Recently I’ve walked clients through buying or selling a business. My concerns are obviously different depending whether I’m representing the buyer or the seller, but there is a fundamental difference between the types of agreements used in these transactions, and fundamental misunderstandings I can clear up.
Often, a prospective buyer will tell me all about how wonderful the business is, how delightful the owners are, and just bubble over with enthusiasm about the revenue the business has been generating. My next question is: “Is it an asset purchase or a stock purchase?” Because that’s legalese, let me explain.
Think of a wardrobe you’re considering buying. Not a bunch of articles of clothing, but an actual piece of furniture. Would you prefer to buy the whole thing, site unseen, and sort through it later? Or would you prefer to open the doors and pick and choose only the pieces you really like?
An asset purchase is sort of like an open closet. The buyer has an opportunity to browse the entire closet and cherry-pick only the good stuff – the assets – of the business, leaving behind all or most of the nasty liabilities which stick like glue to the seller. The buyer will usually form a new entity to hold those assets and continue the business with the “good stuff.” This is the safest approach.
A stock purchase is sort of like buying a closed closet. While you can take a look inside, to get an idea of what you’re buying, the seller might not tell you about the dead roach in the dark corner in the back, or about the giant hole moths have eaten in the Chanel suit. You have to buy the whole closet – the roach, the holey sweater, even those acid-washed bellbottom jeans that make your butt look big. In a stock purchase, the buyer simply steps into the shoes of the seller and takes on almost all the liabilities of the seller. This is, for obvious reasons, the riskier of the two approaches. The seller doesn’t always disclose all the roaches in the corner, and often not maliciously. If you buy a business that’s been operating for several years, it’s feasible the seller entered into some agreement or signed some contract they’ve since forgotten about. Sometimes, however, the seller’s failure to disclose the warts in their business is malicious, and that’s why due diligence is so crucial.
I could tell horror stories on this topic long into next Fashion Week, but I’ll give you some snippets of a few recent ones that have walked in the door.
First, a couple that’s wanted nothing more in life than to own a restaurant buys one. Before the deal is technically closed, they start operating it. Despite the seller verbally pinky-swearing that there were no problems with the equipment, vendors, or taxes, the couple quickly discovered the boiler isn’t working, several vendors are owed money, and the seller is $40,000 in arrears in state taxes. Luckily, they used an escrow company and their asset purchase agreement contained a provision that prevented the escrow company from releasing their deposit to the seller until the deal closed. Well, the deal couldn’t “close” until the tax account was brought current, so the buyers managed to, after a court battle, get their deposit back. They still lost the money they spent trying to make the repairs and bring the accounts current, and paying me to fight for their deposit, but they didn’t have to pay the sizable remainder of the purchase price. Technically a win but certainly didn’t feel like one.
Second, a client who actually consulted with me before she bought this business (but decided not to hire me or any other lawyer) just discovered that the seller had falsified the copy of the tax return provided to the buyer and upon which the buyer based her offer to purchase, inflating the annual revenue of the company to the tune of almost $200,000. The seller had actually refused to allow the buyer access to the Quickbooks file, which was a huge red flag the buyer ignored. Now, the seller is redirecting customer payments from the buyer’s business into the old company account which still bears the same name (because the boilerplate agreement they signed didn’t include the name of the company as an asset).
Third and finally (because my blood pressure is spiking just thinking about these deals), a woman buys a nail salon in a stock purchase. Because English is not her first language, she isn’t able to carefully read the lease agreement, nor does she hire anyone to help. Months down the road, her landlord begins evicting everyone in the shopping center, decimating the foot traffic that’s the lifeblood of her business, and her CAMs begin to skyrocket. When she finally hires someone (me) to review her lease agreement to determine whether she has an out, or whether she should file bankruptcy on the business, I discover a personal guaranty she’d signed. It was buried in the fifth amendment to the lease agreement. “I didn’t read it!” she exclaims. And I had to deliver the bad news that not reading something you’ve signed is not a defense.
So, in order to avoid becoming a business law horror story, if you’re the buyer, hire a business attorney before you sign anything, even a letter of intent. Make sure you have a financial professional like a CPA or CFO review the books for discrepancies, and ensure that your deal has contingencies to protect yourself. Ideally, use an escrow company just like you do when you buy a house, because escrow companies have better ways of searching for dead roaches than even attorneys do. With that team in your corner, you’re doing the best you can to make sure you know what’s in the closet.
If you’re the seller, make sure you have an attorney review your listing agreement and draw up your purchase documents to ensure you sell what you intend to sell and nothing more.
Buying or selling a business is a significant life event, right up there with marriage and divorce, so spend the money to make sure it’s done right. I can almost guarantee that any fees you pay an attorney are a fraction of what you’re paying or receiving in the purchase price, and is well worth the peace of mind.