Purchasing an existing business is a complicated process with several stages. The most important stage for the buyer is the “due diligence” study. A thorough due diligence study should reveal areas of concern and possible mismanagement by the seller. The study will assist the buyer to make an educated determination whether to proceed with the purchase. Regardless of the structure of the purchase transaction (asset sale or equity sale), it is imperative that the buyer conducts a comprehensive review of the business, both from a financial and legal perspective. Hiring an experienced attorney is critical for the legal review, and engagement of an experienced CPA is critical for the financial review. Based upon the findings of the due diligence study, the attorney will make recommendations to the buyer and will attempt to structure the deal to protect the buyer’s best interests. Some issues commonly overlooked by buyers include:
1. Organization and Ownership of the Seller.
How is the selling entity organized? Who are the owners? Does the selling entity have any parent, subsidiary, or affiliated entities? If so, who are the owners of each? What agreements exist between the owners and the related entities? What ownership approvals are required for the sale to take place?
2. Registration, Permits and Licenses.
Where is the business registered? Is the business in good standing in all places where it is registered? Does the business need to be registered elsewhere? What permits and licenses are required to operate the business? Are the existing permits and licenses transferable?
3. Asset Review.
What assets are owned by the business? What assets does the business finance or lease? Where are the assets located? Are there recorded and/or unrecorded liens on the assets? Which assets are going to transfer in the deal? Which assets are not going to transfer? Are the assets transferable?
4. Contract Review and Leases.
What existing contracts is the business a party to? Does the business lease real property? Are the contracts and the leases transferable? What is the process for transferring the contracts and the lease(s)? Will the sale of the business result in a breach of any contract? What contractual obligations will the buyer be subject to following the sale?
5. Employee issues.
Who are the existing employees and independent contractors? Will they remain with the company after the sale? Are there existing employment contracts? Will the buyer want employees and independent contractors to execute new agreements? Is there an employee handbook? Are there employee benefit plans in place? Are there any disclosed or undisclosed employment disputes or potential violations of employment laws?
6. Lawsuits and Judgments.
Are there existing lawsuits against the business? Are there outstanding claims against the business or its owners? Are there existing judgments against the business that have not been satisfied and released? Are there potential lawsuits or administrative claims?
What types of taxes is the business responsible for? Have all prior taxes been paid? Are there any outstanding tax liens or assessments? Have all employee taxes been properly paid? Is there some contingent liability such as employees being improperly classified as exempt or non-exempt?
8. Creditor Issues.
Who are the creditors of the business? How much debt exists? Is the debt going to be assumed? Are creditors going to be paid out of the purchase price?
9. Other Issues
Insurance coverage; Franchise considerations; Environmental concerns; Customer relations; Intellectual property matters; etc.
The information learned from a thorough due diligence study will be critical to the buyer’s decision of whether or not to go forward with the purchase. In some cases, the anticipated structure of the deal will change based on the information that the buyer discovers, as the purchase agreement must be designed to protect the buyer from expected and unexpected legal problems following the sale.
Some ambitious (and imprudent) business purchasers believe that hiring an attorney or accountant to conduct legal due diligence will only “throw cold water” on the deal that the parties want to consummate. However, some of the most commonly litigated issues that arise following a business sale (including fraud and breach of contract) can often be eliminated by having an attorney and an accountant complete a legal and financial due diligence review prior to the closing of the deal.