Avoiding Pitfalls When Buying and Selling a Business: Buyer’s Viewpoint (Part 2)
By Dave Thayer
Selling and buying businesses of any size are not decisions to be taken lightly. With the right amount of research, due diligence and reliance on experienced professionals, you can reduce the inherent risks involved in these types of business transactions. Part 2 in a two-part series, this article explores the common issues to consider from the buyer’s point of view.
As the buyer of a business, you may be investing a significant amount of your net worth and time into the new venture. Making sure that the business you are buying is not over-valued and is sustainable post-closing is essential.
The trail of business sales gone bad is littered with buyer missteps. Some examples include:
• Supply chain debts. A buyer of a business discovered after closing that the seller owed an indispensable supplier a significant amount of money. Even though the transaction was structured as an asset sale and the buyer was legally not obligated to pay this debt, the supplier refused to sell product to the buyer until the seller’s account was paid off.
• Seasonality, one-time or infrequent sales spikes. A buyer of a roofing company was surprised and dismayed when revenues after closing were 50% off from the seller’s financial statements. The buyer discovered too late that there had been a wide-spread and damaging hailstorm in the previous summer that had spiked financial results.
• Sales promotions in lead up to transaction. A buyer of a restaurant was shocked when revenues plummeted compared to the revenues reported by the seller, even though there were no changes in chefs, staff or menu after closing. The buyer later discovered that the seller had performed a massive coupon promotion prior to the sale, which drove up revenues and inflated the purchase price.
Proactively work through the following common issues to keep your transaction on track.
Due diligence is integral
It’s essential that sellers and buyers critically evaluate a proposed sale or purchase of a business to avoid these missteps. This includes performing comprehensive due diligence on the seller and its business to reduce the risk that the financial and operational status of the business is materially and adversely different from what is represented. Examples of due diligence matters that buyers should consider include:
• Background checks, such as UCC searches, credit reports and criminal record searches.
• A detailed and skeptical review of financial statements and revenue numbers.
• Confirm any loan and account balances with banks and other lenders.
• Check the status with important suppliers: Is the seller in good standing with these suppliers? Is the seller current on payments owed to primary suppliers?
• Confirm employee relations. Much can be determined about the financial health and goodwill of a business by assessing the seller’s relationship with its employees.
• Discuss all lawsuits in which the seller has been involved, past and present, and determine if any material threats are being alleged against the seller.
Is the owner key to the business?
Is the business you’re seeking to buy named after the owner? Has the owner been key to attracting business all these years – and is the owner the only one with the required knowledge or a unique skill set needed to operate the business? If yes, once he or she is gone so too could go the credibility and customer base of the business.
Similarly, if there is a key employee that customers are used to dealing with–this could be a significant advantage during the transition of ownership–consider making sure that the key employee knows his or her job is not in jeopardy. Depending on the importance of a key employee, you may want to consider entering into an employment or consulting agreement with the key employee, and even make that a condition to the closing of the transaction.
Include non-compete provisions
Requiring the seller (and its owners if the business is operated through an entity) to directly and indirectly agree to non-compete provisions is essential in protecting buyers of businesses. Non-solicitation provisions generally bar sellers and their affiliates for a specified number of months after closing from soliciting the employees of the business being bought.
Assess legal, tax and accounting consequences
Sales of private businesses are typically structured as either asset sales or stock sales. Most private businesses are owned and operated through some type of entity, such as a corporation or limited liability company.
Buyers generally favor asset purchases to avoid winding up with liabilities of the entity which may or may not have been known to the seller. In an asset sale, the buyer of the business purchases substantially all assets used in the business along with the associated goodwill but does not purchase the entity itself. The purchase agreement should specify how the purchase price is allocated among the assets being purchased (e.g., allocating among equipment and fixtures, inventory, customer lists, business goodwill and, in some cases, post-closing consulting services) to avoid serious income tax consequences for both the buyer and seller.
Navigate transition issues
Often during negotiations, relationships between the parties can become strained and buyers may want to make a clean break with the seller after closing. But it can be difficult to take over a business without some type of transition assistance from the seller and key employees.
During purchase negotiations, lock in the efforts of individuals who are critical to transition success and business continuity. When an owner who is key to attracting business, or holds the required knowledge or skill set to operate the business, or is the namesake of the business, departs too abruptly, the credibility and customer base of the business could suffer.
Prior to closing, the buyer and seller should define the scope and terms of any transition help. This includes the number of hours the seller will devote during the term, the length of the term, and whether such services are part of the purchase price of the business or additional compensation will be paid to the seller for these services.
Don’t over-extend or go it alone
In buying a business, you will likely be making a material financial and time investment in the target business. Performing detailed financial analysis is a must in order to determine whether the purchase is financially feasible and advisable.
Don’t let your emotional enthusiasm for a target business override savvy and objective financial decision-making. Few buyers have the bandwidth and experience to handle the full spectrum of legal, tax and accounting complexities in buying a business. An experienced transactional attorney, CPA, and other professionals can form an invaluable team to assist you in purchasing a business and protecting your interests.
This is part two of a two-part series on mitigating the risks associated with business transactions. For part one, click here.
David A. Thayer, Esq., is a corporate and transaction attorney, and former CPA, that focuses on being a deal maker, not a deal breaker, as he helps clients achieve their business dreams. He can be reached at email@example.com.
THIS INFORMATION IS NOT INTENDED AS LEGAL ADVICE. SEEK SPECIFIC LEGAL ADVICE BEFORE ACTING.