Starting a Business by Buying an Insolvent Business
When it comes to starting a business, the options are endless. There is not just a single way to become an entrepreneur and building a successful business doesn’t always involve starting from scratch. In fact, the high number of failing businesses can offer entrepreneurial minds the option of buying a failing business and turning it around.
This guide will look at what insolvency is and what options exist to buy an insolvent business. We’ll also look at the benefits and risks associated with buying an insolvent business and provide you with tips for taking an efficient approach to starting a business by buying an insolvent business.
WHAT IS INSOLVENCY?
Starting a business is never a trouble-free task to accomplish and it can be especially challenging when you buy an insolvent business. Therefore, you need to understand what an insolvent business is, as well as grasp the full process before you venture on this path to entrepreneurship.
Investopedia’s definition of insolvency states,
“When an individual or organisation can no longer meet its financial obligations with its lenders as debts become due”
Under those circumstances, insolvency proceedings are started. This process involves legal actions against the insolvent entity, individual or business, and the entity’s assets could be liquidated in order to pay off any outstanding debt.
During the process, the entity will strike informal arrangements with creditors, which often means alternative payment arrangements.
Entities could find themselves faced with insolvency in a number of ways. Often, the business suffers from poor management, which has led to cash problems, either as cash inflow slows or cash expenses increase.
The process of insolvency
Furthermore, the entity isn’t able to simply announce insolvency. Before an entity is declared insolvent, it has to be tested to certify it can’t deal with its debts. The test often involves:
- The cash flow test, which measures whether the entity’s current and future debts cannot be paid as they fall due.
- The balance sheet test, which measures whether the entity’s assets are less than its liabilities. The test accounts both the present and future liabilities.
The final declaration involves a court ruling, which begins the process of insolvency. It is important to note, insolvency procedure can start at the request of the business director, the shareholders, current creditors or the court.
The process will involve an appointed person, who’ll need to be licensed to carry out insolvency procedure, and they will take control of the business. The legal name of the person varies from country to country. The person is often referred to as the ‘Administrator’ or ‘Insolvency Practitioner’.
An insolvent company can undergo three routes.
- Administrative receivership
The difference of insolvency and bankruptcy
The most common misunderstanding around insolvency involves a mix up with another similar term, “bankruptcy”. There’s a tendency to assume these two terms are interchangeable.
In fact, the terms have a different meaning. The difference between insolvency and bankruptcy is that:
- Insolvency is a financial state of being – the inability to pay off debts, while,
- Bankruptcy is the process that resolves the issue of insolvency – the legal declaration of the inability to pay debt.
Therefore, declaring bankruptcy can solve insolvency, but there are other routes to follow as well. One of these, which involves the selling of the insolvent business.
Where to buy an insolvent business?
Running a business is not easy and the changing economic circumstances can challenge even the cleverest entrepreneurs. As mentioned, inefficient management often causes insolvency, but failure of management isn’t the only reason behind financial problems.
Nonetheless, there are thousands of businesses each year facing insolvency. While insolvency can be the end of an era for some, insolvent businesses can offer opportunities for other business-minded people.
Finding an insolvent business will require proper planning and searching. Whilst choosing the right business can take additional time, finding a selection of insolvent businesses shouldn’t be too difficult.
You can find insolvent businesses simply by doing an Internet search. You can use search terms such as “Insolvent business”, “failed companies” and “businesses in administration”. You could even contact legal firms, which handle insolvencies, directly. For example, Grant Thornton and BegbiesTraynor are accountancy firms that could help you find a selection of insolvent businesses.
Finally, in some instances, people simply buy an insolvent business they have been personally involved with. You might be working in a company that’s facing financial hardships and you feel better equipped to manage the business.
Check with your local business service and legal services to find out more about the opportunities around your area. Since the process can be quite demanding, it’s advisable to consult a lawyer with expertise on insolvent companies.
