Counsel & Conversation | S1 E4: Selling a Business with Property | Swinburne Maddison

Caroline Smith 0:06
Welcome to Counsel & Conversation at Swinburne Maddison, where our trusted lawyers debate solutions to everyday legal scenarios. With me today, I’ve got Gillian Moir, who’s a Partner in our Commercial Property department, and I’ve got Craig Malarkey, who is a Partner within our Corporate and Commercial department. So, to kick off our discussion today, I’ve got a scenario that I imagine you’ve come across several times before. If I read that out, then I’m going to ask you some questions. I’d like to talk a little bit more about it. So, a business owner is preparing to sell their company, which includes leased premises and properties owned by the business. The buyer has raised concerns about the title, compliance and operational risks of these properties. They are still interested in buying the business, but they want to understand more about how they tackle that. I was thinking, in the first instance, if I’m a business owner, and one of the biggest assets of the business is the property, say it’s a manufacturing business and they’ve got this huge premises, what’s the first thing that you start to do in order to make sure that everything’s in order with that really valuable asset that’s part of the business? Is that something that you would look at first, or would you engage Gillian, Craig, at that point and say, I need you to be involved to do the due diligence around the property?

Craig Malarkey 1:27
Yeah, where there’s a property element, we’d always want the specialists involved get the property team involved as early as possible, because I think it’d be a recurring theme around that sort of topic, but it’s preparation, and it’s kind of preempting problems before they arise. So, one of the first things we would always look at when there’s a property portfolio involved, in any company, would be whether it part of their trading business, or is it investment property? Because there are different considerations for both of those. Think if we work on the basis that it’s a trading business, and this is their trading property, the first things we’d be looking at for getting Gillian’s team involved would be, is it leasehold? Is it freehold? Because the distinctions are massively different. With a leasehold property, you have less control, so we want to see the documentation in advance. I think that would always be key on a leasehold property, understanding the length of the lease, understanding, you know, the terms of the lease, repairing, and you know, the major one we would always come across, I think, would be the repairing covenant, certainly under a leasehold.

Craig Malarkey 2:36
And just explain what that is, Craig.

Craig Malarkey 2:36
I’ll let the expert explain.

Caroline Smith 2:38
Gillian, over to you.

Gillian Moir 2:39
In terms of the repairing covenant, the landlord obviously has the property and has a freehold to it. They let it to the tenant. They want to ensure that the tenant is going to keep it in good repair and condition throughout the term of the lease. Often, a lease may include a schedule of condition, which can sometimes be photographs of the property, a review from a surveyor, often that actually sets out the state and condition of the property at the outset of the lease. And from the landlord’s perspective, they would like the tenant, and they want the tenant to effectively hand the property back in the same or better condition than it was when the tenant originally went into occupation. So the repairing covenant puts the obligation on the tenant to, as I say, keep that property in good repair and condition. So any buyer of the business will want to ensure that if they’re taking on the property, they’re also taking on it in good repair.

Caroline Smith 3:44
So can it happen that those just aren’t there? So, as you do your due diligence in that situation, there isn’t a covenant there.

Gillian Moir 3:52
Covenant is generally part of the lease. If it wasn’t in the lease, it would be a defective lease. Effectively, the lease would generally detail whose responsibility certain things are under the lease.

Craig Malarkey 4:04
We may find there’s no lease, I think, and to be fair, it’s not perceived as a problem, and the business is operating, there’s an established landlord relationship. It’s just, you know, it’s the nature of lots of the businesses that we encounter that they’re so focused on running successful businesses that some of the detail of operating the business is often left behind. You would typically think that something as extensive and as important as the property isn’t one of those things. On numerous occasions, we’ve probably got five or six real-life examples without much thought, where we could come up with an explanation of the scenario where that has happened. So then you’re trying to look at options. Do you put in a new lease before completion, which is actually something that I’m working on with one of Gillian’s colleagues now, where we’re putting the lease in place before we do the deal, or do you then just leave it as is? It is, and allows the buyer to negotiate. And it’s, it’s kind of the, you know, as I’ve said, the key that the topic of conversation is, how do we prepare? How do we minimise the risk? And sometimes it’s engagement with us early. Sometimes it’s engagement with the buyer early. You know, having that conversation. Do they want to negotiate their own terms on a lease? But, yeah, you never, never shocked.

Gillian Moir 5:22
And sometimes we have a position where the seller them may well have have their own lease sorted out, and that may well be in order, but they’ve allowed somebody else to occupy another part of the property that they haven’t actually sorted out a formal lease, and it’s more of a verbal arrangement and that can also cause an issue as well. Of course, any buyer coming into the business wants to ensure that they may be able to get vacant possession. Basically, they may be able to take that, that part of the property back again if they need to.

