How Do Outgoings Influence the Purchase Price in a Sale of Business?

When purchasing a business, the purchase price is not as simple as the initial figure agreed upon. Outgoings, which are the ongoing costs associated with running a business, play a crucial role in determining the final amount a buyer will pay. These outgoings can significantly impact the value of a business and must be carefully considered during the due diligence process.

This article will delve into the various types of outgoings that can influence the purchase price, how they are calculated, and the legal considerations involved. Understanding the impact of outgoings is essential for both buyers and sellers to ensure a fair and transparent transaction.

Understanding Outgoings in a Business Sale

Definition of Outgoings

In the context of a business sale, “outgoings” refer to the regular costs a business incurs as part of its normal operations. These are expenses that are necessary for the day-to-day running of the business and are typically paid in advance. Understanding outgoings is crucial when determining a fair sale price, as they represent ongoing financial obligations that will transfer to the buyer after the acquisition is complete.

Examples of common outgoings include:

• Rent and lease payments for business premises
• Utilities such as electricity, gas, water, and internet
• Insurance premiums for property, liability, and other business-related coverage
• Salaries and wages for employees, including any associated payroll taxes and superannuation contributions
• Marketing and advertising expenses
• Supplies and consumables used in the business operations
• Maintenance and repair costs for equipment and facilities

Accurately accounting for these outgoings is essential to ensure that both the buyer and seller have a clear picture of the business’s financial health and profitability.

Types of Outgoings That Affect Market Value

When a business changes hands, not all outgoings are treated equally. Some outgoings directly impact the final sale price and require adjustments to ensure a fair transaction. These adjustments, typically reflected in the business sale agreement, account for expenses paid by the seller that benefit the purchaser after the completion date.

Here are some key types of outgoings that often necessitate adjustments to the market value:

• Prepaid Expenses: These are costs the seller has already paid for services or goods that extend beyond the completion date. For instance, if the seller has paid for a year’s worth of insurance, but the sale was completed six months into the policy, the buyer would reimburse the seller for the remaining six months.
• Accrued Expenses: These are expenses that the business has incurred but not yet paid, representing liabilities that the buyer will assume upon taking ownership. Examples include unpaid utility bills, outstanding invoices from suppliers, or accrued employee leave entitlements.
• Ongoing Contracts: Existing contracts for services, rent, or supplies that extend beyond the sale date can influence the purchase price. The buyer will need to assess the terms of these contracts and factor in any associated costs or potential liabilities.

Failing to properly address these types of outgoings can lead to disputes and financial surprises for either the buyer or seller down the line.

How Outgoings Affect the Purchase Price

Adjustments to the Headline Purchase Price

When a buyer and seller agree on a purchase price for a business, this initial figure is often referred to as the “headline purchase price.” This price typically serves as a starting point for negotiations and may not reflect the final amount exchanged at settlement. Adjustments to the headline purchase price are often necessary to account for various financial aspects of the business, including outgoings. These adjustments ensure a fair transaction where both the buyer and seller are appropriately compensated.

Prepayments and Their Impact

Prepayments made by the seller for expenses that extend beyond the completion date can influence the final purchase price. These prepayments represent a benefit to the buyer, as they will not have to incur those costs immediately after acquiring the business. For instance, if the seller has prepaid a year’s worth of rent and the sale occurs six months into the lease term, the buyer would essentially be receiving six months of free rent. To account for this, the purchase price might be adjusted upwards to compensate the seller for the remaining value of the prepayment.

Accrued Expenses and Liabilities

In contrast to prepayments, accrued expenses and liabilities can lead to a decrease in the purchase price. Accrued expenses refer to costs that the business has incurred but not yet paid, such as utility bills or employee wages. Liabilities, on the other hand, represent obligations the business owes to others, like outstanding loans or tax payments. These unpaid expenses and liabilities become the responsibility of the new owner after the sale. As a result, the purchase price may be adjusted downwards to reflect the buyer’s assumption of these financial obligations.

Key Outgoings to Consider in a Business Acquisition

Rent and Lease Payments

Rent and lease payments are significant outgoings for many businesses, especially those operating from physical premises. When purchasing a business, the buyer essentially steps into the seller’s shoes regarding these lease agreements. Therefore, understanding the terms of any existing leases is crucial during the due diligence process. This includes reviewing the length of the lease, the agreed-upon rent, any upcoming rent reviews, and the options for renewal.

For example, imagine a business operating from a leased retail space with only a few months left on the lease. This situation could pose a risk for the buyer, as they might face negotiating a new lease at potentially less favourable terms or relocating the business, both of which could disrupt operations and incur unexpected costs.

Employee Entitlements

Employees often transition to the new business owner in a business sale. However, the seller remains responsible for any accrued employee entitlements up to the completion date. These entitlements include:

• Unpaid wages
• Annual leave
• Sick leave
• Long service leave
• Redundancy pay (if applicable)

These outstanding liabilities can significantly impact the purchase price. To ensure a smooth transition and avoid future disputes, both parties must clearly understand these financial obligations.

