The Complete Guide to Buying a Business
Learn how to buy a small or midsized business
Fred S. Steingold, Attorney
August 2011, 3rd Edition
A perfect guide for entrepreneurs
Whether you just want an overview of the business buying process or you're ready to acquire an existing business, you know you’ll need to finance, negotiate and structure the deal. The Complete Guide to Buying a Business will give you everything you need to know including more than two dozen crucial forms and legal documents to help you do it. You’ll learn how to:
- find the right business
- analyze the seller's numbers
- make sense of the tax issues
- prepare and sign a sales agreement
- close the deal
- prevent the seller from competing against you
- work with lawyers, accountants and brokers
The 3rd edition of The Complete Guide to Buying a Business is completely updated to reflect the latest laws and tax information.
“For an overview of the purchase process, see The Complete Guide to Buying a Business.” - San Francisco Chronicle
“Nolo is always there in a jam as the nation’s premier publisher of do-it-yourself legal books.” - Newsweek
- IRS 8594, Asset Acquisition Statement and Instructions
- UCC Financial Statement and Addendum
- Confidentiality Letter
- Attachment to Sales Agreement
- Amendment of Sales Agreement
- Promissory Note
- Security Agreement for Asset Sale
- Security Agreement for Entity Sale
- Escrow Agreement for Stock Certificates
- Escrow Agreement for LLC Transfer Certificates
- Bill of Sale for Business Assets
- Statement Regarding Absence of Creditors
- Assignment of Lease
- Assignment of Contracts
- Consent to Assignment of Contract
- Assignment of Intellectual Property
- Directors' Consent to the Corporation's Purchase of a Business
- Shareholders' Consent to the Corporation's Purchase of a Business
- LLC Members' Consent to the Company's Purchase of a Business
- Partners' Consent to the Partnership's Purchase of a Business
- Covenant Not to Compete
- Independent Contractor Agreement
- Closing Checklist for an Asset Sale
- Closing Checklist for an Entity Sale
- Asset Sale Agreement
- Entity Sale Agreement
Fred S. Steingold
Attorney Fred S. Steingold practices law in Ann Arbor, Michigan. An expert on small business law, he represents and advises many small businesses. He is the author of Legal Guide for Starting & Running a Small Business and The Employer's Legal Handbook. His monthly column, "The Legal Advisor," is carried by trade publications across the country.
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Overview of the Process
1. Thinking About Buying a Business
- Business-Buying Worries
- Which Kind of Buyer Are You?
- Three Ways to Become a Business Owner
- The Basics of Buying a Business
- Key Steps in Buying a Business
2. The Key Legal Issues in Buying a Business
- Understand the Differences Between Buying a Business Entity and Buying Just Its Assets
