Buying a Business – Part 1: Before Closing

This is Part 1 of a 2-part series on what you can expect when you buy a business. Part 1 focuses on the activities prior to the sale and Part 2 focuses on closing the transaction.

Purchasing a business is a complex process.  Every transaction is different.  As a Buyer, you want to be sure to perform adequate due diligence before you are obligated to purchase a business and document the transaction with properly drafted legal documents. Your focus is to anticipate potential post-closing problems and include provisions in the closing documents which will resolve these problems if they arise.

Non-Disclosure Agreement (NDA).  Prior to any substantive conversations, the Seller will usually require the Buyer sign a non-disclosure agreement protecting the confidential information of the business.

Letter of Intent (LOI). In most cases, the first step in the purchase process is submitting a Letter of Intent to the Seller. While an LOI generally is not a binding contract, it describes the basic terms of the transaction, the portions of the business the Buyer intends to purchase, sets a timeline for consummating the transaction and identifies any conditions that must be met for the transaction to proceed. Usually, the LOI prohibits the Seller from selling the business to a third party while the Buyer is evaluating the business.

Due Diligence. It is important to do your research and thoroughly review the business before making a significant investment. Most likely, you will find some information that you are not expecting.  The due diligence process allows you the opportunity to evaluate any problems and work out solutions prior to closing.  The issues you discover may influence how you value the business or you may need to include specific terms in the transaction documents to address these concerns.

Keep in mind that every business is different. It is impossible to identify every item that a Buyer should review, but here are 3 areas that are commonly evaluated during due diligence:

1. 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.

2. Contract Review.  The purpose of the contract review is to evaluate the business’s ongoing and future obligations.  The Buyer will want to review the pertinent terms of supplier contracts, customer contracts, service contracts, leases, etc.

3. Litigation Review.  The litigation review is an opportunity to evaluate the legal liabilities of the company, including ongoing litigation and any potential litigation or regulatory issues.  The Buyer might want to include terms in the transaction documents, such as guarantees, warranties, and/or an indemnity clause, to address these issues.

Asset Purchase or Stock Purchase. The purchase of a business is either structured as an Asset Purchase (when the Buyer purchases the assets of the business) or a Stock Purchase (when the Buyer purchases the ownership interests of the entity operating the business). In most cases, the Buyer will be bet­ter off pur­chas­ing the assets for the following reasons:

• 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.

In some instances, it makes sense to structure the transaction as a Stock Purchase.  For example, the company has existing contracts, licenses or permits that are not transferable and the cost of entering into new contracts, licenses or permits is too expensive or difficult for the Buyer.

Buying a business is a complex transaction. For more information, please contact Kathy Tremmel at Tremmel Law, PLLC at (512) 539-0317 or kathy@tremmellaw.com.

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