Friday, January 22, 2010

Buying a Small Business: Big Things You Need to Know

If you’re buying a business (any business: food cart, large manufacturing company, etc.) you need to know as much as you possibly can about it before signing on the dotted line. This is equally true for business questions (What’s the profit margin for each meal they sell? Is the factory close enough to rail lines?) as it is for legal ones, but for this article I’ll take a legal perspective. You might need to know things like:

Does the cart vendor pay the city rent for the space? Do they have a history of food safety violations? Are they in danger of losing their license?

Does the company have any potentially devastating environmental or litigation liabilities? Are they stuck with ineffective managers, each with a multi-year contract? Does the company have to lease rights to intellectual property? If so, how long is the contract for?

Does the seller even own the whole thing? If not, is she prohibited from selling you her shares?

And that’s just off the top of my head. The number of matters that can arise in a stock or interest transaction is staggering. Though it makes business sense to have your attorney negotiate these matters unencumbered, it is important to be aware of the most important issues in your transaction and how your attorney is handling them. While the delicate matters are likely to vary among transactions, some issues almost always find a way to become difficult, fragile, or especially important.

The first and most pervasive issue is that the buyer doesn’t want to be compelled to make the purchase if they learn something during due diligence that suddenly makes the business an unattractive target. On the other hand, the buyer wants to lock the seller in and prevent them from selling to another party while the buyer investigates the target company. As such, a document called a “Letter of Intent” is likely advisable.

The letter should have clearly delineated “binding” and “non-binding” sections. The terms of negotiation, including any break-up fee, will be in the binding section, and the proposed terms of the deal, such as price, price adjustment, method of payment, and expected ancillary agreements will be non-binding. Keeping payment terms non-binding through the course of negotiation generally benefits the buyer, as the information they learn during due diligence will more likely turn up ammo for a reduced price, not an inflated one.

Once the parties have signed a Letter of Intent, it’s time for the attorneys (and the accountants and bankers, if necessary) to begin the due diligence process in earnest. Due diligence can take a lot of time (and therefore a lot of money), so if your transaction is small and you’re on a budget (who isn’t?), you’ll want to make sure your attorney is focused on the key aspects of the deal. These key aspects could include:

Price Adjustment Clause. One cost-effective way to add value to a deal is to negotiate a price adjustment clause. This allows the buyer to mitigate their risk by adjusting the purchase price based on the business’ performance (based on profits, gross revenues, or any other measure) in the first few years of operation. Of course, the buyer will end up paying more for the business if it beats expectations, but if that happens then, hey, the business they bought is beating their expectations! By reducing buyers’ exposure to the financial risks of ownership, this type of clause may also allow buyers in certain situations to get away with a lesser due diligence effort.

Environmental and Other Compliance Issues. Over the course of many years in business, even good companies can become responsible, long after the transaction is complete, for an environmental cleanup or for fines imposed for failures to meet regulatory standards. The distribution of these potential liabilities could have a strong impact on the future vitality of the company and ultimately on the prudence of the buyer’s investment. Also to consider is the likelihood that the company would be less valuable but for its questionable regulatory practices. In this area as much as any other, reliable information is vital.

Accounts Receivable. If the business has a large amount of unpaid receivables, the buyer may wish to place the risk of non-payment on the seller. Unless the seller is ceasing to operate as a business, this can usually be accomplished by negotiating for the seller to retain some ownership of the receivables in exchange for a reduced purchase price. The beauty of the contract, in this regard, is that the parties can allocate their rights, risks, and rewards in any way they see fit: allocating accounts, sharing payments on a percentage basis, delineating or outsourcing collection duties, etc. The possibilities here are endless.

Contracts. If the business relies on contracts with a few high volume customers or suppliers, it is important that the buyer’s attorney review them to ensure their value, enforceability, and breadth. Otherwise, the buyer may be in store for the shock of paying for a business and receiving only its equipment and employees.

Indemnification and Escrow. Without indemnification or an escrow arrangement, the buyer has no recourse to recover from the seller for material deviations from the contract. The parties can arrange for a portion of the purchase price to be held in escrow, to remit to the buyer in the instance of negotiated contingencies and be released to the seller after a certain time period. For seller’s liabilities exceeding the escrow amount or occurring after the release of the escrow funds to the seller, the buyer should look to a negotiated indemnification clause to cover any losses due to the seller’s deviations from the contract or other losses sustained by the buyer (negotiated by the parties, of course). The buyer prefers to put as much of the purchase price into escrow as possible, as it is much easier to access funds owed from an escrow account than from an indemnifying seller.

Other Issues. Admittedly, these are just a handful of the endless number of issues a buyer may face in purchasing a business. These often include labor and employment concerns, intellectual property rights, insurance coverage, compliance with the IRS and state tax collectors, and real property rights. Indeed, I often sum up the business attorney’s job: think of everything, act accordingly.

With these issues in mind and a good, thorough attorney, you can be certain that at closing you’ll end up owning the business you wanted to buy. Otherwise, numerous hidden problems could have you swatting flies and putting out fires instead of focusing on your new business. This problem-oriented approach inevitably translates to big losses, even bigger headaches and, here’s the kicker, legal bills that would dwarf the expense of good representation up front.

This article first printed in the Autumn 2009 Madison Business Law Quarterly "Think of Everything, Act Accordingly."

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