- Consider Forming a Corporation or LLC to Buy the Business
- Be Clear on What You'll Buy and What the Seller Will Keep
- Pay Special Attention to the Transfer of Intellectual Property
- Know the Legal Consequences of Not Making Installment Payments on Time
- Assure That There Are No Liens on Business Assets
- Protect Yourself From Competition by the Seller
- Limit Your Legal Liability for Past Obligations of the Business
- Comply With State and Local Laws That May Affect Your Purchase
3. Tax-Saving Strategies
- Understanding Business Write-Offs
- Buying Assets vs. Buying the Entity
- Allocating the Purchase Price in an Asset Sale
- Writing Off Purchase-Related Expenses
4. Finding the Right Business for You
- Before You Begin
- Attractive Businesses May Be Nearer Than You Think
- You May Be a Strategic Buyer
- Finding a Business by Word of Mouth
- Finding a Business Through Advertising -- Yours and Theirs
- Business Brokers Can Help Find Sellers
- What Sellers Want to Know About You
5. What's the Business Worth?
- There's No Universal Pricing Formula: Many Factors Affect Price
- Sales of Comparable Businesses
- The Asset-Based Approach
- The Income Valuation Approach
- Industry Formulas and Rules of Thumb
- How Appraisers and Other Experts Can Help You Decide on a Fair Price
- Putting Together All the Information
6. Working With Lawyers, Accountants, and Brokers
- Business Brokers
Getting Ready to Buy
7. Financing Your Purchase
- Lump Sum Purchase
- Installment Purchase
- How Sellers Try to Protect Themselves in an Installment Sale
- Show Me the Money: Where You Can Get Funds for a Lump Sum Purchase or Hefty Down Payment
- The Difference Between Loans and Equity Investments
8. Structuring Your Purchase
- Asset Sale vs. Entity Sale
- The Seller's Future Role
- Restrictions on the Seller: Noncompete Agreements
- The Future of Key Employees
9. The Investigation Stage: How Buyers and Sellers Check Each Other Out
- Your Investigation of the Seller's Business
- Paperwork the Seller Should Provide
- The Role of Confidentiality Agreements
- Information to Garner From Other Sources
- Why and How the Seller May Check You Out
10. Drafting a Letter of Intent
- Why Use a Letter of Intent
- What to Put in Your Letter of Intent
- Why You Should Only Sign a Nonbinding Letter of Intent
- Format for a Letter of Intent
Preparing the Sales Agreement
11. Preparing the Sales Agreement and Other Legal Documents
- Overview of Your Sales Agreement
- Related Legal Documents
- Well-Drafted Documents Are Crucial
- Preparing Your Sales Agreement and Related Legal Documents
- How to Prepare Attachments to Your Sale Agreement
- Steps in Finalizing Your Sales Agreement and Other Documents
- Amending Your Sales Agreement
12. Who's Selling, Who's Buying -- And What Is Being Purchased
- Naming the Parties
- Identifying the Business and What You're Buying in an Asset Sale
- Identifying the Business and What You're Buying in an Entity Sale
13. The Sales Price and Terms of Payment
- Sale Price: Asset Sale
- Inventory: Asset Sale
- Dealing With the Purchase of Accounts Receivable: Asset Sale
- Sale Price: Entity Sale
- Payment at Closing
- Promissory Note
- Security for Future Payment: Asset Sale
- Security for Future Payment: Entity Sale
14. Dealing With Liabilities and Representations
- Liabilities in an Asset Sale
- Liabilities in an Entity Sale
- Representations: What They Are and Why They Matter
- Seller's Representations
- Buyer's Representations
15. Payment for Noncompete Agreements and Consultant Deals
- Seller's Agreement Not to Compete With the Business After the Sale
- Seller's Agreement to Work for Your Business After the Sale
- Current Employees of the Business You Are Buying
16. Other Important Legal Language for the Sales Agreement
- Contingency Clause
- Closing Arrangements
- Dispute Resolution Clause
- Technical Contract Clauses
- Additional Optional Clauses
17. Signatures on a Sales Agreement
- Required Signatures for Sole Proprietors on a Sales Agreement
- Required Signatures for an Entity on a Sales Agreement
- A Spouse's Signature on the Sales Agreement
- Signature Clause in a Sales Agreement
- Typical Formats for Signing a Sales Agreement
- Accepting Personal Responsibility for Commitments in a Sales Agreement
- Signing the Sales Agreement
Preparing the Promissory Note and Other Sales Documents
18. Promissory Notes and Other Installment Payment Documents
- The Promissory Note
- The Security Agreement
- The UCC Financing Statement
- Escrow Agreement for Entity Sale
19. Bill of Sale, Lease Assignment, and Other Documents for Transferring the Business
- Bill of Sale: Asset Sale
- Bulk Sales Compliance
- Assignments in an Asset Sale
- Transferring an Entity
- Assignments in an Entity Sale
- Your Entity's Approval of a Business Purchase
20. Documents for Noncompete and Future Work Commitments
- Covenant Not to Compete
- Contract for Employment
- Contract for an Independent Contractor
Closing the Deal
21. Preparing for a Smooth Closing
- Where and When to Hold the Closing and Who Should Attend
- Documents for Transferring Assets
- Documents for Transferring an Entity
- Handling Last-Minute Problems
- Looking Ahead
22. Running a Small Business: Some Legal and Tax Basics
- Entity Concerns
- Safe Business Practices for Your Corporation or LLC
- Tax Basics
- Insuring Your Business
- Negotiating a Favorable Lease
- The Road to Success
A. How to Use the CD-ROM
- Installing the Form Files Onto Your Computer
- Using the Word Processing Files to Create Documents
- Using Government Forms
- List of Forms on the CD-ROM
B. Sample Sales Agreements
- Sample #1: Asset Sale of a Restaurant by One Sole Proprietor to Another
- Sample #2: Entity Sale of a Bookstore by the Two Shareholders to an Individual
- Sample #3: Asset Sale of a Landscaping Business by a Single-Owner LLC to a Partnership
- IRS Form 8594,
- Asset Acquisition Statement and Instructions
- UCC Financing Statement and Addendum
The Key Legal Issues in Buying a Business
Understand the Differences Between Buying a Business Entity and
Buying Just Its Assets.................................................................. 28
How an Entity Sale Works......................................................... 29
How an Asset Sale Works......................................................... 29
Why Sellers Usually Prefer Entity Sales, and Buyers Asset Sales 30
Consider Forming a Corporation or LLC to Buy the Business........ 31
Be Clear on What You’ll Buy and What the Seller Will Keep........... 32
Pay Special Attention to the Transfer of Intellectual Property......... 33
Know the Legal Consequences of Not Making Installment Payments
on Time ....................................................................................... 34
Assure That There Are No Liens on Business Assets.................... 36
Protect Yourself From Competition by the Seller............................ 36
Limit Your Legal Liability for Past Obligations of the Business........ 37
The Liability Rules for Buyers................................................... 38
Ways to Deal With Past Liabilities............................................. 39
Comply With State and Local Laws That May Affect Your Purchase 40
Buying a business is one big legal transaction, made up of a whole slew of discrete legal issues. You’ll need to master all these subsidiary legal issues to get the larger legal transaction right.
