10 Things to Look Out for When Buying a Business
If you're thinking about purchasing a business for sale, this legal expert tells you what you need to be wary of to protect your investment.
A reader sent in the following question recently in regards to buying a business:
"I've been working on and off with a local building contractor for 17 years. Last week he told me he's thinking about selling his business and asked if I'd be interested in making an offer. I did, and he accepted. Now what do I do?"
First off, get a good business lawyer and an accountant to help you with the paperwork, because even with a small business like this, there's going to be a ton of it. Frankly, it sounds like you should have asked lots of questions before you made your offer, but it's not too late since your deal with the seller is only a "handshake" at this point. Here are some things you should insist on--and be clear about--before you close on the deal:
Make sure you're buying the assets, not the business. If the seller is a corporation or LLC, under no circumstances should you buy stock in his business. Instead, offer to buy the assets of the business, and form a separate company to act as the purchaser. Why? Two reasons. First, you get a better tax treatment, since your "tax basis" in the assets will be the amount you paid for them, rather than the amount your seller paid for them long, long ago. Second, if he owes money to people or is being sued by someone, you won't assume any of those liabilities if you buy the assets.
Ask about sales taxes and payroll taxes. In many states, even if you buy a business's assets, the state tax authority can come after you if they find out the seller owed sales, use, payroll and other business taxes. If the seller has employees (other than himself), ask if he was using a payroll service, and make sure he's current in his employment tax payments. Then ask the state tax authority to issue a "clearance letter" saying the seller is current in his sales and use taxes on the closing date. This may take a while, but it'll save you tons of heartache down the road.
Determine who will deal with the accounts receivable. Chances are, some of the business's customers will owe the seller money on the closing date. Who will be responsible for collecting these overdue debts? There are only two ways to handle this: Either you purchase the accounts receivable at closing (for a discount, to reflect the fact that some of these folks won't pay up), or you let the seller collect them at his leisure. My vote is for you to buy the accounts receivable at closing--that way, if the delinquent customer wants additional work done after the closing, you're in a stronger bargaining position.
Find out if you can assume the seller's lease. Is the seller leasing the premises where he conducts his business? If so, you should find out (1) how much time remains on the lease term and (2) whether the landlord is willing to let you assume the seller's lease "as is," without an increase in rent. If the lease has less than two years to run, you might want to spend the money now to negotiate a new lease with a five- to 10-year term. Also find out if the landlord is holding a security deposit (usually two months' rent, but sometimes more). Your seller will probably want you to purchase his security deposit on top of the agreed-upon purchase price for the business assets. If the seller is including the security deposit in the purchase price, make sure that's spelled out in writing somewhere.
Are there prepaid expenses? Take Yellow Pages advertising, for example. When you buy a Yellow Pages ad, you normally pay for a whole year in advance. Chances are your closing will take place sometime during the year, and the seller will want to be reimbursed for the portion of the year when you're running the business and benefiting from the Yellow Pages ad. Prepaid expenses--like the seller's security deposit--usually aren't included in the agreed-upon purchase price but are tacked on at the closing. Ask the seller now for a list of "closing adjustments"--amounts the seller has prepaid that will have to be "pro rated"--so you can budget for them accordingly and there'll be no nasty surprises at the closing.
Negotiate a "letter of intent." Also called a "term sheet," a letter of intent (or LOI) is a short, two- or three-page agreement between the buyer and seller of a business that spells out all the important terms and conditions of the sale. For example, it will include the purchase price, how and when the purchase price will be paid, the assets that will be sold to the buyer (and those the seller will keep for his own use), the terms of the seller's noncompete agreement, and so forth.
While LOIs are technically not binding on the parties, it's well worth your time and effort to hammer out as many of the business issues involved in an LOI before the lawyers begin drafting the "definitive" legal contracts that will document the sale. A well-drafted LOI helps the lawyers get the sale documents right on the first (or possibly the second) draft, since most of the important terms and conditions will already have been dealt with in the LOI and aren't subject to further negotiation. Without a LOI, you'll end up negotiating the business deal and the "legalese" of the definitive documents at the same time, requiring multiple drafts of the sale documents and tons of money in legal fees.
Watch out for bulk sales laws. Most states have done away with these, but many states still require the buyer of a business to notify the seller's creditors that the transaction is going on. Failure to get a list of the seller's creditors and send "notices of sale" to them may give the seller's creditors a shot at undoing (or "rescinding") the transaction in order to prevent the seller's assets from being sold out from under them. Even if the seller has no creditors at all, which is a rare occurrence, the state tax authority generally wants a copy of the "bulk sales notice" so it can determine if the seller owes any sales, use or other business taxes. If the seller does, he'll have to pay them before the closing takes place.
Get an indemnity from the seller. Even if you and your advisors have torn apart the seller's books and records, sometimes things get overlooked and you find yourself getting sued because of something the seller did (or failed to do) before you took over the business. Get an indemnity from the seller, promising to defend the lawsuit and pay all judgments and fees if that should happen. Likewise, you should be prepared to give the seller an indemnity if he gets sued because of something you do--or fail to do--after the closing takes place.
Make sure the seller sticks around for a while. In many retail and service businesses, the customers have a personal as well as business relationship with the owner. Be sure the seller continues to make an appearance at the business for a few weeks after the closing to introduce you to customers, help you figure out the books and "ensure a smooth and orderly transition of the business." Consider paying the seller for his time so he has an incentive to stay off the golf course--at least until you're comfortable you know what you're doing.
Get to know the employees. Before you buy a business, make sure the "key employees" are willing to stick around, since they're often the ones who see the customers day to day, operate all the tricky machinery and know "where the bodies are buried." Many sellers will be reluctant to let their employees know the business is up for sale, for fear they'll quit en masse. In that case, put a provision in the sales contract that reads as follows: "Seller and Buyer will announce the proposed sale to all employees of the Business within forty-eight hours before the Closing, and Buyer will be given a reasonable opportunity to meet with each employee individually before the closing date to determine, to Buyer's reasonable satisfaction, the employee's willingness to continue working for the Business." Then add a provision allowing you to walk from the deal if you're not totally satisfied that the key employees will stay on board at least long enough for you to learn what they already know.
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