BUYING AN EXISTING BUSINESS

The decision to buy a business is an extremely important one, for such an acquisition almost inevitably brings significant changes in the buyer's financial situation and personal life. Such purchases, then, should not be made before first thoroughly investigating all aspects of the business under consideration and the impact that ownership of that enterprise would likely have on the buyer's personal and professional life.

Even before beginning the search for an appropriate existing business, would-be buyers are encouraged to honestly assess the level of commitment and resources that they are willing to bring to bear to made a new business endeavor a successful one. Small business experts encourage potential business buyers to frankly ponder the levels of time and energy that they can devote to a new enterprise. Are the number of hours available sufficient given the work involved? Does the business require a higher level of exertion than you are prepared to expend?

Experts also encourage potential business buyers to canvass their families about their attitudes regarding the sacrifices—both financial and personal—that are sometimes necessary to move an acquired business forward. In addition, buyers should investigate whether the nature of the business will be a rewarding one for them. What are their motives in pursuing a business purchase? What criteria are being used to search for one? Finally, potential buyers should determine the level of financial commitment that they are willing to make to the new business (and the level of financial assistance that they are likely to be able to secure, if needed). If, after a thorough assessment of these factors, the would-be buyer is still in the market for a business, he or she can proceed.

EVALUATING BUSINESSES

"The first step a buyer must take in evaluating a business for sale is that of reviewing its history and the way it operates," wrote John A. Johansen in the Small Business Association's How to Buy or Sell a Business. "It is important to learn how the business was started, how its mission may have changed since its inception and what past events have occurred to shape its current form. A buyer should understand the business's methods of acquiring and serving its customers and how the functions of sales, marketing, finance and operations interrelate."

In an article for the Houston Business Journal, Scott Clark mentioned several key questions prospective buyers should consider in evaluating a business for purchase. For example, it is important for the buyer to understand why the business is being sold, whether the business is financially sound, and what legal considerations may be involved in the sale. Clark also noted that buyers should evaluate the market value of the business's assets as well as the market potential of its products or services.

BALANCESHEET Much of this information—and all-important data on the company's fundamental financial health—can be gleaned through an examination of the enterprises's financial statements and operations documents. Johansen pointed to several areas of the business's balance sheet that should be thoroughly looked over when evaluating a company:

* Accounts Receivable—can provide information to buyers on diversification of customer accounts (or lack thereof), accounts that are overdue or in dispute, accounts that have been pledged as collateral, and the company's credit policies.
* Accounts Payable—as with Accounts Receivable, can provide information on diversification and status of accounts; can also help buyers identify undisclosed or contingent liabilities.
* Inventory—can provide buyers with information on the size, age, and condition of the inventory, the method of inventory valuation, the process by which damaged inventory is valued, and other data on current owner inventory methods.
* Real Estate—these records can help buyers establish the condition and market value of all buildings and lands that are part of the business, and can be valuable in assessing whether to secure the services of an appraiser; also provides information on various aspects of maintenance, including business relationships and costs.
* Marketable Securities—can aid buyers in determining the value and status (restricted or pledged) of any marketable securities.
* Machinery/Equipment—schedules of machinery and equipment owned or leased by the company can provide potential buyers with information on 1) condition, age, and maintenance needs of equipment and machinery; and 2) those items that are used to adhere to local, state, or federal regulatory requirements, and whether existing machinery is sufficient to meet those requirements.
* Accrued Liabilities—schedules of accrued liabilities inform buyers about the business's accounting mechanisms for unpaid wages, accrued vacation pay and sick leave, payroll taxes due and payable, and accrued federal taxes, among other accruals.
* Notes Payable and Mortgages Payable—can help buyers identify causes of debt, determine terms and payment schedules of those debts (and whether they are assumable); also delineates whether a change in ownership would accelerate the note or mortgage or trigger a prepayment penalty.

Problems in any of these areas can help prospective buyers decide whether to secure the services of an appraiser.

The balance sheet, though, is only one of myriad aspects that need to be thoroughly evaluated by buyers. Other areas of the business that should be examined include its financial ratios, income statements, rental or lease arrangements, employees, station in the marketplace, and other legal issues (ranging from status of patents to current level of adherence to legal requirements).

INCOME STATEMENTS Profit and loss statements provide vital information on the business's recent financial history and potential for future success. Experts commonly advise would-be buyers to examine income statements from the previous three to five years, and to substantiate the data contained therein via the company's tax returns. Johansen cautioned, though, that the business's earning power "is a function of more than bottom line profits or losses. The owner's salary and fringe benefits, non-cash expenses, and non-recurring expenses should also be calculated."