Craig Malarkey 5:57
There are very few scenarios that can’t be resolved.

Caroline Smith 6:01
That’s good to know.

Craig Malarkey 6:03
Yeah, sometimes it’s the headache you don’t want.

Caroline Smith 6:06
So, what would your advice be then? So a business owner that, I mean, it’d be quite good to talk separately about, perhaps assets within the business that are properties that are not the main premises, and for the operation of the business. I’d be quite interested to talk about that, because I’m assuming someone is some purchases might not want those assets, but, but if we just stick with that scenario of making sure that the lease is in place, the covenants there, what would you recommend somebody who’s looking to sell their business in the future to do, to make sure that they’ve kind of covered the checklist,

Craig Malarkey 6:40
Taking it away, even from just the legal conversation, I think the main takeaway for anyone watching, who owns their own business and has an exit strategy which involves a sale, that’s not just lawyers, but fundamentally, obviously that’s what we’re most interested in getting involved in, but that would be with your accountant, with your tax advisor, with your CF advisor. But for us, it’s almost doing a full health check on the business before you get to the point of taking it to market. Because once you’ve taken it to market, you’ve probably arrived at a price. So there’s, you know, there’s maybe things we can advise on in terms of contractual, you know, putting in place longer-term supply agreements, putting in place protection of intellectual property, are all things I can add to the value of the business. But aside from that, it’s once it’s out there, you’re then being driven by the buyer on a process. And one of the things that we always say to sellers, once you’re engaged in the process of sale, the buyer has control of that process. They’ve always got to have the ability to say that’s not the right deal for us anymore, or we don’t want to do this deal. So the way to avoid that is to preempt the problems before they arise, and preempt the problems before that. It’s the buyer presenting them to us, looking at the lease before you’ve released it to the buyer, understanding the issues. But it’s the same with everything else. It’s the same with your employment contracts is the same as the commercial arrangements with the intellectual property protections. We know what those issues are before we’ve had to make them evident to a third party, where we can try and address them and try and resolve them. Often, what we find in these scenarios is that you’ve got the sellers, who are also their own landlord. So you know, it seems like a really great idea to put a really long lease in place on a high rent, but that’s not going to work once the deal gets going. So it’s trying to kind of give that sensible advice from the get-go, from day one, but if that day one starts once there’s already a buyer crawling all over the business, it’s a really much more challenging exercise. Sometimes an opportunity presents itself like they weren’t expecting. You know, you get offers that come out of left field a little bit.

Caroline Smith 8:48
It kind of makes sense. Because you imagine, if you’ve got somebody who wants to buy your business, you want to keep the momentum, don’t you? We want to make sure that things are just running along. And I mean, I don’t know what the average timescale is, I’m sure it varies across all different businesses and different sectors, but I guess what you’re saying is, if you’re considering selling your business, get your ducks in a row before you even get to that point of looking for somebody to budget

Craig Malarkey 9:13
Absolutely. Yeah, the thing that’s often said, and I won’t pretend it’s something I’ve ever come up with, but it’s time kills deals. So, if it takes a long time to resolve a problem – so, I think of an example where Gillian and I were working together, and we had no control over how long the landlord was going to take, and that’s when you lose momentum. That’s the key thing you mentioned, you lose the momentum in the deal, and it just everybody thinks the business will suffer because it’s a tough process. It’s not easy, it’s intense. We ask a lot in terms of the deal process, in terms of commitment from clients to provide information, and fundamentally, they’ve got a full-time job already, and when we’re asking for this, so the business will potentially suffer. Where, as I said, it’s easier said than done, but if you’re ready to go with a really well-structured company, if you’ve got as good as it can be, and your ducks are in a row, as you said, then you give yourself the best chance of getting through the process without any unexpected hurdles.

Caroline Smith 10:17
So then, continuing the theme about property, Gillian, you were also talking about the fact that for some businesses, they might have, as part of the balance sheet, some assets that are actually maybe rental properties that aren’t needed for the day-to-day operation of the business. Does it happen where somebody purchasing that business might actually say, I don’t really want that. That’s diluting my expertise; I’m not interested in that. Have you come across that situation before?

Gillian Moir 10:44
In those instances, you can often carve those out of the business itself, if it’s a share sale, and those particular properties are in the name of the sort of target company we would look at transferring those out to either another company or to the individual directors.

