PURCHASING AN ON-GOING BUSINESS is an excellent opportunity for an entrepreneur seeking the financial and personal rewards of owning and operating a business.
Buying vs. Starting a Business
A chief advantage of purchasing a business (as opposed to starting one “from scratch”) is the opportunity to acquire goodwill. In essence, goodwill consists of a business’ reputation, patronage and other intangible assets. Typically, a successful business develops these attributes over a period of time. Thus, the buyer can benefit by acquiring a company with some level of “ready-made” business. However, disadvantages of buying an on-going business include: (a) the price “premium” sought by the seller for the additional value associated with goodwill, (b) a greater potential for “hidden” or unknown risks, liabilities and adverse business conditions, and (c) higher transactional costs (legal, accounting and other professional fees). The following highlights some of the legal aspects and potential pitfalls of various stages of the business purchase process.
The early stages of any business acquisition will entail some preliminary negotiations between the proposed buyer and seller. It is this stage where the parties will begin to explore the broad issues and characteristics of the transaction such as price, payment terms, and the legal structure of the sale (e.g. stock sale, asset sale, etc.). The parties typically converse and may exchange correspondence as well as other informal documents. It is here where the parties may unwittingly encounter their first legal land mine. There is a subtle difference between negotiation and words that give rise to a binding contract.
Letters of Intent
In some cases, a letter of intent (LOI) can facilitate negotiations. LOIs are often misunderstood and can represent significant legal risks. Many times, people wrongly view LOIs as documents that are “somewhat binding.” LOIs can have binding and/or nonbinding provisions— but there is no middle ground. LOIs must be drafted with care. If a purportedly “nonbinding” LOI is sufficiently definite as to the essential terms and demonstrates an intent to be bound, courts may construe it as a binding contract, despite the document being labeled “Letter of Intent.”
Primary and Ancillary Transaction Documents
A business sale/purchase may be structured in numerous ways. Popular structures include the stock sale, asset sale and merger. The legal structure of the transaction will determine the type of primary transaction contract that creates the legal obligation to transfer ownership of the business in accordance with the stated terms and conditions— for example, Stock Purchase and Sale Agreement, Asset Purchase and Sale Agreement or Merger Agreement. Depending on the nature of the transaction, a variety of other agreements, contracts, documents and instruments may be required— for example, loan agreements and promissory notes, employment/consulting agreements, stock pledges, security agreements and financing statements, personal guarantees, assignments, bills of sale, “corporate” consents, resolutions and authorizations, deeds, leases and restrictive covenants.
Due Diligence and Risk Reduction
Due diligence is the care and investigation undertaken (primarily by the purchaser) to assess the legal, financial and market risks of a proposed transaction. Since caveat emptor (buyer beware) remains the general rule of business transactions, due diligence is critically important to purchasers. The parties should delineate the scope of, and time for, due diligence and establish contingencies based upon the discovery of negative conditions as well as the parties’ respective opportunities to cure same. Admittedly, due diligence is time consuming and will increase short-term transactional costs. Thus, the “appropriate” amount of due diligence may be determined by evaluating the nature of the business being sold, the dollar amount and complexity of the transaction, as well as the parties’ risk tolerance. In addition, the parties may reduce and allocate the risk of a transaction through appropriate contractual language. Examples of contractual provisions that may be used to reduce or allocate risk include warranties and representations, escrows and indemnification clauses.
Time and Effort
Consummating a business sale often takes longer than the principals initially anticipate. This is due largely to the time needed to identify, evaluate, propose, negotiate, memorialize, review and often renegotiate major deal points as well as ancillary issues. The principals often expect or want the transaction to be fast and easy. This sentiment brings to mind the true story of a driver who entered the parking lot of what once was New York City’s Pan Am building. (The parking lot was actually several stories up in the middle of the building. When the patron exited his car in this partially indoor/outdoor structure, he could see city streets several stories below.) The patron asked the attendant, “What’s the fastest, easiest way to the street?” The attendant answered, “Jump! But if you want the safer, smarter way, take the stairs around the corner.” To be sure, jumping would be faster and easier than the stairs. After all, the rate of descent would be quick and gravity would do all the work. Business transactions have something in common with reaching the street, there is a fast and easy way, and a prudent way.
In conclusion, purchasing a business implicates important commercial and legal issues. Entrepreneurs will be well served by obtaining professional advice regarding such transactions. Please contact the author if you wish to discuss this article or his practice areas.
This article is provided solely for the general interest of the reader. The article and its contents are neither intended as, nor should be construed as, legal advice or opinion. Legal advice and opinion are provided by the firm only upon engagement with respect to specific factual situations.
Barry F. Gartenberg, L.L.C.
Attorney at Law
505 Morris Avenue, 1st Floor
Springfield, New Jersey 07081