Introduction to Buying A Business
Buying a business can be an excellent way to become a business owner, but beware of the pitfalls. When you buy a pre-existing business, you can save both time and money in locating suitable commercial space and equipment, hiring and training employees, and building an initial customer base. But if you are not careful, these benefits may be heavily outweighed by the assumption of liabilities which can lead to disaster. This article discusses seven (7) ways the buyer can limit his or her exposure to common liabilities that often attach to the purchase of a business.
1. Demand Full and Complete Disclosure.
When buying a business, the buyer should insist that the seller disclose all liabilities concerning the operation of the seller's business. This should be done even if the buyer does not intend to assume the seller's liabilities. That said, the Purchase and Sale Agreement between the buyer and seller should also contain the representations and warranties by the seller regarding:
- contracts which affect the property, such as: equipment leases, maintenance contracts and similar agreements;
- taxes relating to the operation of the property, including: income taxes, payroll taxes, sales taxes, and real property taxes;
employee wages and other benefits;
- amounts owed to suppliers; and
- existing obligations to both present and past customers.
Disclosure is the first step towards obtaining an accurate picture of what the seller owes and what the buyer might be responsible for upon purchase. The second step is ensuring that the seller stands by his assertions by warranting them in the Purchase and Sale Agreement.
2. Investigate Employee Matters.
The buyer should demand that the seller provide a current list of employees, including job title, social security number, wages, salaries, bonuses, vacation, sick pay and any other benefits payable to the employee at the time the Purchase and Sale Agreement is signed, and again at the time of closing. The seller should also be made responsible for all of the accrued wages, salaries, bonuses and benefits that relate to the period before closing.
3. Investigate Potential Tax Liabilities.
Obviously, the buyer does not want to assume any of the seller's tax liabilities. However, it is often difficult to determine what those liabilities are, particularly where the seller has been paying taxes on an estimated basis or has not yet filed an applicable tax return. The buyer should be particularly wary of the types of taxes that run with the land or business being acquired, as these may become the buyer's obligation, by law, if unpaid by the seller. Many states have "bulk sales" laws, which must be complied with when a buyer is purchasing all, or substantially all, of the seller's assets. Failure to comply with the bulk sales laws may lead to the buyer being liable for any liability owed by the seller. A lawyer can be particularly valuable in this setting, as compliance with such "bulk sales" laws falls on the buyer, not the seller.
At a minimum, the buyer should obtain the seller's representation and warranty that no lien exists, and that no lien can be asserted against, the business or real estate being purchased by the buyer due to the seller's failure to file any tax return or report or pay any federal, state or local taxes. In addition, the buyer should demand that the Purchase and Sale Agreement contain a provision obligating the seller to pay any taxes which relate to the seller`s prior ownership of the assets, but are not assessed until after the closing. Many states and municipalities issue lien certificates, or other documents, from which the buyer can verify a seller's tax liability.
4. Review All Existing Contracts.
The importance of reviewing existing contracts cannot be overemphasized. Many businesses routinely enter into contracts for almost everything, including: furniture and phone rentals, equipment leases, advertising, additional office, storage and warehousing space, etc... A prospective buyer should analyze every contract to determine whether they are acceptable.
If the buyer finds a contract is acceptable and wants to assume the contract, then the buyer should review the pertinent contract to ensure it can be assigned to the buyer without the vendor's approval. If the vendor's prior approval is required for a valid assignment of the contract, the Purchase and Sale Agreement should obligate the seller to obtain that prior written approval before closing.
If the buyer does not want to assume the contract, the buyer should determine whether the contract can be terminated early by the seller. If the contract in question cannot be terminated early, the buyer should negotiate this point in the Purchase and Sale Agreement. The buyer may require the seller to either buy out the contract, or simply agree to remain responsible for the payments required by the contract (even if the buyer does not want to assume the benefits of the contract).
5. Review The Account Receivable and Payable.
Assume the seller is leasing equipment for the business, but is several months behind in his rental payments at the time of closing. Further assume that the Purchase and Sale Agreement states that the buyer is not responsible for the seller's liabilities arising before the date the buyer acquires the business. Is the buyer adequately protected? Well, Yes and No!
From a legal standpoint, the buyer may not have any legal obligation to the equipment lessor after closing. But, from a practical standpoint, the buyer may be left in a difficult position. If the buyer is unaware of the amounts owed on the equipment lease by the seller before closing, the buyer may receive a call from the lessor saying that he will confiscate the equipment unless the buyer pays the amounts owed by the seller. This leaves the buyer in the precarious position of either having to pay the seller's debt, or risk business interruption if the lessor retrieves its equipment before the buyer can replace it.
To avoid this situation, a buyer should thoroughly audit the seller's books and records before closing, and try to force the seller to provide evidence that all obligations have been paid in full.
6. Require Minimum Requirements on Acceptance of New Orders.
If the business being acquired has future orders, or works-in-progress, there are probably orders booked for which the seller has previously received a deposit. Some of these orders may have to be filled or completed by the buyer after closing. Before entering the Purchase and Sale Agreement, the buyer should therefore try to obtain a complete list of future orders and works-in-progress, which should be updated periodically and at closing.
In addition, the buyer should attempt to have the Purchase and Sale Agreement: (1) require the seller to assign to the buyer all deposits received for works-in-progress and future orders not fulfilled at closing; (2) set minimum requirements on the seller's acceptance of new orders, and (3) require the seller get the buyer's prior consent before accepting new orders that deviate from those requirements.
7. Three Ways A Buyer Can Protect Himself Against a Seller's Default.
Even if the Purchase and Sale agreement requires a seller to pay for the liabilities incurred by the seller during the seller's ownership of the business assets, what happens if the seller simply does not pay? What can the buyer do to protect himself?
- The Purchase and Sale Agreement can require the establishment of an escrow to last for a certain period of time after closing to pay for all known and any unknown liabilities of the seller that may arise after closing.
- The Purchase and Sale Agreement can contain a clause obligating the seller to indemnify, defend and hold the buyer harmless from and against the seller's liabilities.
- The buyer can attempt to obtain a guaranty from a financially responsible party on the seller's continuing obligation to pay his liabilities.
When buying a business, examine the past performance of the seller's business and the seller's assets from both an income and expense standpoint. Examine the current status of the seller's liabilities and how you are going to deal with them. Demand full disclosure by the seller and demand that the seller accept personal financial responsibility. If you do, the risks assumed upon acquisition of the property, business assets, and ongoing business will be minimized.