The Nuts and Bolts of Buying a Small Business

I. What types of questions should an interested buyer ask when contemplating the purchase of an existing business?

It’s very important to be thorough in your “due diligence” when contemplating the purchase of an existing business. You want to ask the right questions, examine the right documents and look beneath the surface to determine if this business investment makes financial sense—these are the common sense questions:

a. Why is the Seller selling? (Is he/she retiring; has he/she let the business run into the ground; not equipped to handle changing trends in the industry; doesn’t have the capital infusion needed to take the business to the next level).

b. Can I talk to current employees? (Will give you a good idea of worker morale and personalities; see first hand who is responsible for what; who shares your ideas/vision; who are the workers and who are the slackers).

c. Can I observe the operation for a few weeks and/or work in the operation? (Will help eliminate surprises once you take over; a must if at all possible-if it’s not possible, is the Seller trying to hide something?).

d. Will Seller help facilitate the transition of the business post-closing? (You can work out an arrangement in which the Seller either works for free or gets paid for certain period of time).

e. Will Seller provide 3 years of tax returns for the business, certified statements of income, cash flow/balance sheets? (Obviously, you want to know the gross revenue, profits, cash flow, assets and liabilities of the business).

f. What are the current working conditions? (Are you going to have to make interior repairs, equipment upgrades, install HVAC, etc.–all which add to your out-of-pocket investment).

g. Any existing environmental or other hazards in the workplace?

h. What are the existing obligations of the business including leases, accounts payable, third party contracts, and other indebtedness? (Are there obligations that you need/are willing to take on such as a lease OR are there some obligations that you want satisfied prior to closing such as lines-of-credit that are secured by equipment you need to run the business).

i. What are the existing employee salaries, bonuses, benefits, etc?

j. Does Seller offer financing for the purchase?

k. How did Seller determine the sale price of the business? (Is it merely a multiplier of the Seller’s investment in the business, and if so, is that a true and accurate measure? Is it a multiplier of actual profits, and is that industry standard? Seek the advice of an accountant or business valuation expert!!)

II. What is a Letter of Intent (LOI) and is it recommended in the sale of a small business?

A. Typically comes about once the key terms of the deal have been agreed to;
B. Short letter setting forth some of the key terms of a proposed transaction; Example: purchase price, financing terms, equipment included, time frame for due diligence to be conducted, anticipated closing date, liabilities to be assumed, etc.
C. LOI is generally non-binding (need to specify if any parts are binding) and states that it will be superceded by the formal written agreement;
D. What are the conditions to getting to a final deal? What is the time frame?
E. Does Seller have to provide anything to assist in due diligence?
F. Key representations and warranties of the parties;
G. Assists the Buyer in obtaining financing;
H. Specify what else the Buyer needs in order to conduct his due diligence;
I. “No shop” clause so that Seller can solicit competing offers for a specified period of time.

III. Is it necessary to form a legal entity, and should I purchase the business in the name of that entity?

A. Depends on several factors such as: potential personal liabilities in that line of work, federal and state tax considerations, financing needs, and the management structure;
B. Forming an entity shields the individual(s) from personal liabilities, and typically only the assets of the business are subject to exposure in civil suits;
C. Beware of the fact that lenders, landlords and vendors may require personal guarantees if you are not yet established. Personal guarantees do open your personal assets up to lawsuits;
D. An act of fraud or reckless conduct may expose the individual(s) to personal liability.

IV. What type of entity should I consider forming?

a. Sole proprietor
1. Not incorporated;
2. Owned by an single individual;
3. May be appropriate where liabilities of the business are not a concern or are adequately covered by insurance;
4. No employees; example would be a home-based consulting business;
5. Business income and expenses included on the individual’s income tax return.

b. Partnership
1. An association of 2 or more people who will co-own a business;
2. Maybe appropriate for situations that are similar to that of sole proprietor, but there happen to be more than one owner;
3. The partners are personally liable for all debts and other obligations of the partnership;
4. Partners are generally considered equal in terms of management authority and conduct of the business; if the partners want to change this arrangement, then they must draft a partnership agreement;
5. Property of the partnership belongs to the partnership and NOT the individual partners;
6. Income and losses are taxed to the individual partners equally OR as provided in the partnership agreement;
7. The partnership must file an information return with the IRS.

