If
you're thinking about buying an existing business, be sure to consider
these key factors.
by
Mary Hanson, MBA, Attorney-at-Law
Buying a business is
risky. The keys to making a successful purchase are identifying
a good business to acquire, investigating the business thoroughly,
and negotiating an appropriate purchase agreement.
As with all business decisions, you must first have a firm idea of why you
are interested in buying a business, how you plan to operate the business,
and what your overall goals are? After identifying a potential purchase, a
thorough review is necessary.
The following are just a few of the many questions which must be asked in
order to determine whether this business fits your overall plan:
What
are the products and services of the business? Are these products and
services for which there is an adequate demand?
Does
this business have a good competitive position? Does it have the right
pricing, quality, relationship with customers, and relationship with vendors
to continue operating successfully?
Will
the good circumstances of the business continue in the future? How will
this business be affected by the economy, additional competition, the aging
of customers, etc.?
Do I know enough about this industry and the market for these products and
services to operate the business successfully?
After considering the above, if the business seems to be a good candidate,
the financial aspects must be reviewed. The books and records of the business
should be analyzed to determine whether the business can be operated at a profit
and provide an adequate return on investment to the buyer.
If the purchaser is not trained and experienced in financial analysis or tax,
he or she should work with a CPA or other professional who can advise the purchaser
on the financial condition of the business.
The financial review of the business must consider all of the following:
the condition of the financial records of the business, as an indicator of
a whether the business is well run, as well as an indicator of whether the
financial records are reliable:
what the cash flow of the business is and will be if the interested buyer
makes the purchase
how much additional money must be invested in the business in order to make
the changes and implement the business plan of the new owner;
what the return on the investment will be, considering funds used for the
purchase, additional funds invested, and interest paid on borrowed funds;
what purchase price is appropriate considering the financial projections and
projected return on investment;
the tax consequences of the purchase.
After reviewing the overall nature and financial condition of the business,
you need to sketch out a structure for the purchase of the business, and
consider what terms will be needed in the purchase agreement.
The Structure
As a general rule, you should purchase an owner-operated business as an asset
purchase, not a purchase of stock. An asset purchase offers the buyer ways
to cut off responsibility for liabilities arising out of operation of the business
prior to the purchase.
In a stock purchase, the buyer purchases the corporate stock of the seller,
and takes over all liabilities as well as all assets. This means that the buyer
of stock may be purchasing tax liabilities, lawsuits, and other problems, some
of which may not yet be evident. For this reason, the preferred method for
buying a business is the purchase of assets.
The asset purchase also gives the buyer the opportunity to allocate the purchase
price to the assets acquired, and begin to depreciate the assets from the new
book value. In a stock purchase, the buyer is stuck with the tax structure
established by the prior management.
If you do have compelling reasons to purchase a business as a stock purchase,
for example, in order to obtain permits or licenses held by the corporation,
such a purchase requires even greater investigation of all aspects of the business.
The next step is to determine the other important terms of the purchase. The
interested buyer must be able to present the key terms of the purchase at the
same time that the purchase price is offered. It is impossible to determine
an appropriate price range without knowing what is being purchased, what terms
are included in the purchase, and how payments will be structured.
The following are some of the terms that need to be considered:
List all assets
of the business which you wish to acquire. Don’t forget
to consider customer lists, logo's, trademarks, the business name, and other "intangibles" among
the assets.
Allocate the
purchase price among the assets in the agreement. If the seller
insists on different allocation in order to obtain tax consequences more favorable
to him or her, the price paid by the buyer should be reduced from the initial
offer.
Get the seller's
warranty that equipment is in working condition, that the seller has
clear title to all assets to be transferred, and that financial
records, earnings, etc., on which the purchase price is based are accurate. You also need the seller's warranty that there are no undisclosed legal liabilities
facing the business.
A method for
purchasing inventory must be set out, if there is inventory. A physical inventory must be done and a method for valuation needs to be devised.
Treatment of
accounts payable and accounts receivable must be set out. The
price attributable to accounts receivable, if purchased, should depend on how
collectible those accounts are.
