What You Should Know When Buying a Business
We get it – as a buyer you’re already shelling out money to buy the business and don’t want to shell out additional money to pay an attorney to walk you through the process, especially when the escrow company or broker is nice enough to give you a form purchase agreement to use.
Stop. Right. There.
First, it’s unlikely either the escrow company or the broker is also a law firm, therefore they shouldn’t be providing contracts in the first place. Second, they are probably not representing YOU so they aren’t looking out for YOUR best interests. They just want the deal to close so they get paid their commission or their escrow fees or whatever. That’s why you need someone representing your interests because there are a ton of pitfalls to avoid when buying a business. Let’s walk through the process.
Okay, you find a business you might want to buy. You might find this business through a listing, word of mouth, through a broker, etc. Now, given that you don’t own the business, you aren’t privy to all the information about the business that would help you make an informed decision. Consider the TV show Storage Wars. If you haven’t watched it, the format goes like this: a storage unit place (what are they even called?) will, after a customer stops paying, take ownership of the contents in the storage unit and sell them off. In the TV show, a group of people gather at the storage unit place (again, there’s got to be a term for that) and the owner of the SUP (I give up) will open the door to the unit to waiting bidders. At that point, the bidders have only a short amount of time to decide whether they want to buy everything in the unit and the bidding begins, with the entire contents of the unit going to the highest bidder.
Note that the buyers haven’t had the luxury of sifting through the contents of the storage unit; they have to decide whether to bid based only on what they see when the door is opened. They might get lucky and find a vintage motorcycle in the back, or there might be a rat-infested couch that should be set on fire. The buyer won’t know until AFTER they buy the unit. That grab-bag approach is akin to a stock purchase agreement, where you, as the buyer, purchase basically the entire company, warts and all. In an asset purchase, you as the buyer get to cherry-pick what you want out of the company. For reasons that are hopefully obvious, a seller often likes the idea of a stock purchase because they can wash their hands of the business in one fell swoop. The buyer, on the other hand, usually prefers an asset purchase because you buy only what you want and leave the rest behind.
Let’s get back to the business buying process. Once you’ve identified a business you might be interested in buying, you will typically present the seller with what’s called a Letter of Intent (LOI). In the LOI, you’re basically saying “hey, seller, I think I might want to buy your business for approximately $X but need to know more. So, I’d like you to share information with me you wouldn’t otherwise share with an outside party, take the business off the market for a period of time, and cooperate with me while I conduct my investigation to see if I really want to go through with the purchase.” Most of the terms in an LOI are non-binding, but don’t let that trick you into thinking that ALL the terms are non-binding.
If the seller accepts the LOI, then you either start a process called due diligence or you start work on the purchase agreement. If you are borrowing money to make this purchase, you’ll have to supply the bank with a copy of an executed purchase agreement. If you aren’t, then the signing of the LOI is often immediately followed by due diligence.
During this time, you request all sorts of information from the seller. We have a very long due diligence checklist we share with our clients that includes everything from licensing information to payroll records, contracts, lease agreements, etc. You want to request any and all information you need to decide whether this business is a good investment. This is definitely where a CPA brings a ton of value because a CPA can quickly look at tax returns or financial statements and assess the profitability of the business. Lawyers are no slouches either, because we can analyze the contracts to determine whether the value of the business will continue and what other steps need to be taken to get the purchase done.
Because I JUST had to explain this to someone, the lease for the business location is NOT an asset of the company and DOESN’T transfer, automatically, to the buyer. In fact, the lease is probably the first thing I tackle when I get a new client looking to buy OR sell because 99.9% of the time, transfer of the lease to someone else requires the landlord’s written permission and landlords are often inconvenienced by the prospect of having to vet a new tenant and therefore don’t respond quickly.
Also, if the business is a franchise, you will need permission from the franchisor to own the business. The franchisor did a whole bunch of its own due diligence when deciding whether to sell a franchise to the seller, and they’ll do the same to you as the buyer. You can’t just buy a McDonald’s without McDonald’s corporate headquarters signing off on the deal.
Back to the purchase agreement (PA). In the PA, the seller will make “representations and warranties” that basically confirm that certain things about the business are true – the company is not the subject of any litigation, the company has the required authority to sell to you, the person signing on behalf of the company has the company’s permission to do so, the information contained in the documents disclosed in due diligence are true and correct, and more. I highlighted that one because the same caller that thought a lease was an asset also thought that the seller’s verbal claim that the business made way more money than it really did was grounds for him to get his money back. Unfortunately, that verbal claim did not make it into the final purchase agreement (which was actually not a proper purchase agreement but a CYA for the escrow company that only outlined its obligations to hold and then disburse the purchase price). See above comment about needing someone to watch out for YOUR interests.
While this particular buyer might have a claim for fraud because he wouldn’t have entered into the agreement were it not for the seller making that revenue claim, it’s a steep hill to climb, and likely requires litigation, which is profoundly expensive and takes a very long time. The whole “the seller didn’t give us his financials” is not an argument either. As buyer, if you failed to request those financials, or if you decided to go through with the purchase without having seen the financials, that’s your fault. Speaking of, head over here for details on state tax liability.
As a buyer, it is IMPERATIVE that you request information from the seller. It is crucial that you enlist the help of advisors (CPAs and lawyers, mostly) who can review that information. And it is downright foolish to try to handle one of these transactions without someone looking out for your interests only unless you have so much money that you could set fire to the purchase price and not blink an eye.