If you don’t, you risk not getting all the benefits that you bargained for. For example, if the seller is going to remain responsible for some or all of the business’s past debts and liabilities, you want to make sure you have legal recourse against the seller if he or she fails to pay creditors as agreed. And typically you’ll want the seller to agree not to compete with the business once you become its owner. To get these and many other legal protections, you’ll need to carefully craft a sales agreement and other legal documents. This chapter will introduce the key legal measures you can take to protect your financial interests throughout the sales process.
Later chapters will tell you more about how to deal with legal issues. You’ll find clause-by-clause details of a sales agreement in Chapters 11 through 17 and examples of other necessary legal documents in Chapters 18 through 20.
See an Expert
This book provides the information you’ll need to handle all or most essential legal tasks yourself. But especially when lots of money is involved, it usually makes sense to have a lawyer review your handiwork. In addition, we’ll alert you here to legally fraught or tricky situations in which professional help is especially important. For an overview of specific ways that lawyers can help with legal issues, see Chapter 6.
Understand the Differences Between Buying a Business Entity and Buying Just Its Assets
Any business you’re considering buying is probably being operated as either a sole proprietorship, a partnership, a corporation, or a limited liability company (LLC). If a business is legally organized as a corporation or LLC, there are, broadly speaking, two principal ways to structure the purchase. The first method is to buy the corporate or LLC entity. The second method is to buy all or most of the entity’s assets and let the seller hold on to the entity.
If you’ll purchase a sole proprietorship or a partnership, you can skip this chapter. That’s because with a sole proprietorship, there’s no separate legal entity to buy; by definition, the seller, as the sole proprietor, will be selling just business assets. And although it’s theoretically possible to buy a partnership by substituting new partners for old, a sale of a partnership is also almost always structured as an asset sale.
The importance of understanding the differences between asset and entity sales will come up repeatedly in this book. It affects everything from how you write off the sale price on your tax return, to liability issues and how ownership will be transferred. So although this material is seriously short on sex appeal, you’ll want to master it.
How an Entity Sale Works
Let’s assume that the business you’re considering is either a corporation called Protobiz Inc., or an LLC called Old Stuff LLC. Here’s how an entity sale will work. If you’re buying Protobiz, a corporation, the shareholders will sell you all their stock in Protobiz Inc. In that case, you’ll become Protobiz’s owner and will have the right to control all the assets the corporation owns: furniture, fixtures, equipment, inventory, intellectual property, and so on. The corporation, under your ownership, will remain responsible for the debts and other liabilities of the business. Likewise, if you’re buying Old Stuff LLC, the members of the company will sell you their membership interests, making you the owner of the LLC itself—again, with the right to control all its assets. The LLC, under your ownership, will remain responsible for the debts and other liabilities of the business.
How an Asset Sale Works
Now let’s assume that you’re considering buying the assets of Protobiz Inc., or an LLC called Old Stuff LLC rather than either entity. Here’s how an asset sale will work. If you’re buying the assets of Protobiz, the shareholders will arrange to have the corporation sell you all or most Protobiz Inc., assets, but not the corporation itself. That means the existing shareholders will continue to own what amounts to nothing more than the Protobiz corporate shell. The corporation will have no (or few) assets other than the promissory note you sign for the balance of the purchase price.
