Buying a business is risky. If you know what you’re doing, you can end up with a profitable venture. But if you don’t, you can end up losing your hat.
The outcome will largely depend on the buyer’s ability to purchase the right business and negotiate the right sale agreement. To make it work, you have to get to know the business inside and out. You also have to negotiate an agreement that will adequately protect your interests.
This article will give you some idea of how this plays out through acquisition.
Acquisition has three distinct phases:
The first phase begins with selecting the right structure for the acquisition. There are two structures to choose from: the stock transaction, in which the buyer acquires the seller’s owner interest in the company that owns the business, and the asset transaction, in
which the buyer acquires the assets of the business.
Many sellers will want to use the stock transaction to reduce their income taxes on gain realized from the sale. However, most buyers will reject this transaction. Why? Because the buyer doesn’t want the liabilities of the company. Here’s how this works:
In a stock transaction, the buyer steps into the shoes of the seller. When that happens, the buyer inherits all the liabilities of the company. It’s an inheritance nobody wants. A buyer can be faced with Internal Revenue Service deficiency assessments, unpaid sales taxes on past tax periods, actions filed by disgruntled employees for past violations, actions filed by other parties for unpaid accounts, or for breach of contract or warranty that occurred before the sale. If the buyer just buys the assets, the buyer leaves these liabilities with the seller.
The second phase is the due diligence investigation, which is the most time consuming and important part of an acquisition.
In due diligence, the buyer has an opportunity to inspect all the financial, accounting and other records of the business to ascertain profitability. The buyer also gets to inspect and determine the condition of assets.
Finally, a sale agreement is negotiated to structure the legal relationship between the buyer and seller. The buyer must ensure that the terms of the agreement adequately protect his backside. This is especially true in stock transactions.
Agreements typically have three measures — representations and warranties, indemnity, and rights and remedy — to protect the buyer. Each plays an important role.
Reps and warranties are the seller’s assurances about the business. They are made to induce the buyer to acquire the business. Accordingly, the buyer must preserve the right to sue the seller should any assurance prove false. Reps and warranties go to the guts of
the transaction. Some examples:
- The financial and accounting records are true and accurate. 2. There are no undisclosed liabilities. 3. All ofthe seller’s tax returns were properly filed and all taxes were fully paid. 4. The seller has good and merchantable title tothe assets. 5. The assets are in good and operable condition.
An indemnity provision is a seller’s guaranty that he will hold the buyer harmless from any claims that accrued before the sale. As a part of this guaranty, the seller should be obligated to provide a defense to such claims. The seller should also have to pay any loss or judgment on such claims.
Rights and remedies give the buyerinjunctive relief to force the seller to live up to promises not kept. These provisions also give the buyer the right to recover any damages that resulted from seller’s breach, and to recover his costs and attorney fees.
Acquisitions can get pretty complicated. A lot of accounting and legal issues will come up, and you must know how to resolve them. It’s a good idea to take your attorney and certified public accountant along with you. They’ll become your best friends during due diligence.
Printed in Four Rivers Business Journal (Paducah Sun), January 2009.