FINANCIAL RATIOS Information contained in the company's income statements and balance sheet can be used to figure important financial ratios that can provide insights into the company's fiscal well-being. Important financial ratios include current ratio, accounts receivable turnover, inventory turnover, and sales/accounts receivable.

LEASE ARRANGEMENTS Any examination of a business is woefully incomplete without also checking on the business's lease or rental obligations. All such agreements should be closely studied to learn not only about the length of the contract, but other matters as well. For example, some landlords include a "percent of sales" clause in their leases which require commercial tenants to pay them an additional fee over and above their rent (some also call for additional fees for common area maintenance, etc.). Other lease agreements include option periods and/or demolition clauses. Lease contracts also detail maintenance parameters (will the landlord fix the air conditioning, or will you foot the bill?) and conditions—if any—under which the lease can be assumed or extended by a new owner.

EMPLOYEES A business's work force can be among its most attractive assets. Conversely, it can also be a problem area. Key information that should be analyzed when looking at a company's personnel include job descriptions and current compensation (including benefits) for each employee, skill levels, and morale. In settings where unions are present (or imminent), buyers need to inform themselves about current contracts and management-union relations. Finally, buyers that are pondering acquiring a business in an industry with which they are unfamiliar need to determine whether they will be able to retain key personnel after a purchase is made.

MARKETPLACE STATUS Potential buyers should find out not only about the targeted company's market standing—including market share, competitive advantages, and geographic strength—but also about the strengths and weaknesses of its competitors.

LEGAL ISSUES Diligent buyers will make certain that they are well-informed about a company's legal situation, from its standing with the IRS to its vulnerability to litigation. Would-be owners should determine if any lawsuits against the company have been filed or are pending. They should also ensure that the company is meeting OSHA and EPA requirements, and that the business is in compliance with state registration and local zoning requirements. Articles if incorporation, bylaws, partnership agreements, supplier contracts, and franchise agreements should also be carefully reviewed if applicable.

NEGOTIATING A PURCHASE PRICE

Once a buyer has located a suitable business—usually through newspaper advertisements, industry contacts, or intermediaries (business brokers or merger and acquisition consultants)—undertaken the appropriate research into the enterprise's strengths and weaknesses, and determined what sort of business organization (partnership, sole proprietorship, corporation) will be most advantageous in terms of taxes and other issues, he or she must then go about the process of negotiating a purchase price with the seller.

Buyers and sellers of corporations often lock horns when the time comes to decide whether the acquisition will be a stock sale or an asset sale. The choice has ramifications for both parties in terms of both taxes and legal liability for past operations. Under the terms of a stock sale, the seller receives an agreed-upon price for his or her shares in the company, and after ownership of those stocks has been transferred, the buyer steps in and operates the still-running business. In this kind of purchase, the buyer receives both company assets and company liabilities. This arrangement is popular with sellers because of its tax advantages. The sale of stock qualifies as a capital gain, and it enables the seller to avoid double taxation, since sale proceeds flow directly to the seller without passing through the corporation. In addition, a stock sale frees the seller from any future legal action that might be leveled against the company. Lawsuits and claims against the company become the sole responsibility of the new stock owner(s).

Partnerships and sole proprietorships, meanwhile, must change hands via asset sale arrangements, since stocks are nonexistent under these forms of business. Under asset sale agreements, the seller hands over business equipment, inventory, trademarks and patents, trade names, "goodwill," and other assets for an agreed-upon price. The seller then uses the money to pay off any debts; the remainder is his or her profit. Asset transactions are favored by buyers for two big reasons. First, the transaction sometimes allows the buyer to claim larger depreciation deductions on his or her taxes. Second, an asset sale provides the buyer with greater protection from unknown or undisclosed liabilities—such as lawsuits or problems with income taxes or payroll withholding taxes—incurred by the previous owner. Given the dramatically different impact that asset and stock transactions have on both the buying and selling parties, it is hardly surprising that negotiations on this issue can become arduous. "This subject usually deserves a fair amount of negotiating time and, if there is radical disagreement, it can be a deal breaker," warned Lawrence Tuller in Getting Out: A Step-by-Step Guide to Selling a Business or Professional Practice.

