Buying a Business? Buy Right!

Buying a Business? Buy Right!

SHARE

In the commercial world, the terms ‘company’ and ‘business’ are often used interchangeably. Statements such as “my business employs 20 people” or “my company manufactures handbags” are commonplace, but what exactly do they mean?

In law, a company and a business are distinct concepts, and the purchase of a company has different legal consequences to the purchase of a business.

A clear understanding of the two is useful to businesspeople looking to obtain control of a particular business. This article provides an overview of how a company differs from a business, with reference to some of the key consequences of buying a business versus buying a company.

The tax and employee-related aspects of the two transactions are not dealt with, although they are important aspects of each transaction. For this and other reasons, the following should not be understood as legal advice.

What is a company?

A company is a legal concept, intended to promote commerce by allowing people to conduct business without personal liability. A company, once validly registered in terms of the Companies Act, No. 71 of 2008, has legal personality – in other words, it is able to transact in the same way as a natural person.

Just as a natural person owns assets, and is directly liable for his debts, so a company may also own assets and is directly liable for the debts that it incurs, generally to the exclusion of its shareholders.

 

Entrepreneur-Newsletters
Entrepreneur’s daily tips & insights delivered direct to your inbox.

What is a business?

A business is simply a collection of assets, both physical and non-physical, which generate income, as well as liabilities (debts)  that have arisen in the course of trying to generate that income.

A shoe manufacturing business, for example, would consist of:

  • physical assets, such as machinery and equipment;
  • contractual relationships with trusted suppliers and important customers;
  • intellectual property, such as shoe designs and trade marks (its brand name, perhaps);
  • accounts receivable and cash in the bank.

In addition, a number of debts might have arisen in the running of the business, such as amounts owed to suppliers for raw material, rental amounts owed to the landlord of the premises from which the business is conducted, and amounts owed by way of salary to people who work in the business.

A business is not a legal person and has no legal personality. It cannot enter into commercial transactions in the way that a natural person or a company can. In other words, a business cannot sign a contract. Rather, a business will be owned and operated either by a natural person (in other words, a sole proprietorship) or by a legal person such as a company.

A useful way to avoid confusing a company with its business is to remember that a company could own and operate a number of different businesses.

Acquiring control of a business

Let’s assume that Mr Smith has his eye on a successful shoe manufacturing business. The shoe business is owned and run by a company, Shoe Co Proprietary Limited. Shoe Co has two shareholders, Mrs and Mrs Sole.

Mr Smith decides he’d like to own the shoe business and run it for his own benefit. He has two options. He could buy all of the shares in Shoe Co from Mr and Mrs Sole, thereby acquiring the company which owns and operates the shoe business. Alternatively he could buy the shoe business from Shoe Co itself.

Buying the shares

Should Mr Smith choose to buy all of the shares in Shoe Co from Mr and Mrs Sole, he will become the only shareholder of Shoe Co. Mr Smith will therefore be in control of Shoe Co and all of its operations (including the shoe business). In this scenario, Mr and Mrs Sole will be the sellers, and Mr Smith will pay the purchase price for the shares to Mr and Mrs Sole.

The key disadvantage of this approach for Mr Smith is that Shoe Co, as a legal person, will continue to be liable for all the debts incurred by it before Mr Smith took over. Shoe Co may, for example, owe significant amounts to suppliers, to the Receiver of Revenue, or to other third parties, which Shoe Co remains liable to pay.

The existing debts will affect Mr Smith’s back pocket because, no matter how successfully the shoe business is run after he takes over, the amount available as profit for dividends to Mr Smith will necessarily be less after Shoe Co has paid its various debts.

It is for this reason that prudent purchasers insist on a due diligence investigation being conducted into the affairs of a company, prior to acquiring the shares. The purchase price for shares in a company burdened by significant debt should be correspondingly reduced.

As mentioned earlier, a company can own a number of businesses. If Shoe Co owns more than one business, buying the shares in Shoe Co is not the best way for Mr Smith to obtain control over the shoe business, because he will obtain control over all the other businesses operated by Shoe Co, at the same time.

Buying the business

The other option is for Mr Smith to buy the shoe business from Shoe Co itself. In this scenario, Shoe Co is the seller, and Shoe Co will therefore receive the purchase price. The shareholding in Shoe Co remains unchanged, and Mr and Mrs Sole continue to be its shareholders.