THE BENEFITS AND RISKS OF BUYING AN INSOLVENT BUSINESS
Similar to any method of starting a business, buying an insolvent business has its advantages and disadvantages. Understanding the benefits, together with the risks, can help during the purchase proceedings and guarantee you are prepared for the process.
The benefits of buying an insolvent business
First, the biggest benefit is all about the cost of starting a business. Buying an insolvent business, a business that is in financial difficulties, is naturally cheaper than trying to purchase a business, which is performing efficiently.
Furthermore, it can be cheaper to starting from scratch. An insolvent company will have benefits such as existing customer base, acquired assets and so on. These can all finish boosting your chances of success, as you won’t necessarily need to spend much initial capital on them.
The administrators are already hoping to get the business to new hands, either by selling it off or liquidating its assets, and therefore, your approaches to buy will generally be met with enthusiasm. The process of buying, while involving plenty of paperwork and legal procedures, will typically be swift, as the administrators don’t want to hold on to these companies for too long.
Furthermore, there are certain situations that make buying an insolvent company even more beneficial. For example, if you are buying from an insolvency administrator then the old liabilities are often left with the insolvent debtor. Therefore, you don’t always need to worry about the liabilities, but can start relatively afresh.
The risks of buying an insolvent business
Whilst buying an insolvent company can seem cheaper compared to starting from scratch, there are certain significant risks involved with the process. Although you can limit these risks by approaching the process with due diligence, you need to understand the risks fully before committing to the process.
Firstly, you need to keep in mind the fact that you are essentially buying a failing business. This means you cannot guarantee your approach will solve these issues. Furthermore, it adds the financial risk layer to the equation. Depending on the deal, you might be liable to pay off certain aspects of the business, which could hurt your short-term gains.
The administrators are expecting for immediate credit payment in most cases. Therefore, you don’t often have the luxury of searching for further investment or loans. You must be able to pay your share as soon as you start.
Furthermore, you need to be aware of which parts of the business asset and liabilities are transferred to you. For example, the majority of insolvent companies require the new owner the responsibility of controlling the existing employment contracts. This means you won’t be able to simply lay off staff immediately or you might have employees in your company, which were partly behind the downfall of the previous business.
Many of these risks can boil down to not having enough time to conduct proper checks. As mentioned above, insolvency process involves very short timeline and decisions need to be made relatively swiftly. This increases the risk factors, as you might not have enough time to carefully weigh in every aspect of the business.
THE BEST APPROACH TO BUYING AN INSOLVENT BUSINESS
Since time is of the essence when you are considering buying an insolvent business, you need to approach the process with the right mind-set and game plan. Starting a business by buying an insolvent business will involve plenty of quick thinking and research, but the following steps will help you deal with the process correctly.
Consider the timing
The first aspect is all about the timing. The process of insolvency tends to be swift and if you are aiming for the best deal, you need to be able to act quickly. Therefore, you must have made the decision to buy and narrowed down the type of business you are thinking of buying before you begin searching. Once you find a promising company, you won’t have time to start thinking whether you are ready to buy or not.
Waiting for a long time can also increase the risk of the company deteriorating further. If the business remains in the hands of the insolvency practitioner for long, it will cause nervousness and jitters among employees, debtors and even creditors. Therefore, not only can the business suffer further damage, the deal might be financially less rewarding for you, as the buyer.
You should approach the insolvency process with a clear set of goals and objectives to ensure you quickly identify the business you need to buy. Furthermore, any legal paperwork from your side should be ready, or available within days, once you begin your search.
In addition, you must also be aware of the process used in the case of the business you are thinking of buying. As mentioned in the section explaining the processes of insolvency, each process can impact on the kind of sale available.
- When the company is in liquidation or administration, the directors of the business won’t have much say and the insolvency practitioner has the power to negotiate and conclude a sale.
- If the business is in administrative receivership, the insolvency practitioner won’t have the authority to pay your unsecured creditors.
Consider carefully what process appeals to you and which offers you the most advantages. Make sure you understand the legal definition of each process and the way it influences what your rights and responsibilities are.
