The Basics of Buying a Business
Know what you're getting into.
March 1, 2013
Anyone who considers buying a business should investigate it carefully enough to arrive at a sensible valuation. Prospective buyers should seek professional advice with regard to legal due diligence, documenting the purchase, and tax issues.
A business purchase can take two basic forms: an entity purchase or asset purchase. In an entity purchase, the purchaser buys the corporate stock or limited liability company’s (LLC) certificates. By buying the entity, the purchaser indirectly owns the assets and assumes responsibility for its liabilities.
Alternatively, the buyer can purchase the entity’s assets. In an asset purchase, the seller retains ownership of the entity, which receives compensation for the asset and remains responsible for the liabilities. To avoid unlimited personal liability, asset purchasers should form their own entity to hold the assets.
Most buyers do not pay all cash. Most deals are installment sales. Buyers make a down payment and execute a promissory note for the balance of the price. The note sets out a payment schedule and rate of interest. There is a risk that a buyer could default on the note. The business might fail, management might be incompetent, or the new owner might have poor credit.
Among the things a seller can do to reduce risk are (a) negotiate a substantial down payment to ensure that the buyer has a vested interest; (b) require a co-signor; (c) maintain a security interest in the assets giving the seller repossession rights; (d) (in an entity purchase) require that the entity’s ownership certificates be held in escrow until the note is paid off; (e) negotiate the right to take back the lease; and (f) require the buyer to maintain term life insurance to cover the note balance.
Prospective buyers should perform business and legal due diligence. Business contracts may contain especially favorable or unfavorable terms, but they may also contain a change in control provision that terminates the contracts upon change in ownership. The buyer may not be able to renegotiate favorable terms. In an installment sale, where parties will have a continuing relationship, they should investigate one another’s creditworthiness.
In an asset purchase, the buyer will seek the seller’s assurance that there are no liens on the asset, but the buyer should verify this through a UCC search in the public records. If a lien exists, the purchaser should insist that the seller pay it off. Buyers should be aware of many types of liabilities including (1) bank loans, (2) trade credit owed to vendors, (3) contract obligations, (4) court judgments, (5) pending lawsuits or regulatory actions, (6) IRS tax liens, and (7) property tax liens.
Some businesses, such as manufacturing, are subject to successor liability. Toxic wastes (chemicals, heavy metals, asbestos) may have leaked, been dispersed, or been dumped contaminating the structure, soil, water, and air. The buyer may be responsible for remediation, or clean-up, costs that could bankrupt the company. Sellers may agree to remain responsible for some liabilities, but if a seller goes bankrupt or can’t afford to defend a lawsuit or pay a verdict, the promise is worthless. This is an important issue that must be addressed.
In businesses with the potential for environmental liability, buyers may request that the seller commission an environmental study. In a Phase I study, a specialist researches the site’s history and past uses. If a Phase II study is warranted, chemists and engineers test the structure, soil, air and water to determine if pollution is present.
When negotiations become serious, some parties sign a nonbinding letter of intent so they can inform other interested parties. Among other things, the letter will state the form of the transaction, price, payment terms, responsibility for liabilities, terms to be negotiated, and a target closing date. Because the letter is nonbinding, it is still possible that the deal won’t close, but the letter can provide a road map enhancing the likelihood of an agreement.
Editor’s note: This column does not constitute legal advice.