In this scenario, Mr Smith is buying the collection of assets which make up the shoe business from Shoe Co. He might be taking on some of the shoe business debts as well. The key advantage of this option for Mr Smith is that he will be able to negotiate which of the shoe business debts he will take over, and which debts will remain behind with Shoe Co.

Mr Smith might agree, for example, that he will assume and be liable to pay debts due and owing by Shoe Co to its suppliers, as long as those debts are no more than three months old. All other debts will remain with Shoe Co, and it will continue to be liable to pay those debts.

By buying the shoe business out of Shoe Co, as opposed to buying the shares in Shoe Co, Mr Smith protects his commercial operations and his finances from Shoe Co’s debts and liabilities.

Of course, the extent to which Mr Smith is prepared to assume Shoe Co’s debts will likely affect the purchase price payable for the shoe business. In general, the more debts the purchaser agrees to assume, the lower the purchase price for the business.

Buying the shoe business out of Shoe Co will also work well for Mr Smith where Shoe Co owns a number of businesses which Mr Smith has no interest in acquiring. Only the shoe business will transfer to Mr Smith, while the rest of Shoe Co’s operations will remain behind.

Commercial circumstances

The decision as to whether control of a business which is housed in a company is best obtained by a share purchase or the purchase of the business itself is always dictated by the commercial circumstances of the particular transaction.

In very general terms, purchase of the business is more appropriate when:

  • the buyer does not wish to take over all of the company’s liabilities, or there is a danger of undisclosed liabilities in the company;
  • the buyer wishes to acquire only some of the company business assets and not all of them;
  • the company owns a number of businesses and the buyer is only buying one of them; or
  • there are difficulties with acquiring the majority shares in the company, perhaps due to pre-emptive rights, or where certain shareholders do not want to sell their shares.

The purchase of the shares in a company might be more appropriate when:

  • the success of the business depends on certain agreements which the company is not allowed to transfer, such as a licence agreement, a supply agreement or an important lease;
  • one of the business assets is a property, which the purchaser wishes to acquire without going through the actual transfer process;
  • the sellers insist on selling their shares in the company, rather than selling the business out of the company; or
  • tax considerations dictate that a sale of shares will be more tax efficient than a sale of business.

The agreements

Since the transactions are different, the agreements regulating each transaction are also different. A sale of a business agreement will typically cover aspects such as:

  • which assets are to be sold, and which liabilities (if any) are to be transferred;
  • whether any consents or approvals are required before important contracts may be transferred;
  • the purchase price for the assets, which frequently includes a portion for goodwill;
  • the date upon which the purchaser will become the owner of the business;
  • the manner in which delivery of the assets will take place;
  • whether the transaction will be zero-rated for VAT, provided both the seller and the purchaser are registered VAT vendors;
  • whether the transaction is to be advertised in terms of section 34 of the Insolvency Act, No. 24 of 1936; and
  • whether the seller makes any warranties regarding the business, and whether the seller has put a limit on its potential liability to the purchaser, should any warranty be breached.

A sale of shares transaction will typically cover aspects such as:

  • how many shares in the issued share capital of the company are to be sold;
  • whether the sellers have any shareholders loans against the company, and whether those will also transfer to the purchaser;
  • the price to be paid for the shares;
  • whether any approvals or consents are required before the shares may be sold (such as obtaining the consent of any other shareholders);
  • the manner in which delivery of the shares will take place (usually by the seller handing its share certificates and a signed share transfer form to the purchaser); and
  • whether the seller makes any warranties regarding the shares and the company, and whether the seller has put a limit on its potential liability to the purchaser, should any warranty be breached.

In practice, the decision as to whether the purchase of a business or the purchase of a company is more appropriate is determined not only by the factors discussed here, but by tax considerations and considerations relating to the employees in the business, if any.

For this reason, it is usually advisable to obtain legal advice on the best approach under the circumstances.

Sarah Lawrence
Sarah Lawrence is a commercial legal consultant at Caveat Legal. She holds a BA in English, Sociology and Industrial Psychology from the University of Stellenbosch, an Honours degree in English Literature from the University of Cape Town, and a BA LLB from the University of Cape Town. Sarah completed her articles at Edward Nathan Sonnenbergs and was admitted as an attorney of the High Court of South Africa in 2010. She specialises in Corporate Commercial Law, with a focus on transaction work.