As buyers enter into negotiations with sellers, they should make it clear that they expect the seller to provide asked-for information in a timely and detailed manner. "Whatever the results of [the] negotiation," wrote Tuller in Buying In: A Complete Guide to Acquiring a Business or Professional Practice, "be very careful to make the agreement contingent on satisfactory completion of a thorough and complete investigation of the company's records, facilities, people, and markets. Ordinarily the seller doesn't object to this proviso. He knows what skeletons will come out during detailed due diligence and, if he has been honest, realizes there won't be any major surprises. If, on the other hand, he insists on a firm Offer to Purchase at the conclusion of this first round of negotiations, there is something important he hasn't revealed and you better back off fast." In return, sellers often ask prospective buyers to sign confidentiality agreements in which they promise not to divulge any information about the business to anyone other than immediate advisors. Sellers also sometimes ask for would-be buyers to provide personal financial statements so that they do not waste time with people who do not have the financial wherewithal to make a serious offer.

If a buyer is still interested in acquiring the business in question after negotiating the above issues and securing a reliable valuation of the business, he or she can proceed with an opening offer. This can take the form of a letter of intent (which is generally nonbinding) or a purchase and sale agreement (which is usually legally binding). Both kinds of offers will typically include the following:

* Total compensation offered, including breakdown (size of security deposit, down payment, seller-financed debt, bank debt)
* Warranties of clear and marketable title
* Detailed list of all liabilities and assets to be purchased
* Assurances of the validity and assumability of contracts (if applicable)
* Tax liability limitations
* Operating condition of all equipment and machinery at time of purchase
* Stipulations allowing buyer to adjust the purchase price in the event that: 1) undisclosed liabilities come due after settlement, and 2) actual inventory purchased does not match amount specified in sale agreement
* Provisions that the business passes any and all necessary inspections
* Provisions that final sale is contingent on verification of financial statements, license and lease transfers
* Provisions that final sale is contingent on obtaining financing for purchase
* Restrictions on business operations until final settlement
* Non-competition and advisory clauses
* (these are sometimes arranged in a separate document)
* Allocation of purchase price
* Date for settlement

Business buyers are encouraged to secure the services of professionals during this process. Attorneys, accountants, consultants, and SBA counselors can all provide valuable assistance to people interested in acquiring a business.

FINANCING

Whether the buyer and seller ultimately agree to an installment sale, a leveraged buyout, a stock exchange, or an earn-out to transfer ownership of the company (see the entry "Selling a Company" for descriptions of these options), the sale cannot proceed if the buyer is unable to secure adequate financing.

Most small businesses are acquired by buyers who finance a considerable portion of the purchase price themselves. Even so, the buyer must still make sure that he or she has enough money to make a down payment and cover the business's capital requirements. Sometimes, then, buyers are forced to secure financing from outside sources. Johansen noted that "to grant such financing, an institutional lender is almost certain to require personal collateral for the loan as well as a compendium of financial and operating data of the business to be acquired. It is rare indeed to be granted a loan to purchase a smaller, privately-held business when the loan is secured only be the assets of the business. The most attractive types of personal collateral from the lender's point of view are real estate, marketable securities and cash value of life insurance."

Lending institutions like banks and consumer finance companies are more open to borrowers involved in purchasing larger companies, but even in these instances, the institutions often ask buyers to put up the company's inventory, machinery, real estate, and accounts receivable as collateral. As Johansen observed, "It is rare for a privately-held business to be acquired without leveraging the business's assets in some manner, pledging them as collateral for a loan made either by the owner of the business or an outside lender." Sensible buyers in need of outside financing will make certain that they approach potential lenders with a comprehensive and well-considered loan proposal (including a good business plan).

CLOSING THE DEAL

Closings are generally done either via an escrow settlement or via an attorney performs settlement. In an escrow settlement, the money to be deposited, the bill of sale, and other relevant documents are placed with a neutral third party known as an escrow agent until all conditions of sale have been met. After that, the escrow agent disburses the held documents and funds in accordance with the terms of the contract.

In an attorney performs settlement, meanwhile, an attorney—acting on behalf of both buyer or seller, or for the buyer—draws up a contract and acts as an escrow agent until all stipulated conditions of sale have been met. Whereas escrow settlements do not require the buyer and the seller to get together to sign the final documents, attorney performs settlements do include this step.

Several documents are required to complete the transaction between business seller and business buyer. The purchase and sale agreement is the most important of these, but other documents often used in closings include the escrow agreement; bill of sale; promissory note; security agreement; settlement sheet; financing statement; and employment agreement.

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