Craig Malarkey 11:04
It’s a really key point, because if they are investment properties, and they’re not used for the core trading activities, it can have massive implications for tax. So it’s really important to say, to have that established early on in the process, so that we have the time to enable that to be addressed by virtue of either those properties being sold to a third party or introduced as back into the to the sellers of the business. So the experience of doing that is less prominent now because of the changes to pension rules, but where people would purchase properties out into their own pension funds. But what we have seen as well recently is some buyers just aren’t interested in property on their balance sheet, so they’ll ask us to extract the properties out. And obviously, again, that’s something that we would structure that process through with them, to make sure it’s done in a tax-efficient fashion, with their accountants. Make sure it’s done in a commercial, you know, get it where it wants to be. Make sure that they’ve there’s value in those properties being leasehold properties, you know, do you want to retain them? Do you want to sell them to a third party? So everything’s on the table, really, in terms of that point.

Caroline Smith 12:11
And really, it’s down to the owner to sort of talk about what they want, what it is, what aspects of the business they want as part of that is a purchase. So I think what’s really coming across to me is the importance of, if you’ve got property as part of a business, you guys working closely together. So talk me through that.

Craig Malarkey 12:30
If it’s a business sale, be that by asset sale or share sale, it would typically come into our department first. What happens then is it’s essentially part of the diligence exercise. So we’re very much talking a lot about the property elements, for obvious reasons today, but it’s one part of the business. It’s usually a really big part, whether that’s in value or in complexity or importance. So it really is a key factor, typically. It’s only one part, so we form part of the full due diligence exercise, where we would, you know, get involved with the client at that and looking through what they currently have, what they perhaps should have, and kind of moving through that forward into then subsequently, absolutely answering the buyer’s inquiries to help negotiate the rest of the documents involved in the transaction.

Caroline Smith 13:21
In terms of that whole scenario that we’ve talked about, what considerations are there for leasehold property versus freehold property?

Gillian Moir 13:30
A seller would have more control in respect of a freehold property because they actually own the freehold to the building; they don’t lease it from a third party. If you’ve got a share sale where the seller actually owns the freehold of the property, that’s probably the easiest from my perspective, that’s most straightforward. If you’ve got a leasehold and a share sale, then the seller themselves don’t have quite as much control, because a third party effectively will own the freehold to the building in a share sale, again, that will pass to the buyer.

Caroline Smith 14:07
Could it be that from a leasehold point of view, say that building that is used as the main operational hub for the business, a purchase of that business might find it’s only a five-year lease, for instance, and they don’t feel comfortable with that. Does that happen where somebody wants that extended before they’re prepared to go ahead with the purchase?

Gillian Moir 14:26
It does yes, if there’s a shorter term on the lease and the buyer has long term plans for that property within the business, we have had scenarios, yes, where the buyer has come forward and said, well, we’re happy to take the property, but we want to know that we’ve got commitment from from the landlord, that we’re going to be able to remain in it. And yes, we’ve then had to deal with a scenario where we’re surrendering the existing lease and having a new lease granted to the and to the buyer, even on a share sale.

Gillian Moir 14:50
And has that sometimes been a deal breaker?

Craig Malarkey 14:58
It could be, couldn’t it? Because, ultimately, you’re then in the hands of the landlord. So it shouldn’t be a deal breaker. And as we’ve alluded to before, most things can be resolved. And you know, a surrender and re-grant of a lease with a longer term shouldn’t be problematic, but it just brings in an external party who’s got no vested interest at all, no skin in the game. And I think it would be wrong to say it couldn’t be an issue. That would lead to the deal falling through. I think what’s probably more likely, and what’s probably more our experience, is that it just adds time. There’s probably a commercial reason why they would be happy to extend the lease, and it gives them a little bit more security, assuming they haven’t got other plans for the property themselves, but currently, they’ve got a tenant who’s probably paying rent, and they’re probably quite happy with that scenario.

Gillian Moir 15:51
If there’s already an existing lease in place, and that lease is just to be assigned as part of an asset sale to the buyer, that lease itself will impose some conditions on the landlord in terms of them not unreasonably withholding their consent or unreasonably delaying that consent to the assignment. On the scenario that Craig just mentioned, there is the surrender and re-grant, when you’ve got the landlord dealing with that side of things.

Craig Malarkey 16:18
Typically, what that will present itself in is, you know, they may seek to change the terms, I guess, but they’re definitely going to want their bills paying what’s going to be an additional cost, and probably, in that scenario you’ve described there, the buyer is not picking up that cost. It’s probably going to fall to the seller initially, unless we’re in a really strong position to negotiate that.

