Here are the 10 things you must do before you buy a business or invest in a private entity that owns a business, to minimize the risk of a financial and legal nightmare, while maximizing the odds of a profitable opportunity:
1. Learn The Difference Between Buying Assets and Buying Equity, and Determine Which Is Right For You.
A business purchase can be structured as a purchase of the assets of the business or as a purchase of an ownership interest in the company that owns the business. There are important differences between these 2 alternatives for legal, tax and accounting purposes. For example, if you buy assets you are not responsible for the business' liabilities unless you specifically agree to assume them.
Sometimes it will be in your best interest to buy an ownership interest in the seller's company despite the fact that the liabilities will remain. However, there may be legal or contractual restrictions on your ability to do so. Only by reviewing all of the facts can you determine what considerations apply to your purchase, and ensure the deal is structured in the way that's best for you.
2. Identify The Assets That Are Included In The Purchase.
Each business consists of a variety of assets, tangible and intangible. A business may own or lease its assets or have the contractual right to use them.
Be sure you know which assets you have to get, which (if any) you can live without, and whether the business owns, leases or has contract rights in those assets. Then, make sure the contract gives you the assets you need.
3. Explore Seller Financing.
You can pay for a business purchase in many ways, using cash, property, stock, borrowed money, or other things of value. The method of payment can affect the total cost of the purchase and have important tax consequences for you (and the seller).
One method of payment that is often overlooked is seller financing. This can take several forms, from the seller's extending credit to you to his or her providing ongoing services to the business. If you present a properly structured incentive, often you can persuade a seller to agree to this type of arrangement and reduce the cash you need for closing.
4. Determine If the Purchase Is Right For You Before You Obligate Yourself to Close.
Obligating yourself to close a purchase before you have determined if the purchase makes sense and have gathered and thoroughly evaluated all relevant information is a recipe for financial and legal disaster.
How do you protect yourself? You negotiate for what is commonly known as a “due diligence" period in which you to investigate the seller and the business so you can make a sound decision to proceed with the deal or terminate it.
Make sure you know exactly what things need to happen during the due diligence period, and that the purchase agreement spells out in detail how and when these things will occur.
5. Get Written Assurances From The Seller.
As a buyer, you may perform a variety of investigations during your due diligence period. For example, you may review the seller's books and records, inspect the business premises and assets, speak to key employees, conduct studies or tests on real estate, and see what you can find out about the business from third parties.
But are you really getting all of the pertinent information? Have you overlooked something, or worse yet, has the seller misled or lied to you?
In most cases a seller has no legal obligation to tell you anything you don't discover for yourself. It’s “Buyer Beware!" If you miss something important and the seller didn’t mislead you or lie to you about it, it's your problem.
So how does a buyer flush out the existence of unknown negative information before closing, as well as confirm the results of his or her own investigations? By getting the seller to make representations and warranties in the purchase agreement about all of the key facts.
Written representations and warranties by the seller shift all or part of the risk of the buyer's non-discovery of important information to the seller by making the seller tell you what the facts are and what he or she knows about certain matters. If any representation or warranty is false or misleading, you'll have a much better case against the seller than you would have based only on your own investigations, or the seller's verbal statements.
How much of the risk of non-discovery is shifted to the seller depends on the representations and warranties that are included and exactly how they are worded. This is an extremely critical part of every negotiation for the purchase of a business. Without comprehensive representations and warranties covering all of the material facts, you don't really know what you are buying. Know what to ask for, know if you aren't getting it, and understand the risks you run if you close the deal anyway.
6. Identify the Circumstances Under Which You Can't or Shouldn't Close, and Obtain the Right to Terminate the Purchase Under Those Circumstances.
Unpredictable things can happen during the period between signing a purchase agreement and the closing date that make it impossible, unwise or even illegal to close. For example: (1) the bank turns down your loan application; (2) the business loses important customers or key personnel; (3) the law changes in a way that is bad for the business; (4) the landlord refuses to let you assume the lease unless the rent is raised substantially; (5) a government agency turn down your application for a license you need to conduct the business; (6) the business becomes embroiled in a big lawsuit; or (7) the premises are partially burned down.
You may be obligated under a purchase agreement to close the purchase, despite these events. This means that if you don't close, you could lose any deposit you made, owe the seller substantial damages, and face the monstrous cost and stress of litigation.
Don't let this happen to you. Identify every single condition that must be met before you are obligated to close, and get the right to terminate the deal if any condition is not met.
7. Protect Yourself and the Business From Actions The Seller Might Take Before the Closing.
Between the time you sign a purchase agreement and the time you close, the seller can do things that greatly harm the business. For example, the seller might: (1) borrow against or sell key business assets; (2) fire key employees; or (3) change his or her methods of doing business in a way that alienates customers, suppliers or employees.
Or, the seller can do things that considerably reduce the value of the ownership interest you are buying in the seller's company. For example, the seller might: (1) issue stock or sell equity in the company to other people, thereby reducing the percentage of the company you will own after the closing; or (2) change the company's organizational documents or operating agreement in a way that eliminates or decreases some or all of the rights you will get if you buy the ownership interest, while increasing some or all of the obligations you will have.
If you don't protect yourself, you may find that you've bought something very different from, and worth a lot less than, what you thought you were buying. Be sure the purchase agreement spells out what the seller must do, and what he may not do, before the closing.
8. Protect Yourself and The Business From Actions The Seller Might Take After the Closing.
Outside competitors won't be your only worry when you close your purchase. Unless you protect yourself, even the seller can take actions that seriously damage or even destroy your new investment.
How can you minimize the risk of suffering harm from the seller's actions? By finding out how you can legally restrict competition and protect confidential and proprietary information and trade secrets from actions the seller might take, and putting carefully worded provisions in the purchase agreement to protect you.
There are treacherous pitfalls for the unwary in the law governing competition and trade secrets. Find out your rights and don't let yourself be blind-sided.
9. Ensure the Business Has Good Title to Key Assets.
You don't want to find out for the first time, after the closing, that there is any doubt about or dispute over who has title to key assets, or that key assets are subject to liens in favor of creditors, or that key assets infringe on the rights of third parties. All of these matters damage or destroy the value of the assets and potentially expose you or the business to substantial liability and litigation costs.
Careful wording of the purchase agreement, thorough investigation and review of public information and records, and other steps can minimize or in some cases eliminate these risks.
10. Determine How To Resolve Disputes With the Seller.
All too often the buyer experiences a problem with the seller and can't resolve it amicably. What happens next depends on whether you had the foresight to plan the process for resolving disputes before you signed the purchase agreement.
Did you determine if you would be better off dealing with this problem in court or before an arbitrator? Or in a particular city? Or under the law of a particular state?
There is no "best way " to resolve disputes that works for every purchase situation. Each situation presents unique facts and requires individual analysis. Just make sure you anticipate all of the types of problems that may arise, choose the solution that is best for your situation, and spell it all out in the purchase agreement.
Some Final Thoughts
Buying a business or investing in a private company that owns a business is an complex undertaking, involving many issues that go beyond the scope of this article. This is especially true where there is also a purchase or lease of real estate, as is usually the case.
Consult with a seasoned business attorney who can analyze the specific facts of your transaction and give you advice that is tailor-made to fit your needs.