Similarly, if you decide to buy the assets of Old Stuff LLC, the company’s members will agree to have Old Stuff LLC sell you all or most of the company’s assets. The LLC members will continue to own the LLC shell. If the LLC sells its assets to you, its only remaining asset will probably be the promissory note you sign. When you buy the assets of the LLC, you won’t automatically become responsible for the debts and other liabilities of the business, but you may agree to assume liability for at least some of them.
When you buy the assets of a corporation or LLC, you don’t automatically become responsible for the debts and other liabilities of the business. You may, however, agree to assume liability for at least some of them as part of the sale contract.
It’s important to understand that the assets that an entity sells to you may not be limited to physical property. You can acquire the entity’s intangible assets as well, such as the company’s goodwill and its trademark.
Why Sellers Usually Prefer Entity Sales, and Buyers Asset Sales
Why is the legal distinction between an asset or entity sale important if the result under either approach is that you end up owning your business? One important reason is that how your transaction is structured will affect how you write off the purchase price on your tax returns, and how the seller gets taxed. As you’ll see in Chapter 3, you’ll typically be able to begin getting depreciation benefits sooner if you acquire only the assets than if you buy the corporate entity or LLC. The flip side is that the seller will usually fare better from a tax standpoint selling the entity rather than its assets, because the seller will pay tax at the low long-term capital gain rate. By contrast, in an asset sale, part of the seller’s tax bill may be computed at the ordinary income rate, which is higher. Sellers are especially skittish about using an asset sale for a C corporation, since they face the distasteful risk of double taxation.
Incidentally, this tax benefits issue is often resolved by a compromise between the seller and the buyer that’s reflected in the sale price or the terms of payment. For example, you may prefer to buy a business on an asset basis so you can immediately begin to get tax benefits. The seller may have set the selling price at $500,000 based on the expectation of an entity sale and may face an additional $40,000 in taxes if there’s an asset sale. To compensate, the two of you may agree to an asset sale, with an adjusted sale price of $520,000—a kind of middle ground.
Another reason why you, as a buyer, might prefer an asset sale is that it gives you the valuable opportunity to pick and choose among the assets you’ll acquire. You’d like to negotiate a good deal for assets you want, leaving behind (and not paying for) those that aren’t valuable to you.
Finally, the treatment of existing debts and other liabilities of the business is very different in entity and asset sales. Typically in an asset sale, you’re not going to be responsible for existing debts of the business, unless you agree to accept responsibility. By contrast, in an entity sale, it’s assumed that all the liabilities go along with the sale—though to make the deal happen, the shareholders or LLC members who are selling may agree to be responsible for some specified liabilities, such as a recent bank loan.
But again, as mentioned above, what’s legally and financially best for you may not be best for the seller, who would probably find it most advantageous to transfer the entire corporation or LLC entity to you. That way, the seller gets favorable tax treatment, is less likely to have to keep any undesirable assets of the business, and shouldn’t have to worry about paying existing business debts and liabilities. Still, even where your interests diverge, it may turn out that you have more clout than the seller when it comes to setting the terms of the deal, and you may be able to insist on an asset sale. This might be true, for example, if the business has been on the market a long time and the seller is anxious to unload it. Or you may be willing to make an unusually large down payment.
Still, in some situations, you may decide not to strenuously resist buying a complete entity rather than only its assets. This can be especially true, for example, if the business is highly sought after, putting the seller in a very strong bargaining position. Similarly, you may be quite willing to go along with an entity sale if the corporation or LLC has a valuable lease for the space where it does business, and the lease can’t be assigned to you. By buying the corporation or LLC, the entity continues to be the tenant, so you get the benefit of the lease. (This won’t always work, since some landlords state in the lease that a change in ownership of the entity will be treated as a forbidden transfer of the lease and cause a termination of the lease contract.) You’ll learn more on this subject in Chapter 8. For now, just be aware that an entity sale can sometimes be the most practical choice even if it doesn’t seem that way on the surface.
Not all entity sales are exactly the same. Important details may differ. For example, in buying a corporation or an LLC as an entity, you and the seller may agree that some assets will be transferred to the seller before the closing. You and the seller may also agree that the seller will assume personal responsibility for some of the existing debts of the business.
