Buying a business is a great way to hit the ground running as a business owner.
Understanding these ten issues will help reduce your risk and maximize your profits when you buy a company.
1. The Next Right Step
After agreeing in principle to buy the business (through a Letter of Intent, Term Sheet, or handshake), the buyer and seller must decide on what comes next.
The seller might favor negotiating and signing the purchase agreement, followed by a period of due diligence investigation, followed by a closing. The buyer would probably prefer to take care of the due diligence first, and then “sign and close.”
2. What are You Buying?
Stock or assets? The seller will probably want to sell the stock (or other company ownership interests) of the target company, but this exposes buyer to greater risk from liabilities arising prior to the sale.
The buyer might prefer to buy all the business assets, but valuable contracts and rights belonging to the company might be subject to transfer restrictions, making an asset purchase difficult.
3. Says Who?
It is important to know, as early as possible, whose approval is required for the transaction. Certainly, the stock (or other equity) owners of both buyer and target company, but what about option holders? What about the target company’s lenders, landlord, or other contract parties? What about government agencies?
4. Kick the Tires
The most important step in the purchase process is a thorough due diligence investigation of the target company. Insist that the seller answer all of your questions and let you review every contract, record, and detail about the target company.
The purchase agreement should make the seller liable for misleading the buyer, but it’s easier to do the due diligence up front than to rely on seller’s contractual obligation.
5. On the Hook
The purchase agreement should include detailed representations and warranties from the seller that the target company is clean, except for “warts” that are specifically identified and acceptably dealt with. The purchase agreement should also explicitly provide that the seller will indemnify the buyer for any losses or costs resulting from an undisclosed “wart.”
6. Get Back.
Representations, warranties, and indemnification are a must, but they only give the buyer the opportunity to sue seller over any breach of the purchase agreement or liability not assumed by the buyer. Lawsuits are never much fun, and the results can be surprising.
A safer means of protection is to hold back payment of part of the purchase money (or put it in escrow) until the indemnification period is over.
7. Taxes for All
You know that seller will pay capital gains taxes on the sale of the stock or business assets, but the buyer might be liable for taxes as well.
Purchase of certain business assets (especially vehicles) might give rise to sales taxes. Purchase of real estate will require documentary stamp taxes, and payment with a promissory note may trigger intangibles taxes. Who pays these taxes should be negotiated.
8. Thanks, Internal Revenue Code
An election under IRC Section 338(h)(10) allows the buyer to purchase corporate stock but the seller to effectively sell the business assets. This takes the tax sting out of a stock purchase by allowing the buyer to allocate the purchase price to the basis of the business assets.
9. Stay or Go
Should the seller be required to continue working in the business after the transaction? Don’t expect sellers to work as hard for the buyer as they did when it was their company. On the other hand, the seller has valuable information about running the business.
10. This Ain’t a House
Beware a purchase contract that is no more than a broker’s form real estate contract with “Business” written at the end. These contracts don’t protect buyers at all. In fact, they mostly just protect the broker. You need a real purchase agreement (and a real business attorney).