Buying a business can be a great way to jumpstart your entrepreneurial journey, expand into related fields or simply grow your existing business. However, it can also be a complex and challenging process, requiring careful consideration, creative thinking and strategic planning. As a transactional attorney with experience representing both buyers and sellers in transactions across various industries, I can tell you that while the metrics used to value the business may differ by industry, the general framework of a transaction is nearly identical (assuming the business is not a franchise because that’s a whole other ball of wax). That’s not to say that any two deals will be exactly the same; in fact quite the opposite. Below I’ve provided legal, financial, logistical, and other considerations buyers can use if they’re thinking about purchasing an existing business. In addition, you’ll see tips from my experience that show the points of negotiation that make every deal unique.
Pre-Transaction Considerations:
Financial Due Diligence. Before you decide to buy a business, you need to have a clear understanding of its financials. This includes examining the company’s revenue, expenses, profit margins, cash flow, and any outstanding debts or liabilities as well as the seller’s business or personal tax returns. Typically willing sellers will release this information upon both parties executing a Non-Disclosure and Confidentiality Agreement. It’s important to have a qualified accountant or financial advisor review these documents as well as any other contracts the business has in place with suppliers or landlords in order to help you assess the financial health and viability of the business. Additionally, make sure you understand how the business is valued and consider obtaining a third-party opinion on the purchase price from a qualified appraiser or someone that has significant experiencing running and/or purchasing businesses in that industry.
Industry and Market Analysis. Understanding the market in which the business operates is crucial to determining its short- and long-term viability. This includes researching the competition, analyzing market trends and customer behavior, and identifying potential opportunities and threats.
Legal Considerations:
The first decision you will need to make is do you buy the entity or just the entity’s assets? Unless the business has significant goodwill by name and reputation (think local mom and pop store with 50 years in the community), most sales will consist of purchasing all of the business’s tangible and intangible assets via an Asset Purchase Agreement. The reason this strategy is preferred over purchasing the entity is because purchasing an entity means purchasing the entity’s assets AND its liabilities. Most buyers do not want to take the risk that a creditor with a valid claim may come knocking on their door after the seller is long gone. While sellers generally warranty to buyers in entity purchases that there are no known creditors, if one shows up, it’s on the buyer to go after the seller to enforce that warranty and prove that they knew or should have known that the creditor existed. If the legal fees to pursue the seller are greater than or equal to the cost of paying the creditor, the buyer may decide to pay the creditor and be done with it. I always encourage my clients to pursue asset purchases over entity purchases and if there is significant goodwill, consider executing a licensing agreement with the seller to utilize the name of the business without taking on the liability of the entity.
Financing the Deal:
The second consideration that should be done in conjunction with the first because securing financing is the #1 thing that delays deals, is will you purchase the business using cash, will you finance it or will you do a combination of the two? From a financing perspective, will you get a conventional business loan? SBA? Line of credit? Hard money? Or will the seller be your bank? If you are pursuing financing, consider the collateral that will be pledged for the loan. I strongly discourage buyers from purchasing a business using a home equity line of credit on their primary residence if other financing options are available. Why? Roughly 20% of new businesses fail in their first year and 65% fail in their first decade (U.S. Bureau of Labor Statistics. “Survival of Private Sector Establishments by Opening Year.”). Getting home equity lines on investment properties, however, is a strategy I’ve seen buyers use, but many lenders are reluctant to offer this type of financing and frequently request a risk premium in the form of a higher interest rate.
Logistics:
Okay, you figured out the legal and financing terms, now what? Now you need a transition plan with the seller, key employees (if any), and landlord (if applicable). The most successful transactions often involve a transition period, which is spelled out in the Asset Purchase Agreement or in ancillary documents whereby the seller acts as an employee or consultant to the buyer in order to teach them important business operations and/or introduce them to the customer base. I strongly encourage buyers to work with sellers to map out a training plan ahead of closing and structure the compensation to the seller on a month to month basis to allow for flexibility if more or less time is needed in the transition (subject to a hard stop date). If key employees are involved, consider having them execute a Non-Disclosure Agreement and getting them involved in the transaction in the period leading up to closing, if at all possible. Landlords can be an X-factor that buyers ignore or neglect in the transaction because there’s often so many other things going on. Make sure your attorney reviews any existing lease agreement and that you discuss lease renewal and ascertain the landlord’s intentions for the property so you know ahead of the time whether they intend to hold or sell. If selling is a possibility, your attorney should make sure the lease protects you from business interruption and, if appropriate, allows for a right of first refusal to purchase the property at market rates if the landlord decides to sell. Most leases do not contain a right of first refusal, but it can be negotiated for a premium if the property owner is willing.
Insurance:
If you’re purchasing an entity, you must consult with the seller’s insurance company to make sure they’re adequately insured in the event claims that originated during their ownership come to haunt you after they’re long gone. If you’re concerned about latent claims, you can protect yourself by purchasing commercial “tail insurance” which extends the coverage the seller had in place to your ownership period. However, depending on the type of business and the length of time they’ve operated, tail insurance can be quite expensive.
If you’re purchasing the assets of a business, the public may not be aware of a change in ownership, particularly if not much has outwardly changed with the business (or if the proper forms have not been filed with the secretary of state such as a DBA). If a claim arises and your business implicated, even if there’s no liability, you’re still stuck spending time and resources to get dismissed (and if you didn’t file things properly, that may complicate things).
Conclusion:
Buying a business can be a complex and challenging process, but with careful consideration and planning, it can also be a rewarding and profitable investment. It’s important to work with a transactional attorney that has experience representing both buyers and sellers so they can provide you with dual perspectives and negotiate strategically and tactically. If you’re looking for a transactional attorney to advise you on the purchase of an existing business, click the “Schedule” link above.
