable future
  • Working capital requirements to ensure that the business is properly capitalized and that the buyer has the capacity to maintain a good level of capitalization
  • The accounting practices of the business leading up to the sale

Additional Due Diligence / Tax Due Diligence

In a share purchase, the buyer is also assuming the target company’s tax liabilities, including any undisclosed or unknown liabilities that may have resulted from improperly reporting some item of income in the past. Further, the CRA may assess the target company for additional taxes in the event that it disagrees with any of its previously submitted tax filings (including payroll, GST, and other tax filings), subject to the statute barred rules. This means that any future tax issues of the target company will become the responsibility of the buyer so it is important for the buyer to gain comfort over the historic filing practices and positions of the target company.

In these situations, we conduct a comprehensive analysis of the past tax filings that we believe may pose a risk for as far back as we feel is necessary. We begin by analyzing tax filings within the statute barred period and determine if additional work beyond those years is required.

It may be possible to have the seller sign an agreement indemnifying the buyers from any future tax liabilities, however the CRA doesn’t recognize such indemnities so any future tax liabilities will still fall to the buyer, and then the buyer must go through the (often lengthy and un-effective) legal process to enforce the indemnity. A buyer’s best defense is to have a tax professional carry out due diligence procedures well in advance of the sale closing.

As a buyer, you need to be sure you are using someone with a high level of tax expertise for your tax due diligence. This helps ensure you won’t be faced with undisclosed or unknown past tax liabilities somewhere down the road.

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