Consider Forming a Corporation or LLC to Buy the Business
If you’re not buying a company that’s already organized as a corporation or an LLC, you might consider creating one of your own, so you can have an entity to buy, own, and run the business. Of course, if you already have a corporation or LLC and that existing entity is buying the assets of another business, creating a new entity won’t be necessary.
But let’s say you’re buying the assets of a business that’s organized as a sole proprietorship or partnership and you don’t now have a corporation or LLC. In that case, you face the same concerns as anyone starting a new business from scratch. If you alone own the business, you’ll be a sole proprietor and have unlimited personal liability on all business debts, as well as any court judgments that are entered against the business. Likewise, if you and one or more other people own the business, you’ll have a partnership and each of you will have unlimited personal liability for business debts and business-related court judgments. This means that with either a sole proprietorship or partnership, your personal bank accounts, your investments, and even your home will be at risk for business debts.
By contrast, if you form a corporation or LLC to own and run the business, you’ll reduce the scope of your personal liability and that of your co-owners. For example, you won’t be personally liable for the actions of employees or for business loans that you didn’t personally guarantee. Because the cost of creating a corporation or LLC is fairly low and the paperwork burdens are minimal—especially with an LLC—many small businesses choose to set up one of these limited liability entities. Before you do, though, you should also become familiar with how taxes are computed and learn whether there are other benefits available that make a corporation or LLC an attractive choice.
You can safely defer your decision on whether or not to form a corporation or LLC. You can, for example, negotiate a deal for the purchase of assets and then form the entity before you sign a sales agreement. Or you can even wait until after the closing, create a corporation or LLC at that time, and then transfer the assets to the new entity. But while timing is not crucial, it does pay to begin considering this issue early on.
For an in-depth look at the pros and cons of the various types of business entities: see Legal Guide for Starting & Running a Small Business, by Fred S. Steingold (Nolo).
Be Clear on What You’ll Buy and What the Seller Will Keep
You and the seller may agree to an asset sale. (This will always be true when you purchase a sole proprietorship or partnership. It may or may not be the case when you purchase a business that’s run as a corporation or LLC.) In an asset sale, you’ll want the sales agreement to state very clearly all of the assets you’re buying. This may seem obvious, but a surprising number of sales agreements simply say the seller is selling, and the buyer is buying, “all the assets of the XYZ business.” Including a specific list in the sales agreement is good common sense even if the seller plans to transfer every last asset to you. But a list is especially important if the seller will be keeping some of the assets, such as cash, accounts receivable, or perhaps even a desk and chair the seller has grown attached to. Or maybe the seller is going to license to you—rather than sell to you—some item of intellectual property like a proprietary formula, copyright, or patent.
Again, the point is that to avoid future arguments, you need to be specific in the sales agreement about what’s being sold and what’s not. Otherwise, you may get into a legal fight later over whether something as seemingly trivial as the business’s phone number or trade name belongs to you or the seller. Or you might find yourself taking on responsibility for things you’d like to exclude, such as potential lawsuits or liability for later-discovered toxic damage.
If you’re buying the seller’s corporate or LLC entity, rather than the assets of the business, you usually don’t have to worry about specifying in the sales agreement the assets being sold. By definition, everything the corporation or LLC owns that isn’t specifically excluded will be transferred as part of the sale. But often there are some corporate assets that you and the seller agree won’t be included in the sale. For example, the corporation may own the computer the seller uses, which is loaded with programs and data which the seller would like to keep. If you buy the corporate stock, the computer will automatically be transferred as part of the sale. To prevent that from happening, the seller will need to transfer the computer—and, in some instances, the software and information it contains—from the corporation to himself or herself before the closing of the sale. The sales agreement should make clear that the computer—and any other items the seller is keeping—won’t be owned by the corporation when the stock is transferred to you.
Likewise, the sales agreement for an entity sale should exclude any items that the seller personally owns that are present on the business premises. Since personal items were never owned by the business entity in the first place, this may appear to be unnecessary. But you as the buyer may not otherwise know that the original Jackson Pollock painting on the seller’s office wall and the handsome Oriental rug in the conference room are the seller’s personal treasures and not owned by the business. To avoid a possible misunderstanding, a careful seller should mention these items in discussions with you and make sure they’re specifically called out as exclusions in any listing of the property the company owns.
Chapter 12 helps you craft appropriate language in your sales agreement that clearly spells out what’s being sold and what’s not.
