Real Value of Due Diligence and Independent Advice.

The enemy within

It never ceases to amaze me how people can be so trusting when entering into a business transaction with someone they don’t know very well.

As part of small business management, it is usual when acquiring an asset that the director exercises a reasonable level of due diligence before committing to the transaction. Certainly, a high level of scrutiny is given to the purchase of such items as plant and equipment or stock. One can only wonder why a director would leap into a financial or structural change without the same degree of scepticism.

Recently, I encountered another example of a business that had been created with a potential significant time bomb lodged in the structure.

My clients were skilled construction individuals who had created a unique method of surface material application and decided to start their own business.

Lacking the acumen, advice and funding, they accidentally discussed the matter with an unknown third party, who decided to offer them start up finance. A company was duly formed and, on the advice of the accountant for the third party, a change in the constitution occurred.

This was a significant moment in the life and destiny of the business. The accountant made it clear that he was acting only in the interests of the third party investor, but for some inexplicable reason, this did not trigger a warning to the other two to seek independent advice.

As a result, a special class of shares was issued to the third party and highly restrictive voting powers imposed upon the two original shareholders. In fact, the third party forced a change to the constitution to the extent that, at any time, the third party could appoint himself as a director.

The two working directors, who had taken the majority of the business risk, were left having no real control over the company, could not seek out further or alternative funding and certainly could not complain about the management style of the third party.

Regardless of their predicament, they set about working hard in the business seven days a week; taking risky contracts with difficult time lines; employed and managed the staff; juggled cash flow; and somehow managed to repay the third party the principal and interest on time. To make matters worse, from the outset, the spouse of the third party shareholder had a registered first charge over all the assets and undertaking of the company pending receipt of the final payment of principal and interest.

Effectively, upon a minor or technical default, such as production of figures or reports, the spouse could have appointed a receiver at any time.

Eventually, the two original directors reached the end of the period of repayment and, due to the growth in the business and increasing complexity of financial management, they finally sought independent accounting advice. The accountant was surprised to find the change in voting rights and the registered charge had been orchestrated from the outset and gave the directors their first independent view of their position.

It came as a shock for them to understand that they could lose all that they worked for at any time and that, in fact, they at no stage really controlled the company.

No formal meetings were ever held and surprisingly, the third party sat back and let the principal and interest repayments come in without inquiring further.

The next stage of the relationship became critical. Now they had obtained this independent advice they were angry at the way that it had occurred, but understood all to well that now was not the time to incite an argument with the third party or his spouse as secured creditor.

Two crucial outcomes were sought:

  1.  To ensure that at the point that the loan was repaid in full, a release of charge would be provided in exchange; and
  2. At the same time, a change to the constitution would occur whereby the voting rights would become equal again.

You can well understand that they felt a little intimidated, calling a meeting to resolve the matter. On advice, they were open about the agenda for the meeting, the changes they were seeking and produced an independent valuation for the shares. They now realised that they were not guaranteed to free themselves of the existing shareholder with higher voting rights and that, as the company improved its financial position, so too did the value of the shares. The longer they waited to address the matter, the higher the exit price would become for the third party.

From an innocent first handshake discussion they had been outmanoeuvred carefully and had indeed helped create an enemy within.

The choices were:

  • Pay a premium on the shares; or
  • Liquidate the company and start again.

All the hard work could be undone in a matter of one moment of disagreement with the third party.

Thankfully, the share price reflected a very good capital gain for the third party and the element of risk for the future was enough to convince them to take a clean exit. The two original directors have learned a valuable lesson about business due diligence and they are addressing several other outstanding issues:

  • A formal shareholder’s agreement and a business succession plan, and
  • A review of their trading terms and conditions and the structure of their finance.

They have formal meetings which are recorded and copied to the accountant. The lesson is always the same: If it sounds too good to be true, it usually is.

ATC Digest Edition #75