Every buyer of a small business should consider the following three key legal issues when acquiring a business.
1. Buy Assets and Not Liabilities. Most small business purchases are done as what are called “Asset Purchases”. In an Asset Purchase the buyer of the business acquires the assets of the business only. The assets include the goodwill, name, equipment, supplies, inventory, customers, etc. According to the terms of a properly drafted Asset Purchase Agreement, the assets do not include the prior owner’s business liabilities (the known or unknown). Under an Asset Purchase the buyer typically establishes a new company which will operate the business. This new company is free from the prior company’s liabilities and actions. A “Stock Purchase” on the other hand occurs when the buyer acquires the stock or LLC units of the existing business. There are a few downsides to acquiring a business under a stock purchase. First, if you buy the stock or units of an existing company then you get the existing assets AND the existing liabilities of the acquired company. Since a new buyer hasn’t operated the business it is impossible for them to accurately quantify the existing liabilities. The second downside to a Stock Purchase is that the new owner of the company takes the current tax position of the departing owner when it comes to writing off equipment and other items in the company at the time of purchase. The downside to this is that the seller of the business may have already fully written off these items leaving the new business owner with little business assets to depreciate (despite a significant financial investment). If, on the other hand, the buyer acquired the “assets” in an Asset Purchase the buyer would depreciate and expense those assets as the new business owner chooses and in the most aggressive manner possible. Bottom line, an Asset Purchase has less liability risk and has better tax benefits that will allow the buyer to generate better tax write-offs and deductions over the life of the business.
2. Negotiate For Some Seller Financed Terms. Many small business purchases include some form of seller financed terms whereby the seller agrees to be paid a portion of the purchase price over time via a promissory note. Seller financing terms are excellent for the buyer because they keep the seller interested and motivated in the buyer’s success since business failure typically means that the buyer wont be able to fully pay the seller. If the seller gets all of their money at closing then the seller is typically less interested in helping transition the business to the new owner as the seller has already been paid in full. Also, if the seller misrepresented something in the business during the sale that results in financial loss to the buyer, the buyer can offset the loss or costs incurred by amounts the buyer owes the seller on the note. In sum, the seller financed note gives the buyer some leverage to make sure the value in the business is properly and fairly transferred.
3. Conduct Adequate Due Diligence. While it may go without saying that a buyer of a business should conduct adequate due diligence, you would be surprised at how many business purchases occur simply based on the statements or e-mails of a seller as opposed to actual tax returns or third party financials showing the financial condition of the business. A few due diligence items to consider are; get copies of the prior tax returns for the company, get copies of third party financials, make the seller complete a due diligence questionnaire where the seller represents the condition of the business to the buyer (similar to what you complete when you sell a house to someone). A lawyer with experience in business transactions can help significantly in conducting the due diligence and in drafting the final documents.
Buying an existing business is not only a significant financial commitment but is also a significant time commitment. Make sure the business is something worth your time and money before you sign. Oh, and make sure you get a well drafted set of purchase documents to sign.