Pay Special Attention to the Transfer of Intellectual Property
A substantial number of small businesses own intellectual property—a legal term that covers copyrights, trademarks, patents, and trade secrets. Things that the seller or an employee has invented or material they’ve written are considered intellectual property and can be the most valuable asset that a business owns—even more valuable than tangible assets like goods or buildings. If a business has built a solid reputation for the high quality of its services or goods, then the business or product name will have positive associations among existing customers. If you’re buying that business, you’ll want to get the benefit of the reservoir of goodwill, knowing it will help ensure that current customers not only return, but also that they’ll recommend the products and services to others.
Get the customer list. For most run-of-the-mill businesses, the customer list may be the most important asset you buy. It also may be considered a trade secret, so make sure the sales agreement says that you have the right to the entire customer database. (The noncompete clause could also state that the seller can’t use the customer list after the sale.)
In preparing the sales agreement, you need to be clear about how intellectual property will be dealt with. In some cases, it may be appropriate for the seller to retain legal ownership of intellectual property but license you to use it. Let’s say the seller owns a patent on a manufacturing process. You and the seller can agree that the seller will continue to own the patent, but that you’ll have a license to use it—and that you will pay the seller a royalty fee for each item you make using the patented process. In other situations, the reverse may be the way to go: The seller can transfer the intellectual property to you but receive back a license to use it. So you might become the owner of the patent for the manufacturing process, but permit the seller to use the process; here, the seller would be paying you the royalty fee. Chapters 12 and 19 have more information about a business’s intellectual property, including the type of paperwork you’d use to make agreements about the use of intellectual property.
See an Expert
Intellectual property law is a legal specialty. Relatively few business lawyers have extensive training and experience in this field. If highly valuable intellectual property will be among the assets you’re buying, consider consulting an intellectual property specialist for advice.
Know the Legal Consequences of Not Making Installment Payments on Time
Usually, when a small business changes hands, the seller doesn’t receive the purchase price in one lump sum. Cash deals do occur—especially where the buyer is a larger corporation or can get third-party financing—but more typically, the buyer makes a down payment and gives the seller a promissory note for the balance. The promissory note usually sets up a schedule of payments to be made over a period of time, such as three or five years, with the buyer also agreeing to pay interest on the unpaid balance. This is called an installment sale.
With such arrangements, there’s at least some risk that the buyer won’t come through with all the required payments. How concerned a seller is about the possibility that you, the buyer, might default on the promissory note will probably be related to two things: whether the business itself is healthy, and what your management and credit record is. If the business is thriving and you’re an experienced businessperson with good credit, the seller will probably feel reasonably confident that you’ll pay on time and that all the money will be paid in the end. If your history isn’t that great, or if the business is in trouble, the risk of default increases. Savvy sellers typically reduce their risk by insisting on selling to someone who is financially strong, has a good credit record, and has a proven record of entrepreneurial competence, ideally in the same field.
But no matter what the condition of the buyer, the reality is that the seller will be looking at protecting his or her own interests in case you default. The negotiations between you and the seller about what’s being sold, and the price and terms of the sale, are primarily business, and not legal, matters. But when you start to put your deal in writing, the seller will want to build in legal protections, which you’ll need to look at and understand the risks to you, your family, and perhaps even your guarantors.
Here are some common techniques that sellers use to reduce their financial risks:
• Getting a substantial down payment. The seller knows that a buyer with a good chunk of money already invested in the business has a powerful incentive to keep the business alive and thriving, and to pay off the promissory note.
• Having the promissory note cosigned by the buyer’s spouse and possibly guaranteed by a parent, friend, or investor who’s clearly financially solvent. When a second (perhaps wealthier) person is standing behind the buyer’s promise to pay, it’s much more likely that the seller will eventually receive the full sale price for the business.
• Getting the buyer to give a first or, more likely, a second mortgage or deed of trust on real estate the buyer owns that contains enough equity to cover the amount outstanding on the promissory note. Yes, that could mean your house!
• Having the buyer sign a security agreement allowing the seller to take back the business assets if payments aren’t made.
• If the business operates from rented space, seeking the right to take back the lease as well so the seller can get back into business if necessary at the same location.
The seller’s interest in protecting against your default may be understandable, but now let’s look at the risks to which you’re subjecting yourself—and possibly your family members and friends as well.
