Considerations When Buying a Business
Buying a business is daunting prospect. What follows are a few of the more important issues to consider when negotiating a purchase agreement.
Assets or Stock?
This first issue is probably the most neglected, yet most important consideration in buying a business. Are you buying the assets of the business or ownership of its stock? The buyer usually is better off purchasing the assets only. When the purchaser acquires the stock of a business entity, the purchaser assumes all liabilities of the business entity. So if two years ago, under the former owners, a customer slipped on ice in the business’s parking lot, you may very well be served with a lawsuit the day after closing and could be liable for every penny.
For that reason, a buyer should not purchase the stock of a business unless the purchase agreement includes two things. First, the seller must agree to indemnify the buyer for all liabilities not disclosed within the purchase agreement. Second, the seller should execute a bond to insure that money would be available to effectuate the indemnity agreement. Indemnity is worth little when the seller later goes insolvent.
However, the most risk-proof scenario is for the buyer to purchase only the assets.
Your purchase agreement should address the disposition of such intangible assets as website URLs, fictitious names filed with the secretary of state, trademarks, copyrights, patents, and any other trade secrets. Further, the remedies section of the purchase agreement (every contract should have such a section; if your attorney drafted a contract without one, fire them) should authorize the judicial remedy of specific performance for failure to take whatever steps necessary to transfer or assign these rights. When a court orders specific performance, the court is ordering one of the parties to do or not do something, usually something that is stated in a contract. Because there are circumstances in which it is difficult to determine whether specific performance is the appropriate remedy, it is best to state in advance that the parties agree to that remedy.
One frequently overlooked intangible in buying a business is the company’s passwords. Prudent businesses use passwords for everything: computers, email, software, websites, etc. Therefore, not having every password on day one can cause major delays. The purchase agreement then should require that the seller at closing provide a document with every password used in the performance of the business.
Contingencies are things that must occur (or must not occur) before a contractual performance is required. In purchase agreements, they can be your savior. Take the time to consider carefully everything that might happen between signing and closing that would make the transaction impracticable, impossible, or completely undesirable. The most typical example is financing. Most business purchases of which I’ve been a part involved bank financing, which usually is finalized after signing. Closing should alway be contingent on the buyer obtaining financing sufficient to cover the agreed purchase price. Sometimes the agreement includes a separate price for the real estate on which the business operates and the business itself. If that’s the case, the closing should be contingent on the lender agreeing to finance both for the full agreed amount.
Also, what happens if after signing the business erupts in flames because a cook left the stove unattended? Some purchase agreements terminate the contract upon such an event. I, however, like to give the buyer the option upon substantial damage to the property to either (1) terminate the agreement or (2) collect the seller’s property insurance proceeds. If the latter is included in the agreement, the purchase agreement should suspend the sale until a specified time after the buyer is able to collect from the seller the property insurance proceeds.
Contracts are best thought of as instruments of risk allocation, and warranties are the ultimate risk-allocation mechanism. Even with the best due diligence, not every catastrophic problem can be foreseen. When representing a buyer, I try to obtain the warranty of the seller for as many of these scenarios as possible. I’ll identify a few highlights here:
The Comprehensive Environmental Response, Compensation, and Liability Act (“CERCLA” or the “Superfund Act”) requires the cleanup of toxic substances by, among other possible culpable parties, the owner or operator of the site of the toxic substances. What this means to you the buyer is that the former owners could illegally dump toxic waste on the property, but you could be liable for its cleanup. This could be a devastating liability for your new business. To absolutely avoid this nightmare scenario, the buyer has two options: (1) Conduct an expensive on-site inspection of the property, including excavating into the subsurface OR (2) obtain a warranty from the seller that the property contains no toxic substances as defined by CERCLA. If the seller is confident that it released no toxic substances during its possession of the property, option two is clearly the least expensive option for both parties. Again, if there is even the slightest doubt, a bond executed by the seller is very desirable here.
The buyer will also want the seller to warrant that it is in compliance with all applicable permits and that there are no liens attached to business than any that are disclosed in the purchase agreement.
Lastly, your remedies section should include a statement that the buyer is entering into the agreement in reliance upon the warranties of the buyer and that the buyer shall be liable for any and all damages arising out of breach of any of the buyer’s warranties.
There are two transition periods that are important in the process of buying a business: the one from signing to closing and the one immediately after closing. If I represent the buyer, I insist that the purchase agreement require the seller during the pre-closing period continue to carry on the business in its ordinary course. Otherwise, the seller may fail to keep merchandise stocked, may reduce employee hours, and may fail to keep the premises maintained. All of these would save the seller money, but to the detriment of your new business.
The second period is immediately after the actual sale. It is not uncommon for the seller to “stick around for awhile” and oversee the transition of the buyer into the owner’s role. One method of carrying this out is to require the seller to work a certain number of hours for the first few weeks after the sale. I’ve seen some agreement require the seller to work a full-time schedule for a week and then for decreased amounts over the following weeks. The need for such a transition period depends greatly on the complexity of the business and certainly does not come without adjustments to the purchase price. However, having the commitment of the former owners in the transition period is not only helpful in an of itself, but also tells you a lot about the seller’s willingness to stand behind their product.
Non-compete agreements are frequently neglected clauses that can make or break your new business. The former owners likely have a business reputation in the community that you don’t have yet. So what happens when you purchase a business only for the former owners to change their minds and set up shop again? You will have paid the former owners a significant sum, only to miss out on the benefit of the bargain—the business goodwill. I promise if this has happened to you, you weren’t the first.
An agreement then that the former owners are absolutely prohibited from engaging any business like yours is usually a must.
But caution! Covenants not to compete are frequently struck down by courts for over breadth. In the coming weeks, I will include an article on what to look for—both practically and legally—in these agreements.
Business purchase agreements are complicated documents. The above-mentioned issues are but a few of the typical problem areas when negotiating and executing them. For assistance in buying a business, please do not hesitate to contact my office.