While it is challenging to make a comprehensive list of items that a prospective buyer should investigate, what follows is a list of general categories and a few helpful hints. It bears repeating - this is why the buyer should engage their own team of experts. No one person can have the expertise or the time to cover all the bases that should be covered.
It helps to start with a high level perspective, and then to focus in on areas that pose the greatest risk of future economic impact, whether in the form of lost sales or penalties and legal costs.
The Consumer Finance Protection Bureau (CFPB), established by Dodd-Frank, has announced its 2016 Rulemaking Agenda. The CFPB is a multi-faceted entity, having been given rule-making, supervisory, reporting, and enforcement authority that has so far appeared to be broad in scope.
You can get the full text of the 2016 agenda here. In brief, here are the primary areas of interest:
The Bureau also referred to its longer term rule-making agenda, which was last updated in the fall of 2015, and includes an ongoing inquiry regarding credit reporting and its impact on the availability of credit, access to checking accounts, employment, and housing. Student loan servicers are also under the Bureau’s microscope, as it continues to monitor practices and evaluate potential rules.
 Dodd-Frank Wall Street Reform and Consumer Protection Act
Peeling the Onion
The process of disclosure by a seller is similar to peeling an onion. In order to pique buyer interest, some disclosure of a general nature is common, often in the form of a broker’s presentation or memorandum. The buyer will have signed a nondisclosure agreement and in exchange be given some high level financial and business information.
At this point an instrument known variously as a letter of interest, term sheet, expression of interest or something similar may be drafted by the buyer and presented for the seller’s consideration. They are usually nonbinding in terms of any commitment to buy or to sell, but the benefit is that they lay out the terms broadly, and the buyer will often have also gotten a stand-still arrangement wherein the seller ceases to market the business or entertain other offers. This is because the time involved, and the cost to the buyer of using their team of experts to assist them, is an investment that the buyer doesn’t want to see go up in smoke because the seller was still out looking for interested parties. Think of it as a pre-engagement ring- the couple has agreed that they want to get engaged but they are not actually yet engaged.
The Purchase Agreement- Inking the Deal
Handshake deals are a wonderful concept. However, given the risks involved in today’s world, especially that the person with whom you have an agreement may not be the one you end up dealing with later, they are simply not tenable in most circumstances. This is especially true for something as complex as buying someone’s business, even a very small one. While acquiring a going concern is often a very good solution for someone, there are several ways this can go very wrong. A comprehensive, well-written purchase agreement need not be a treatise, but it should encompass several things.
The Dealer Holds the Pot
Other decisions that should be made fairly early in the negotiations include whether bulk sale laws are applicable, and whether an escrow agent will be used. Often these two considerations are commingled, and some confusion may result.
In general in California, bulk sale compliance is required for businesses whose principal business is the sale of inventory from stock, including manufacturers; restaurants; and certain auctions, or series of sales. One way to think about this is to consider whether it is possible that someone else is owed money that was used for the purchase of the goods, or inventory, being sold by the business. The bulk sale laws protect such creditors by requiring notice of the impending sale of either a majority of the assets or the entity itself.
Contrary to common understanding, there is no statutory requirement for an escrow with an asset sale, even if the transaction falls under the bulk sale transaction.
Taking a sham guarantee doesn't invalidate the loan or the core collateral, it just means you won't be able to pursue the guarantor personally to collect a deficiency on a real estate secured loan following foreclosure.
As defined by the courts, a sham guarantee is one that is unenforceable because it was structured for the purpose of circumventing California's single action and anti-deficiency rules.
These laws were developed years ago as a result of lenders who took advantage of unsophisticated buyer/borrowers. A practice had developed in some arenas to inflate the value of the property in a sale, lend against that value and then when borrowers could not pay, and the property didn't satisfy the loan, the borrowers would be faced with a huge deficiency judgment. Lenders were also filing multiple legal actions against these borrowers, who lacked legal resources and knowledge to combat them. The single action rule applied to real property loans means that the lender gets one bite at the legal apple in pursuing collection. The anti-deficiency component, when applicable, prevents the lender from pursuing the borrower for collection of any loan losses not covered when the lender forecloses and sells the collateral.
Structure of the transaction
[For the next several posts, we are going to focus on the steps involved in purchasing a business, rather than starting one. Later we'll return to the topic of startups.]
One of the first considerations in negotiating for the purchase of a business is how the transaction will be structured, whether as an asset sale or a stock sale. Typically a seller will prefer a stock sale, and a buyer will desire an asset sale. For the seller, a stock sale allows for potential capital gains tax savings. Conversely, in a stock sale a buyer will not be able to capture a step-up in basis for the depreciable assets that are part of the transaction, and will therefore lose out on the benefit of depreciation expense write-offs thereafter. (see http://www.smallbiztaxadvisor.com/federal/top10.lasso)
Buyers also usually prefer asset sales because it is more feasible to limit their liability for the seller’s prior acts or omissions. Not that an asset sale is bulletproof in this regard- failure to comply with applicable laws, conduct due diligence and incorporate strong indemnification and other clauses in the sale contract may leave a buyer exposed to seller-created liability in spite of its structure as an asset sale. However, in a stock sale, the buyer typically gets the whole frog, warts and all. In an asset purchase, the buyer can carefully exclude any or all liabilities and build in protections in the event of a future claim- in the case of the frog, the buyer can select only the legs, and not the rest.
Real Estate as Part of the Business Acquisition
If the transaction involves either the purchase of real estate, a commitment to a real estate lease for a period of greater than a year, or the business being acquired is location dependent, the buyer will want to consider including some real estate experts. A business may be location dependent due to market access, or zoning laws, or the seller may be packaging the deal to include a lease of seller-owned property.
Setting up shop
At some point prior to closing, in addition to conducting due diligence on the services/vendors with which a seller has contracted, the new business owner will want to research and establish relationships with various providers. This will depend on the industry, the local legal requirements, and the new owner's existing providers, if any. Here are a couple of the most common services a business needs:
Assembling the Team
Whether your decision is to buy or build a business, you will find that it’s not something you can do entirely on your own. Often a prospective buyer is anxious about spending money before they have a done deal, not wanting to spend money just to eliminate prospective purchase opportunities. Except perhaps in the rare circumstance where the buyer is a very experienced acquirer in the particular industry, and the sale is a fire sale, it is essential that the buyer perform due diligence to avoid a bad buy, overpaying for a business, or avoiding undue future exposure to liability. I liken this to the process of buying a home.