c. Corporation- “S” corp. v. “C” corp.
1. Shields the owners from debts and obligations of the entity;
2. Management is vested in a board of directors who are elected by the shareholders;
3. Board of directors appoint officers to manage the day-to-day operations;
4. Same person can be on the board and hold a position as an officer;
5. Must file a certificate or Articles of Incorporation with the State;
6. Board of directors adopts by-laws;
7. Must follow certain formalities to maintain its corporate status: hold regular meetings, file annual reports, pay corporate taxes, etc;
8. The corporation is a tax-paying entity subject to state and federal tax on income unless it elected “S” status in which case it’s treated as a partnership;
9. Advantages: limited liability of shareholders, centralized management, free transferability of shares of stock, ability to raise capital by selling stock;
10. Disadvantages: corporate formalities, expenses, tax consequences.

d. Limited Liability Company (LLC)
1. Considered a hybrid entity incorporating features of partnerships and corporations;
2. For state and federal taxes, the LLC is treated as a pass-through entity and taxed as a partnership;
3. Owners of the LLC are called “Members”;
4. Members do not have personal liability for the debts/obligations of the LLC;
5. Management is determined by way of an operating agreement;
6. Formed by filing a Certificate of Formation;
7. Advantages include: limited liability, flexibility in structuring management and;
8. Profit/loss allocations, taxation as a partnership.

V. How do I manage the relationship between my partners and myself?

a. Partnership Agreement (not required under law but is a very good idea!!)
1. Address: partnership name, purpose of the partnership, contribution of capital, division of profits and losses, limitation on a partner’s authority, management issues, dissolution by death, retirement or involuntary withdrawal.
b. Operating Agreement (not required but strongly advised)
1. Capital contributions of members, allocation of profits and losses, allocations of distributions, management, transferability of interest, voting rights, admission of new members, and dissolution.
c. Shareholder’s Agreement
1. Percentage ownership of each shareholder, transferability of shares, death or resignation of a shareholder, insurance provisions (buy-sell), etc.

VI. What type of agreements will be needed to consummate the sale of the business?

a. Asset Purchase Agreement
1. Purchasing the assets of an existing business only rather than its stock;
2. Usually applies to sole proprietorships, partnerships and LLCs;
3. Key provisions include: identification of assets to be sold (and/or excluded), purchase price, method of payment, additional, assignment of leases, non-competition clauses, representations and warranties, indemnifications, place and date for closing, an exhibit identifying all fixtures, equipment, furnishings that are included in the sale, documents to be delivered at closing;
4. Make sure to obtain shareholders consent or consent of members from Seller.
b. Stock Purchase Agreeement
1. Similar items as those in asset-purchase agreement are included, however the transaction is usually a bit more complex since the corporation retains all of its liabilities. Purchase has additional due-diligence that is necessary.
2. More extensive representations and warranties dealing with title to assets, corporate stock, capitalization, financial statements.
c. Bill of Sale- Evidences the sale of the tangible property to be sold such as fixtures, furnishings and equipment.
d. Bulk Sales Transfer- In NJ, there is a requirement for the buyer to give notice to the Division of Taxation ten days prior to closing. Division will reply indicating if seller has any remaining tax liabilities. Highly recommended in Pennsylvania as well-application for tax clearance certificate.
e. Assignment of warranties- Equipment
f. Assignment of lease- Do you need landlord’s approval?
g. Assignment of Intellectual Property- Are you utilizing tradenames, marks, systems?
h. Agreement of Sale, Deeds, Affidavits- If purchasing real estate in conjunction with the business.

VII. Miscellaneous

a. Consult an attorney before finalizing the purchase;
b. Consult an accountant to discuss tax implications;
c. Be thorough in due diligence;
d. Assess financial risk/exposure in the event that you lose your entire investments and the business goes under.

Joshua M. Marks, Esq.
Marks & Rosenzweig, LLC
http://www.lawmr.com
[email protected]

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