Purchasing a business is a complex process and every transaction is different.
The two most important things a Buyer can do to minimize issues after buying a business are to perform adequate due diligence before becoming obligated to purchase the business and to document the transaction with properly drafted legal documents. The Buyer wants to anticipate potential post-closing problems and include provisions in the closing documents which will resolve these problems if they arise.
This is Part 1 of a 2 part series on what to expect when buying a business. Part 1 focuses on the activities prior to the sale and Part 2 focuses on closing the transaction.
Letter of Intent (LOI).
In most cases, the first step is for the Buyer to submit a Letter of Intent to the Seller. While an LOI is not a binding contract to purchase the business, it describes the basic terms of the transaction, sets a timeline and identifies any conditions required by either side prior to consummating the transaction. The LOI also includes provisions which protect both parties, such as an exclusivity clause prohibiting the Seller from selling the business to a third party while the Buyer is evaluating the business, and a confidentiality clause protecting the business’s confidential information. If the Buyer is not purchasing the entire company, the LOI should also identify which portions of the Seller’s business are under consideration.
The due diligence process allows the Buyer to thoroughly review the company before making a significant investment in the business. The Buyer will almost always find some information that he or she was not expecting. The due diligence process allows the Buyer the opportunity to evaluate any problems and work out solutions prior to closing. These issues may influence the valuation of the business or the Buyer may need to include specific terms in the transaction documents to address these concerns.
Keep in mind that every business is different. While it is impossible to identify every item a Buyer should look at for their given situation, here are 3 areas that are commonly reviewed:
- Financial Review. The purpose of the financial review is to ensure that the Buyer has a full understanding of the business’s financial position. Often this review is handled by an accountant. Generally, the Buyer will review business’s tax returns from previous years, accounts receivable and payable, the company’s payroll, bank account transactions, and any outstanding loans. Some examples of issues a Buyer would want to uncover include accounts on the books that don’t really exist, missing money, improper tax payments, or a due in full clause upon a change in ownership.
- Contract Review. The purpose of the contract review is to evaluate the business’s ongoing and future obligations and benefits and to identify any upcoming obligations that might affect the Buyer’s valuation of the business. The Buyer will want to review the pertinent terms of supplier contracts, customer contracts, service contracts, leases, etc. Examples of issues a Buyer would want to know include when supplier contracts expire and the cost of goods upon renewal, when contracts with current customers expire, any obligations that aren’t apparent in the company’s operations.
- Litigation Review. The litigation review is an opportunity to evaluate potential legal liabilities of the company, including ongoing litigation, potential litigation and regulatory issues. The Buyer will evaluate any current when determining a proper valuation for the business. Additionally, the Buyer wants to assess potential exposure to any regulatory investigations or law suits based upon prior activities of the current owner. The Buyer might want to include terms in the transaction such as guarantees, warranties, and/or an indemnity clause to address these issues.
Asset Purchase or Stock Purchase.
There are two basic ways to structure the purchase of a company, either purchasing the assets of the business (an “Asset Purchase”) or purchasing the ownership interests of the company (a “Stock Purchase”). In most cases, the Buyer will be better off purchasing the assets. Three benefits to buying the business assets are:
- Tax benefits. With an asset purchase, the parties allocate the purchase prices among the various assets of the company. The Buyer may be able to deduct or depreciate the purchase price paid for certain items.
- No liabilities. The Buyer does not need to assume the existing liabilities of the business.
- Pick assets. The Buyer can pick the assets he or she wants to purchase and only buy the profitable portions of the company.
Occasionally, it does make sense to structure the transaction as a Stock Purchase. For example, the company has existing contracts, licenses or permits that are not transferrable and the cost of entering into new contracts, licenses or permits is too expensive or difficult for the Buyer.