Payment
terms most favorable to the buyer, as well as a purchase price most favorable
to the buyer, should
be proposed in the buyer’s initial offer. A small down payment and long term installment payments should be offered.
The seller should be required to accept installment payments, not only to reduce
the amount of money required up front, but also as a means of giving the seller
a real interest in seeing the business prosper in the hands of the buyer.
Include
a noncompetition agreement by the seller (a "covenant not to
compete"). You
don’t want to have the seller competing with you
after you have purchased the business. He or she could take customers from
you or take other action as a competitor which would reduce the value of
the business you purchased.
State the amount and type of training or other assistance the seller will
be required to provide after the purchase.
Make
the transfer of the business contingent upon certain things taking place. You
don’t want to be bound to purchase the business if you can’t
get a good lease from the landlord, you can’t get a permit you need,
or your ongoing review of the financial information reveals something wrong
with the business. By making the contract contingent upon these things turning
out well, you have the option of backing out of the purchase, without violating
the contract.
If the bulk
transfer laws apply to the purchase, make sure all bulk transfer requirements
will be met. The bulk transfer law makes the buyer liable to creditors
of the seller if the business assets are transferred without compliance with
the law.
The interested buyer must be able to present the key terms of the purchase
at the same time that the purchase price is offered. It is impossible to determine
an appropriate price range without knowing how payments will be structured,
what the tax consequences will be, how much more must be invested into the
business by the buyer to make the business valuable to it, whether liabilities
will be assumed by the buyer, and what types of guarantees the seller is willing
to provide. The purchase price must only be offered based upon the terms and
contingencies identified in the offer.
The buyer must recognize that most of the risks in the transaction are on
the buyer, and that the interests of the buyer and the seller are opposing
interests. It is the buyer who will suffer if any aspect of the business is
not as the buyer anticipates.
It is not just the possibility of fraud (overvaluation, existence of liabilities,
lack of title, misstated financial records, nonexistence of assets) which makes
a thorough agreement necessary. It is also the possibility of misunderstanding,
oversight, mistake, and the lack of business or financial skills by either
party. There may be problems with the way the business was operated in the
past, and there may be problems with the proposed operation in the future.
The Offer
There are two
approaches on what the "Offer" should be. One is a
brief description of all the important terms to the arrangement - price, payment
terms, list of major assets, seller's warranties, contingencies, etc. This
is a brief, two page description of what the intentions of the parties are.
If the parties fail to agree to this broad statement of intent, there is often
no point in going further.
The other type
of "Offer" is actually a complete first draft of
the purchase agreement, covering all the terms, in full contract form, so that
negotiations can begin in detail. This is the "best" way to go, since
it enables the parties to very clearly see what they are negotiating. It is
less often done because of the time required, as well as the risk of incurring
the expense of having the contract drafted, and then having the deal fall through.
There is always a chance that the parties will not be able to reach an agreement.
The buyer should be prepared to deal with this. Many small business buyers
become determined to buy a particular business. This is a dangerous approach.
The key to success in buying a business is buying the right business on the
right terms.
The goal should
be, and should remain, to buy a business that can provide an appropriate "return on investment" for the level of risk assumed.
If such a goal cannot be attained, the purchase must be abandoned. Accepting
a level of return lower than that which meets your established standards, because
the seller demands it, is not a reasonable business approach. Do not select
the business and then negotiate the "best possible deal." You must
set your financial standards and then find the deal that fits it. If the seller
will not agree to terms that allow the business purchase to meet your standards,
you should move on to the next business purchase opportunity.
Preparation, investigation, and negotiation before the purchase are the keys to minimizing the risks and making a successful purchase of a business.
Mary
Hanson is a business attorney in Torrance, California
(Los Angeles County). Her legal career has been dedicated exclusively
to business matters since 1978. She serves business owners by advising
them and handling legal matters in a wide range of business issues
from structuring new ventures to selling or dissolving a business. Information
on legal services provided by Mary Hanson, Attorney at Law:
21515 Hawthorne Blvd. #885, Torrance (Los Angeles
County), California USA 90503 - Telephone (310) 543-1355.
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