By attorney Shahara Wright Menchan, Special to THELAW.TV
Buying an existing business can be a great opportunity for someone looking to gain entry into a certain industry.
Existing businesses come with great perks, like an existing customer list, established vendors and employees, and tangible assets. However, existing businesses can also come with some negatives, such as bad bookkeeping, tax burdens, debt, and poor management. Understanding the various peaks and valleys of purchasing an existing business is the key to making the transaction a success.
A lot of small businesses tend to purchase and sell businesses without an attorney or any professional advice. While this may save you a little bit of money in the beginning, it will cost you a lot of money in the end. When purchasing an existing business, it is important to do as much due diligence as possible. That means understanding what liabilities (debts) and assets the exiting business has.
There are two types of sales that are usually associated with purchasing a business: an asset sale and an interest sale.
With an asset sale, you are only purchasing the assets of the business, i.e. chairs, tables, supplies, customer lists, etc. When an asset sale occurs, you have a Purchase Agreement, a Bill of Sale, and, if you are making payments toward the purchase, a Promissory Note. The purchase agreement will set out all of the assets that you are purchasing in the sale. You want to make sure that there are no liens or debt associated with the property. You also want to make sure that the seller owns the property for which he is trying to sell.
In an interest purchase, you are buying the business itself and all of its assets. Therefore, if the business is corporation or an LLC, you are purchasing the interest in whole or part of the entity. In that case, you have to look at the business as a whole. You will have a transfer agreement that transfers the amount of interest in the company you are purchasing from the seller. You have to determine if the entity has proper financials. Has it filed all of the necessary tax returns (both state and federal)? Has it engaged in property bookkeeping? What type of contracts does the company have to abide by? These are all important questions when purchasing an entity.
Consider this. Ms. Jones wanted to own a restaurant. She decided to purchase an existing business. The business she was interested in was in an excellent location, had existing customers, and a decent reputation. Excited about the opportunity, Ms. Jones jumped at the chance to purchase. She paid the existing owner, Mr. Smith, $40,000. She agreed to take over his lease and run the business.
About three months after the purchase, the landlord locked the doors to the restaurant claiming that the rent was past due. What went wrong? First, and most important if you are purchasing a business that has a lease agreement, you want to make sure that you have spoken to the landlord. Most, commercial lease agreements contain a clause that requires the landlord to agree to any assignment or sublease by the original tenant. In the case of Ms. Jones, she failed to contact the landlord to determine if there was any past due rent. More importantly, she should have contacted the landlord to obtain a new lease. This way she would only be liable for the rent that is due under her own lease and not the previous owner. This means that her original purchase of $40,000 has increased to whatever the past due rent is because she cannot continue to operate if the landlord locks her out.
Another good example would be that of Ms. White. She purchased an existing business through an interest purchase. Using an attorney and CPA, Ms. White realized that while the business could be profitable, the management was incompetent. During the due diligence process, agreements were drawn up to ensure the stability of the business prior to completing the sale. After completing the contract, Ms. White paid $10,000 in escrow to hold the business during the investigation process. Through the due diligence process, it was determined that there was a lot more debt than the owner previously revealed. Ms. White's CPA examined the bank accounts, tax returns, and financial statements, which revealed that the seller was not forthcoming about the amount of debt that was originally presented. It was also revealed that many of the employees had not been paid and were missing paychecks. Through the due diligence process, Ms. White was able to renegotiate the sales price and reduce it based on the debt that was discovered.
You will see that it is important to conduct a proper investigation into the business itself. No matter how big or small, understanding what lies beneath the shiny exterior of a business is the key to a successful purchase. Make sure that you ask the right questions and employ the right professionals to help you make the right decisions. Buying an existing business can be worthwhile, but only if you know what lies ahead.
The author, Shahara Wright Menchan, is an attorney in Houston, Texas.
Nothing in this article is intended as legal advice. The information contained herein is for example. You should consult an attorney regarding your own specific purchase as laws are different in various states and jurisdictions.