Understand what is included in the sale
When you’ve identified an insolvent business in a desired insolvency process, you must check what is included in the sale. This includes understanding the three key areas of:
- Liabilities – these include anything from financial liabilities to contractual liabilities. For example, you want to check whether you are required to continue working with the same third party operators and for how long.
- Warranties – the lack of warranties can be a big risk when buying an insolvent business. You generally won’t receive many warranties from the administrator. Therefore, proper due diligence, which is discussed later, is crucial.
- Assets – depending on the insolvency process and the business, you might have limited access to assets. You need to check all of the assets, not just financial assets, and create an appropriate list of what is part of the sale. For example, you might not be entitled to the business premises, but just the equipment within the premise and so on.
When it comes to understanding the liabilities and assets, employee contracts can be among the most important. It can add a financial burden to your new business, if the contracts are directly transferred to your new business. On the other hand, if the employment contracts cease to exist immediately after the sale, you need to have a plan to hire new employees.
Overall, you should check each asset and liability carefully and notice what other responsibilities, financial or otherwise, it might bring to your business. For example, if the business property is included in the sale, you want to check whether you are able to sell it at some point and whether certain liabilities come with the property.
Check what happens to the company name
Whilst it’s easier to remember to check tangible assets such as the business premises or employment contracts, you also need to pay attention to intellectual property. Most importantly, you need to ensure you understand the rules around the company name.
Overall, the ability to use the name depends closely on country-specific legislation. In many instances, the use of an insolvent company name is unavailable, unless one or more of the limited available exceptions apply. For example, in the United Kingdom, the Insolvency Act 1986 restricts the re-use of an insolvent company.
Furthermore, if a number of the insolvent company’s directors continue to work at your business, the law could impose fees on them for improper use of the name. Therefore, you want to make sure you understand whether you can continue to trade under the company name and under which circumstance.
Undergo proper due diligence
Due diligence can be hard to conduct when you don’t have much extra time on your hands. Nevertheless, you shouldn’t forget about the usual checks you need to make in order to start a new business.
When it comes to buying a business, whether it is an insolvent business or not, three aspects of due diligence require your attention. These are:
- Legal due diligence – this clears most of the points discussed above. It deals with the legality of the sale and addresses all of the litigation and regulatory issues you might have.
- Financial due diligence – since you are dealing with a company in financial difficulty, you want to understand what parts of the finances led to the failure. Make sure you understand the liabilities that may transfer to you, while also focusing on the finances that worked and didn’t work in the business.
- Commercial due diligence – it is crucial to understand what type of market is available for the business, while also mapping out the competition. You must be able to identify the market share you can aim for and pay attention to the problems the company might have had in the sector.
Make sure you are aware of all the responsibilities you have after the business is transferred to you. This might include legal paperwork to ensure you have the rights to do business; for example, if the business operates in the food industry, you would need special paperwork. But also in terms of the employees and previous clients. You don’t want to have any surprises as you start building up the business.
Construct a plan to turn the business around
Finally, you should always approach the process with a proper plan for once you acquire the company. Essentially, you can’t start a business by buying an insolvent business without a proper business plan in place.
An efficient plan is especially important in cases of acquiring an insolvent business. When you are faced with a company that has already failed, you need to know how to avoid the previous management did. Therefore, take time to understand what happened in the business and the decisions and routes that led to its downfall.
You are likely going to implement some changes to the way the business operates. Some of these ideas you might have prepared before you start searching for the company. Even if you are buying an insolvent business, you shouldn’t shy away from implementing your own vision.
Additionally, you’ll learn more about the specific business as you research it and conduct due diligence. Make sure you implement these findings in your business plan as well. Some aspects of the business are unlikely going to be broken and it can be sensible to take advantage of things that work in the business.
If you’ve found during the due diligence that previous contracts will dissolve, you need to check with the third parties whether they’d be willing to continue working with you. Understanding what your client and subcontractor base consists of after the sale can be the key to success.
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