A Worrells Canberra file illustrates the critical importance of getting both good legal and accounting advice before entering into any major business transaction.
SC Pty Limited was selling its training business so its directors could retire. They found an interested buyer who was a contractor to the business, MG, which incorporated a company called W Pty Limited.
W Pty Limited agreed to purchase the business from SC Pty Limited for $300,000. How the purchase price was calculated, is unknown.
The purchase price was fully vendor financed to be repaid in monthly instalments over a maximum of six years, with no interest. The vendor’s (SC Pty Limited) solicitors prepared a sale agreement and the purchaser (W Pty Limited) engaged a solicitor to review the agreement, which was subsequently executed by both parties.
Sounds reasonable – no upfront payment – six years to pay and no interest? There was only one major problem. The instalment payments to SC Pty Limited, were to be paid monthly based on 1/3 of the gross income generated by the purchaser in each preceding month.
While there was a six-month period before the first payment was due, and while the business was profitable, the after-tax profit was insufficient for W Pty Limited to meet its obligations of remitting 1/3 of its gross income to SC Pty Limited each month.
Over the next two years, the director of W Pty Limited used personal funds, increased the company’s bank overdraft, entered into a repayment arrangement with the Australian Taxation Office and even took a part-time job in an attempt to make the company meet its obligations under the vendor finance agreement.
After the company managed to pay approximately $100,000 (1/3 of the purchase price) to the vendor, the financial pressure finally got too much and the director sought advice from a different solicitor.
Unsurprisingly, the advice provided to the director was that the situation was unsustainable. Fortunately the director did not personally guarantee the company’s obligations under the vendor finance agreement. And as the company’s main assets were largely intangible, the director decided to place W Pty Limited into liquidation.
What can we learn from this?
While the director had a solicitor review the sale agreement for the legal aspects of the transaction, it appears the director did not seek any independent accounting advice for the price being paid, and the repayment structure. Obtaining this advice would have identified the potential problem with making repayments based on gross income, and therefore prevented the company from entering into the seemingly impossible.