Due Diligence When Buying a Small Business in Ontario

Due diligence is the checking you do between agreeing on a deal and closing it. You are testing what the seller has said about the business against documents, searches and the people who run it.

In a small business the records are often informal and the owner is the business. That makes the review more important, not less. What follows is a general guide to what buyers commonly check and what should make you pause.

Start with who the seller is and what they own

Anyone can search the Ontario Business Registry for basic information about a business. Ordering search products directly from the ministry costs $8 for a profile report, $3 for document copies and $26 for a certificate of status, and intermediaries may charge extra service fees.

Then search for registered security interests. Ontario's Personal Property Security Registration is a public database of registrations under the Personal Property Security Act and the Repair and Storage Liens Act, searched against an individual debtor, a business debtor or a motor vehicle, one transaction at a time. It does not cover real property. Run searches under the corporation's name and any trade names, and under the owner's name if the business is a sole proprietorship.

This matters because a buyer of a business's assets outside the ordinary course does not get the protection that ordinary-course buyers of goods receive. A lender's lien could still be attached to what you are buying unless it is discharged at closing.

Financial and tax records

• Financial statements and tax returns for several years, matched against bank statements.
• GST/HST filings and payroll remittance records.
• The sales and customer records behind the revenue the seller is claiming.
• A list of equipment, inventory and what is leased rather than owned.

How the deal is structured changes what you inherit. In a share purchase, the change in ownership does not affect the tax values of the corporation's assets, and buying shares is generally not subject to GST/HST. In an asset purchase, you may need your own business number and accounts.

If the seller is a spouse, common-law partner, a person under 18 or otherwise not at arm's length, the transferee-liability rules matter: the person receiving property can be jointly and severally liable for the transferor's tax debts, up to a cap. The same type of rule applies to unpaid GST/HST. Property transferred between separated spouses under a court order, judgment or written separation agreement is treated differently for the GST/HST rule.

Employees, WSIB and contracts

Ask for a list of employees, start dates, pay and written terms. If you employ the seller's people, their time with the seller counts for Employment Standards Act, 2000 purposes, including notice of termination and severance pay. An employee with at least three months of employment is entitled to notice or pay instead, from 1 week for under a year of service up to 8 weeks for 8 years or more. Severance pay can be owed where the employee has at least five years and the employer has a payroll of at least $2.5 million, up to 26 weeks.

On WSIB, when an employer sells or otherwise disposes of all or part of its business, the buyer is liable for amounts the employer owed under the Act just before the sale. The WSIB says asset buyers should get a purchase certificate, requested before the date of sale and valid for 30 days. It is issued only if the seller's account is in good standing, with amounts paid and reports filed, and not while an issue is under appeal.

Also read every key contract for clauses that end or change when ownership changes, and read the lease for assignment restrictions. If a lease bars assignment without consent, it is deemed to say consent cannot be unreasonably withheld, unless the lease expressly says otherwise.

Franchises need extra review

If the business is a franchise, the franchisor must give you a disclosure document at least 14 days before you sign or pay. It should include the franchisor's litigation history, financial statements, costs, proposed agreements, territory, supplier restrictions and a list of current and former franchisees. Call some of those franchisees. Exceptions exist, such as a resale by an existing franchisee that is not effected through the franchisor, so ask your lawyer whether disclosure applies.

Red flags that should change the deal

A red flag is a reason to renegotiate, add a protection to the agreement, or decide not to proceed. Put what you are relying on into the agreement as the seller's statements, and keep the right to leave if the checks fail.

What to do next

• Make your offer conditional on a satisfactory review period.
• Send the seller a written document request list.
• Run the registry and PPSR searches early.
• Have your accountant review the financials and tax filings.
• Ask your lawyer to turn each finding into a price change, condition or seller promise.

Frequently asked questions