Caroline Smith 16:38
So it’s another consideration and another thing that can prevent the momentum that you were saying is so important.

Gillian Moir 16:44
If the buyer, as the new tenant under the lease, doesn’t then pay the rent or service charge or insurance rent, or anything along those lines, the landlord can also ask for a rent deposit to be paid by the incoming tenant, or a personal guarantee be given by them. So often, these are things that you know may not have been considered at the outset. So sometimes it would be good to be a seller in an asset sale with a leasehold property, to get in touch with the landlord, maybe first of all, and just sort of sound them out as to what their position is, maybe.

Caroline Smith 17:20
Talk to me a little bit more about the title, because one of the questions that I had was how title issues can be resolved before completion.

Gillian Moir 17:27
Anyone who’s purchasing or taking an interest in that property is going to want to know that it’s able to be accessed, that there’s got all the rights of way, and that there’s going to be no restrictive covenants on the property that’s going to prevent use of it for the proposed use going forward. Any buyer of a business where there is property will want to ensure that they can trade from that property from day one. Effectively, they’re going to want to know that, you know, if they’ve got a particular business that then trading from those premises isn’t going to be a breach of one of the covenants on the title. So if, for example, there was a business, we were dealing with, a business sale for industrial business, and there was a covenant on that property that they traded from basically saying that they weren’t to carry out any dealings with loud noises, if there was a covenant preventing that, and find they’ve got an issue with sort of trading from that premises. Now it can be possible to get around that by getting indemnity insurance. There’s perhaps an unregistered road with no rights over it; it may be possible to get indemnity insurance, whereby, if anyone comes forward and says, you haven’t got the relevant rights to cross that area, it may be possible to rectify that with the owner of that right of way. But what we would say is not to contact them before we’ve made inquiries with regard to indemnity insurance. Making those inquiries with a third party could actually have an impact on whether indemnity insurance is available.

Caroline Smith 19:12
What are the risks of non-compliance with property regulations?

Gillian Moir 19:16
They can be significant as part of a business sale; we would need to show the buyer that we have all of the sort of relevant property documentation in place. You would need energy performance certificates. Depending on the age of the property, you may need asbestos surveys, fire risk assessments, and all of that type of thing. If the seller doesn’t have those in place, then they would need to disclose that to the buyer. Things like that are often relatively easy to put in place prior to completion, and we would suggest that anyone we are acting for as a seller put those in place prior to completion.

Caroline Smith 20:01
Is that one of those things, again, Craig, that you were talking about, you know, when we were saying, get your ducks in a line beforehand, actually even down to that level of detail, you’d say, make sure all those things are available, that you’ve ticked all those boxes

Gillian Moir 20:15
Absolutely, it’s good practice to make sure that they’re all in place.

Caroline Smith 20:18
Is that something that you think a business could come to you and say, what are the things that I need to consider at this point?

Gillian Moir 20:24
Yeah, we could certainly run through that, because from a property perspective, there are sort of standard commercial property inquiry forms that we use in every transaction, every property transaction, and they’re a good starting point, often for a seller, because a buyer will ask for those replies. So if a seller could have a look at those and start preparing responses and digging out the documents, such as energy performance certificates, fire risk assessments, asbestos reports, that type of thing, because often they have them, they may have them from when they purchased the property, but they may well not be in date anymore.

Caroline Smith 21:08
I mean, I think that would be super helpful. And if somebody were to speak to you in advance and just get that list what they need to consider from a compliance point of view,

Gillian Moir 21:16
If they don’t have them, it is something that we would need to deal with as part of the disclosure process, as I’m sure Craig will talk about shortly. There are warranties in the business sale agreements that we would need to disclose against if a seller doesn’t hold those particular documents.

Caroline Smith 21:37
We’ve talked a little bit about due diligence in advance of preparing for sale. Is it possible for you to say, you know, simply the three things that a business is considering selling?

Craig Malarkey 21:50
No businesses are the same. So I think you know we try and compartmentalise as best we can across sectors, across the size of businesses, but ultimately, each one is different. But if you were going to kind of group the key areas together, I think property is clearly one. It is really regulatory. You’ve got to have certain things in place. So it’s very important. And the sooner you get into that, the better. I think the other two areas, to give you three. The other two areas would be your employment, sort of history, making sure that there’s no sort of skeletons in the closet in terms of disputes, but primarily making sure that your documents are in order, because, again, heavily regulated, you’ve got to have very specific things in place with employees, and that doesn’t just include their terms of service or their contracts, but that’s policies. You know, we’re dealing with the business currently that’s really well run, but it’s relatively small, so kind of, you know, having that full breadth of HR policies is something that hasn’t been a high priority for them. So that would be another one.

