Checklist for Buying a Business – Mary Hanson
The buyer of a business must structure and negotiate the purchase very carefully to obtain the most desirable and acceptable arrangement. If the buyer fails to handle the purchase well, the "penalties" for the purchase range from overpaying for the business to taking on additional liabilities.
Use this checklist to help you cover the issues that arise in the purchase of a business.
- Before entering into discussions or negotiations, plan what you would like to buy, what the structure of the purchase should be, what commitments you would need from the seller, and what price range makes sense.
- Don't purchase an ongoing corporation. Rather than purchasing corporate stock, purchase the assets of the business. Even if there are strong reasons for buying stock, try to avoid doing so.
The buyer of a corporation takes over the whole ongoing business - including all assets, liabilities, claims, contracts, and tax circumstances. Unknown liabilities and claims that have not yet been made still belong to the corporation, and therefore to the purchaser of stock. If a tax auditor shows up tomorrow and finds tax liabilities from three years ago, the problem is yours to handle.
- Identify all the assets you want to purchase as part of the business. Remember to include all intangible assets. Consider customer lists, logos, the business name, telephone numbers, computer programs, copyrights, and anything else related to the business. Check to see that all relevant assets are owned by the same seller. If certain equipment, property, or programs are leased from someone else or owned by one of the business partners, find this out in advance and make certain you are able to get all the parts of the business that you need.
- Make a list of all contracts you may wish to take over. Check the contracts to see if they are assignable and whether you would want to take them over. Take steps to investigate whether there are defaults or problems with the contracts. If you do want them and they are not assignable you will need to negotiate a new contract with the other party.
- Create a checklist of assets and where to check on their "title" or "registration." Check the ownership and check for liens. Vehicles are registered with the Department of Motor Vehicles in California. Real property is recorded with the County Recorder. Copyrights and trademarks may be federally registered. Patents must be federally registered. Liens on personal property are recorded in the office of the Secretary of State by the name of the owner of the property with the lien.
- Do your "due diligence" review and investigation of all aspects of the business. Check public records for liens on assets, proper ownership of assets, corporate status of a corporate seller, and the status of any litigation. Obtain and check the seller's records for financial condition of the business, proper payment of taxes, terms of contracts, lists of assets, employment benefits and employment and management information, insurance coverage, and governmental permits and licenses.
A buyer who is really purchasing a few assets or a customer list to add to an existing business may be less worried about the details of the business operations. But if continuing the operations at a profit is one of your objectives, you must perform the appropriate level of investigation.
The primary concern is a financial review, but in order to minimize liability and risk of encountering liabilities and negative cash flow, a review of employment records, disputes, facilities, contracts, and licensing issues is necessary. If the business is substantial enough that you are taking over a management team or substantial workforce, you will want to also investigate practices, reputation, and attitudes that do not show up in written records.
- When purchasing even the smallest business you must look for the types of contracts that are not obvious but have an impact on the business. Review all insurance policies, alarm contracts, utilities accounts, copy machine leases, yellow pages advertising, and anything else that you would need to operate the business.
- If obtaining customers is a part of the purchase make sure getting a complete list with all customer information is part of the contract. Try to get an adjustment of price for customers that are not retained. Include provisions for the prior owner or manager to introduce the buyer to the customers.
- Determine whether there are any key employees whom you must employ. If certain employees are key, get commitments from them early in the negotiations.
- Negotiate the appropriate level of training, introductions, collecting, and consulting from the seller.
- If employees are to be terminated as part of the sale, make it clear that the seller must be responsible for the terminations.
- Include accounts receivable and cash assets as assets where appropriate. Are there customer deposits that should be transferred to the buyer? Do they need to be prorated? How will this be done? If the buyer will not take over the accounts receivable from prior sales, how will payments made on those accounts receivable be delivered to the seller?