Ongoing Service Contracts

Businesses often rely on various service agreements to function smoothly. These contracts might cover essential services like:

• IT support
• Cleaning
• Security
• Equipment maintenance

The buyer needs to be aware of any ongoing service contracts and their terms, including:

• Contract duration
• Termination clauses
• Associated costs

Imagine a scenario where a business has an expensive, long-term IT support contract with unfavourable terms. This contract could become a financial burden for the buyer, potentially affecting the business’s profitability.

Calculating Adjustments for Outgoings

When a business is sold, the purchase price isn’t always a simple case of agreeing on a number. Outgoings, those essential expenses tied to running the business, need careful consideration to ensure fairness for both the buyer and seller.

Pro rata Calculations

Imagine a scenario where a business is sold halfway through a month. The seller, having already paid the entire month’s rent, shouldn’t be disadvantaged. This is where pro rata calculations come in. Adjustments for outgoings are typically calculated proportionally, based on the number of days the buyer will own the business after the completion date. This ensures that the buyer compensates the seller only for the period they benefit from these pre-paid expenses.

Negotiating Outgoings Adjustments

While pro rata calculations provide a framework, negotiating fair adjustments for outgoings is crucial. Both parties should engage in open communication, backed by accurate financial records. The seller should be prepared to provide documentation supporting their claimed outgoings. The buyer, on the other hand, should carefully review these records as part of their due diligence process to ensure accuracy and reasonableness.

Due Diligence and Outgoings

When purchasing a business, conducting thorough due diligence is crucial to understand its financial health and potential liabilities. This process involves examining various aspects of the business, including its outgoings. By carefully reviewing the seller’s financial records, buyers can gain a clear picture of the business’s expenses and make informed decisions about the purchase price.

Importance of Thorough Due Diligence

Due diligence is essential for buyers to assess the accuracy of the information provided by the seller and identify any potential red flags. This process helps mitigate risks associated with the acquisition. A comprehensive due diligence process should include a thorough review of the business’s outgoings. This involves examining expenses such as rent, utilities, salaries, insurance, and other operational costs. By understanding the business’s spending patterns, buyers can evaluate its profitability and sustainability.

Key Financial Documents to Review

To effectively assess outgoings, buyers should review key financial documents, including:

• Profit and Loss Statements: These statements provide a summary of the business’s revenues and expenses over a specific period, offering insights into its profitability.
• Balance Sheets: A balance sheet provides a snapshot of the business’s assets, liabilities, and equity at a specific point in time.
• Cash Flow Statements: These statements track the movement of cash both into and out of the business, providing a clear picture of its liquidity.
• Tax Returns: Examining tax returns helps verify the accuracy of the financial information provided and ensures the business is compliant with tax obligations.
• Vendor Contracts: Reviewing contracts with suppliers and service providers helps identify ongoing costs and potential liabilities.

Analysing these documents allows buyers to identify any inconsistencies or areas of concern related to outgoings. For instance, a sudden spike in expenses or unusually high operating costs could indicate potential financial risks. By uncovering such issues during due diligence, buyers can negotiate a fair purchase price or, if necessary, reconsider the acquisition.

Legal Considerations Related to Outgoings

Outgoings Clauses in the Sale Agreement

When purchasing a business, it’s crucial to understand that the initial “headline purchase price” often doesn’t reflect the final amount you’ll pay. Adjustments are frequently made to account for various outgoings, and these adjustments are typically detailed in specific clauses within the sale agreement. These clauses outline how outgoings will be handled, calculated, and ultimately impact the final purchase price. For example, a clause might specify that the buyer will reimburse the seller for prepaid rent or insurance covering a period after the completion date.

Warranties and Indemnities

Warranties and indemnities play a vital role in protecting buyers from undisclosed outgoings. A warranty is a statement made by the seller about the business, including its financial position and liabilities. If this statement proves false, the buyer may have legal recourse. An indemnity, on the other hand, is a promise by the seller to compensate the buyer for specific losses, including those arising from undisclosed outgoings. For instance, a seller might provide an indemnity to cover any outstanding tax implications not identified during due diligence. These legal mechanisms provide buyers with a degree of protection and recourse if unexpected outgoings emerge after the sale is finalised.

Conclusion

Understanding outgoings is a crucial aspect of both buying and selling a business. They can significantly influence the final purchase price and impact the financial health of the business post-sale. By carefully considering and negotiating outgoings, both buyers and sellers can ensure a fair and transparent transaction.

Seeking professional advice from accountants and lawyers is essential throughout the process. These experts can help navigate the complexities of outgoings, ensure accurate adjustments to the purchase price, and protect the interests of both parties involved in the sale.

Frequently Asked Questions