Some entrepreneurs love the challenge of starting a new business and creating everything from scratch. However, that may not be the best approach for everyone. Buying an existing business can eliminate the initial legwork of establishing a customer base, training employees, and securing start-up funding, but it is not without its own challenges.
As a prospective business buyer, part of the challenge is figuring out exactly what you are buying. This requires proper due diligence with help from business, tax, and legal experts. Arriving at a fair purchase price and agreeing on a deal is only possible after you have taken a deep dive into the business you are considering purchasing. But getting to that point takes a lot of work. And even after a deal is in place, there is more to do.
Strong Business-Buying Opportunities Remain
Despite powerful economic headwinds in the form of inflation, labor shortages, and recession concerns, Americans are starting—and buying—new businesses at a strong clip.
In the second quarter of 2022, there were more than twenty-three hundred small business transactions, according to BizBuySell.[1] That number is down from the first quarter but still represents a 14 percent year-over-year gain. Notably, the median business sale price dropped 9 percent from the first quarter to the second, which could indicate good buying opportunities amid economic uncertainty and looming interest rate increases. The median asking price of a business sold in the second quarter was $350,000. BizBuySell notes that in the current economic environment, sellers are becoming “more realistic about valuation and asking price.”[2]
Buying a Business and Due Diligence
Ronald Reagan’s quip “trust, but verify” is an apt summation of the due diligence process. Due diligence occurs after business details have been reviewed and an offer has been made, but before the deal is closed.
Typically, due diligence is a condition of the buyer’s offer. At this point, the buyer has already reviewed information about the business and is prepared to move ahead with a deal—barring any unexpected revelations during the due diligence process. Uncovering issues does not mean the deal is off, but it could signal the need for further negotiations (and in some cases, a lower sale price). Due diligence should always be undertaken with assistance from an accountant and an attorney who have experience with small- to midsize business acquisitions.
Due Diligence Checklist
If you have an agreement in principle with the business seller and have sent a letter of intent, you can proceed to conduct due diligence. While your attorney will guide you through due diligence, you should be aware of the information that will be reviewed during the process and what items might need your attention.
- Financial information. This includes income and cash flow statements, profit and loss statements, accounts payable and receivable, balance sheets, tax returns from the past three years, all debts owed by the business, profits itemized by each product or service, analyses of profit margins and expenses, and an inventory of all assets (including their total value).
- Business structure and operations. How is the business structured, and how does it earn money? This is a multi-pronged assessment that includes reviewing the business’s founding documents, investors and shareholders, place of operation, products and services, marketing strategy, industry trends, competitors, customers, and branding.
- Contracts. When you buy a business lock, stock, and barrel, the sale generally includes transfer of any contracts the seller made with other companies and individuals. It is vital that you know what is in these contracts and what obligations you might owe to other companies, such as the promises found in noncompete and nondisclosure agreements, purchase orders and warranties, mortgages, letters of intent, sales and subscription agreements, loans and lines of credit, stock purchase agreements, and contracts between agents and principals of the business.
- Customer information. A principal advantage of buying an existing business is that presumably there is a preexisting customer base. However, you should confirm the strength of the customer base by closely examining sales records, subscriber lists, marketing and advertising programs, customer research data, and purchase and refund policies.
- Employee information. In addition to inheriting customers, you will also inherit employees when you buy a business. That means you should learn about who the employees are, how they are organized, employee contracts and contractor agreements, employee benefit plans and tax forms, payroll data, and the company’s human resources policies.
- Legal liabilities. Does the company have any lawsuits filed against it or issues (e.g., missing licenses and permits, zoning laws, and environmental regulations) that could lead to legal disputes down the road? If so, is the business properly insured to help absorb the potential cost of a judgment or settlement?
- Tangible and intangible assets. Obtain a complete inventory of the company’s physical assets and real estate as well as its intangible assets, such as intellectual property like trademarks, copyrights, and cryptocurrency.
After Due Diligence
Once due diligence concludes, you can finalize the deal. This could mean renegotiating the purchase price and other terms based on issues identified during due diligence. Changes to the deal should be reflected in the purchase and sale agreement, which is the document that is drafted and signed after the buyer and seller mutually confirm the price and terms of the transaction.
This agreement could be structured as an asset purchase—in which the buyer only purchases specific assets and liabilities of the company—or an equity purchase agreement, in which the buyer purchases the entire entity (i.e., all of its assets and liabilities). The former is a more tailored approach that is more complex but can secure tax advantages and help avoid liabilities. The latter approach is much more straightforward, but the buyer could end up assuming unwanted assets and liabilities. You should discuss the pros and cons of both approaches in relation to the specific deal on the table with your attorney and tax professionals.
When (or before) the deal becomes official, your work is not yet done. You may also need to take the following steps:
- Secure capital to purchase the business.
- Transfer permits and licenses from the previous owner into your name or apply for them yourself. Permits and licenses may be needed at the federal, state, and local levels.
- Transfer contracts, assets, governing documents, vehicle documentation, and other paperwork into the new business owner’s name.
- Renegotiate contractual terms with employees, vendors, and other parties (this may be stipulated as part of the deal or specified in the contract itself).
- File required forms with the IRS, such as IRS Form 8594 (Asset Acquisition Statement).
- File additional paperwork to officially transfer business ownership (for example, if one member of an LLC with multiple members or owners wants to buy out the other members, ownership may need to be reapportioned, which may require specific documentation, for example, a buy-sell agreement, in accordance with the LLC operating agreement.
Do Not Buy a Business Without Legal Help
Buying a business, like starting a business, can be one of the most impactful life decisions you make. Even if you have bought or sold a business before, there may be more than meets the eye to a transaction, and every deal should be approached with a fresh perspective.
If you are interested in acquiring a company, an attorney with a track record of representing buyers in small business deals is a must. An attorney can help you perform due diligence, negotiate a purchase price, safeguard against unanticipated liabilities, handle contracts, and properly structure and document the purchase. To schedule a meeting with our business attorneys, please contact us.
[1] Small Business Acquisitions Slow Slightly in Q2 Amid Rate Hikes and Inflation, BizBuySell, https://www.bizbuysell.com/insight-report/ (last visited Oct. 3, 2022).
[2] Id.