Caroline Smith 23:00
And of course, we’re talking about particularly m&a mergers and acquisitions and property. But at the same time, as one of our topics, we’re going to discuss the employment side alongside that. And we do, we do, obviously, have an employment time.

Craig Malarkey 23:15
Absolutely, and all of this that we’re discussing now as part of, you know, the scenario of the business sale. Your ideal scenario, of course, is that you do your proprietary due diligence and you flag nothing because it’s already in order. I guess the third would be commercial contracts, we’re seeing now, more so relevant in businesses that have long-term agreements, so there’s a lot of revenue banked in those agreements, which obviously brings value, and that’s what the buyer is interested in buying. We’re seeing an increasing number of those agreements containing change of control provisions, and what that simply means is that if they sell the company, the other party to the contract may have the ability to terminate that agreement. So if you’ve got a five-year supply agreement that generates recurring revenue that’s been factored into the value of the business, but that contract can be terminated on day one after completion, then that poses a risk to the buyer. There are a couple of different ways you deal with that. The first and foremost is that you can go and get consent, but obviously, that opens up a can of worms with the other party. So it’s a really, it’s a really thorny subject. So I think, yeah, commercial contracting, you’re looking at your terms and conditions, even if it’s on a really basic level like that, what have you got in terms of your contractual relationships with your own customers and suppliers, employment, and then property?

Caroline Smith 24:40
It does feel like it’s a bit of a minefield, so many considerations that you wouldn’t necessarily have. You get excited about selling your business and the value of it, but not the realisation that there is a massive process to go through. Whereas you’re in that process, you’re vulnerable to it not happening.

Craig Malarkey 24:54
It is a process, and I think sometimes that’s a problem. It’s to process that everybody’s so focused on running their business really successfully, you’re not always looking at the end of that process. So I think that is, you know, that is really key. I think, you know, no two transactions are ever the same as well. And what can be a really material factor to one seller or to one buyer is sometimes not to another. Our main goal in any transaction is to reduce the risk. That’s ultimately what the legal process is about. We are looking at protecting against what is the worst-case scenario, and fundamentally, you can’t ever mitigate all the risks, or certainly, you can’t eliminate all the risks. You can mitigate them. We probably, you know, we’re not eliminating those risks, I think, for us, in terms of that value risk, saying, what we’re doing as lawyers is making sure you retain as much value as you can. So, you know, people talk about value, and they’re typically looking at how you value a business, or how you make it more valuable. That would be the role of your accountant or your corporate finance advisor and we would encourage early engagement with those professionals to make sure that, because they’ll tell you, you know, if you do this different, or we present this differently on your balance sheet, this is going to how we’re going to maximise the amount of enterprise value in your business. What we’re doing is making sure that whatever value is paid over is retained. And as you know, as we’ve laboured the point extensively, the way we do that is preparation, it’s due diligence, it’s advanced knowledge of problems, and then once you get into the deal specifics, we’re talking about disclosure, we’re talking about remedying these things along the way. Certainly, most clients that we deal with at Swinburne Maddison are owner-managed businesses that have been their lives, often worked hard to build this up to an extremely successful business. And this is your one opportunity to realise that value. So you want to make sure that it’s done well. And say having that plan from three years out, maybe, maybe even longer for some people, but certainly two, three years worth of having a vision of when you think you’re going to be getting out gives you the time to do what we’ve done, because we’re talking about this, all this advanced work, and that’s all got to be done alongside obviously running that business and say we think it’s that’s advantageous, because it takes the pressure off the transaction. But equally, having that foresight, and having that ability to stop and step back, and you know, that’s where we want clients to engage with us, with our employment team, with our property team, with our commercial team throughout the lifespan of their business.

Caroline Smith 27:38
Early on, I mean, I think what you said about having a plan, knowing what your end goal is for the business, and then preparing for that by having everything organised, sounds great. I mean, I’ve really enjoyed talking to you today. It’s so interesting. I mean, we see each other a lot in the office, and I just love hearing, hearing you talk about your areas of expertise, it comes across. Your passion for it, your interest and your knowledge. So from my point of view, a big thank you for giving me time today. It’s been really interesting, and that’s not the end of it. We’re going to be talking again, because I think it definitely leads on to a lot more questions, particularly when you talk about the employment side of things, and that is something we will revisit. So thanks for your time today.