- Make sure the seller is required to pay accounts payable and other obligations of the business, except those that you specifically list in the contract as payables that you will pay. If the seller is keeping all accounts receivable the seller must be required to pay all accounts payable.
- The seller should be required to accept installment payments, a note, or other stretched out payment arrangements to give the seller an interest in the buyer's success, and to provide the buyer some leverage if the seller's cooperation is needed in the future. Include a buyer's right to reduce or offset payments if certain problems arise (such as customer claims, vendors not paid, and unpaid taxes).
- Get the seller's warranty that equipment is in working condition, that the seller has clear title to the assets to be transferred, that accounts receivable are collectible, and that all customer and financial records are accurate. The buyer also needs the seller's warranty that there are no undisclosed liabilities, lawsuits, governmental proceedings, or known problems facing the business.
- Include in the agreement an indemnification from the seller (and individual owners, if the seller is a corporation). This indemnification is really a type of insurance in which the seller agrees to cover you if claims are made against you that are, under the agreement, the responsibility of the seller. Remember, however that such "insurance" can be no stronger than the corporation or individuals providing the indemnification.
- Even if the seller provides detailed warranties and indemnification, the buyer must perform its own "due diligence," checking for liens on assets, checking the status of contracts, and investigating the background of the seller. Do not put too much faith in the words in the contract or the promises of the seller.
- Make the transfer of the business contingent upon the buyer's obtaining a lease on the property, obtaining needed licenses or permits, and upon any other necessities that could make the purchase of the business undesirable if not obtained. Also state that the buyer's obligation to complete the sale is contingent upon the seller's obligations (such as providing accurate financial statements and tax clearances) being met.
- State how the purchase price will be allocated to the assets purchased. Consider all the tax consequences of the allocation. The buyer will benefit from allocation to items that can be expensed in the first year and to items that can be depreciated quickly. Sales tax, which may apply to many of the assets in an asset purchase, must also be considered.
- Include a noncompetition agreement by the seller and key individuals (a "covenant not to compete") to the extent possible. This noncompetition agreement should restrict the seller from competing in the same area that the business operates.
- If the seller is a corporation or other entity, and the seller must provide future services, support, warranties, or other obligations, make sure these entity obligations are backed by the personal guarantee of individuals. The corporation could be dissolved, leaving the buyer without a seller to hold responsible for performing its obligations.
- Determine whether this purchase must be treated as a "bulk transfer." If so, it is the buyer's responsibility to make sure the bulk transfer requirements are met. Make sure the purchase agreement states that bulk transfer requirements will be complied with.
- If the transfer does not have to comply with bulk transfer laws and no escrow officer will be used, make sure the seller is obligated to provide you with tax clearances and releases from state agencies. In California, the buyer of a business is liable for the seller's payroll tax obligation, sales tax obligations, and other obligations if a tax clearance or release is not obtained from the Employment Development Department ("EDD") and from the State Board of Equalization. If an escrow officer is not handling the transfer, the buyer or the buyer's attorney needs to make sure these are obtained by the seller.
The escrow arrangement should be defined in the purchase agreement. The obligations which each party must meet before actual transfer of the business should be defined in detail. And the agreement should set out who is entitled to the funds placed in escrow if escrow does not close, either because of default of a party or because of operation of the contingencies.
Have a plan for your purchase before entering into discussions or negotiations. As the buyer, you have a lot at risk. Make sure you are pursuing the purchase on your terms. If you cannot structure or negotiate the deal that you want, you must be prepared to walk away.
Have your accountant calculate the tax consequences of the purchase and help you guestimate your cash flow in the first year of the purchase. You must anticipate a negative cash flow. If the cash flow is strong enough to cover compensation to you, your improvements to the business, and payments on the loan used for purchase of the business, why would the seller sell?
You need to know what the negative cash flow will be in order to know whether you can afford the purchase. If you do not have other resources to cover the negative cash flow and unexpected situations, you cannot afford to purchase the business on those terms.