For example, if you personally sign the promissory note or guarantee its payment, you put your personal assets at risk if your business runs into financial trouble and doesn’t produce enough income to meet the monthly payments. And adding your spouse as a signer or guarantor puts at risk the personal assets that you jointly own. Pledging your house as security means that if the business goes bad, you may lose your home. You need to figure, as best you’re able, how risky the business is and how your family and friends will fare if the business takes a turn for the worse.
Sellers almost always want you to be personally liable for the sales price. You’ll pretty much have to go along in order to do the deal. Fortunately, other protections that the seller might also want are subject to negotiation. For example, if you’re wealthy and have a superior credit record, the seller may be less insistent on having you agree to more burdensome protections such as having your spouse cosign the promissory note or pledging your house as security for the sale price.
Assure That There Are No Liens on Business Assets
It’s possible that either the seller of the business that you’re buying, or the business itself, may owe money to another person or business. If so, it’s likely that the creditor has established a lien on assets of the business. (A lien is a security interest in property—either real property or equipment or other business property.) If there’s a lien on business property and the seller or the business fails to pay the debt, the creditor will have the legal right to seize and sell those assets. You’d hate to pay the seller for two trucks and a forklift, only to have them snatched away from you by a creditor whose debt the seller failed to pay or disclose. In short, it’s important to not just take the seller’s word about debts, but also to carefully check for undisclosed liens on the business assets.
Fortunately, it’s easy to check for liens. Establishing a legally enforceable lien on property (other than real estate) requires that the lien holder file papers at a designated state office, such as the secretary of state’s office, following rules established by the Uniform Commercial Code (UCC). For a nominal fee, the filing office will search its records to see whether there are any UCC liens on the assets you’re buying. If any liens do surface, you’ll want to have the seller pay off the debts and then have the creditors notify the filing office that the liens have been canceled.
In addition, a handful of states still have laws called “bulk sales laws” that are intended to protect creditors when a business is sold. Where such laws are still on the books, they generally apply to the sale of retail businesses. If the business you’re buying is in such a state and is covered by its bulk sales law, you’ll need to notify creditors before the sale takes place or get an appropriate sworn statement from the seller, as explained in Chapter 14. Otherwise, business creditors may later surface and claim the right to seize certain assets,
Protect Yourself From Competition by the Seller
When you’re buying a business, one nightmare scenario is that after the deal is completed, the seller begins competing with the business you’ve just bought—and your profitability is seriously affected. Of course, this isn’t always a major worry. For example, the seller may be elderly, seriously ill, or subject to other circumstances that make it clear that his or her entrepreneurial days are over. But in most other cases, the possibility that the seller may start a competing business or go to work for a competitor is a legitimate concern. This means you’ll want to structure the deal to limit the seller’s ability to compete with you in the same field.
Don’t take the seller’s word that he or she is retiring. Many sellers will swear that they plan to retire for good. But a year later, lots of these same people get bored with golf and bridge games and want to get back into business. If they do—and if you don’t have a strong noncompete agreement—they’re likely to try to reenter the field they already know.
The best way to deal with the issue of competition is to ask the seller to sign a covenant not to compete (also called a noncompete agreement) that covers a period of years after the sale. Depending on the type of business you’re buying, the covenant might limit the seller’s competitive activity only in a certain geographic area. But in other instances—a publishing venture or an Internet-based business, for example—the covenant not to compete could prevent the seller from engaging in a similar business anywhere in the United States or, in rare instances, even worldwide.
The covenant not to compete can either be included in the sales agreement or consist of a separate document that’s simply referred to in the sales agreement. How broadly the restrictions are worded is a matter to be negotiated between you and the seller. A seller who’s retiring or going into a completely different line of work won’t care much about how broadly the covenant not to compete is written. By contrast, a seller who may want to do something in the same or a closely related field in the future will look closely at how “competitive” activities are defined. For example, someone selling you a bagel store may never plan to set foot in a bagel shop again, but may want to keep open the possibility of investing in some other food-related business, starting a restaurant, or opening a catering firm.
Covenants not to compete are discussed in greater detail later in this book. Chapter 11 includes appropriate sales agreement language and Chapter 15 includes the covenant language.
Limit Your Legal Liability for Past Obligations of the Business
In addition to checking for liens on business property, you’ll also want your new business to be free from old obligations that may not be secured by liens—that is, debts and other liabilities that the seller incurred. There are several kinds of liabilities you should look out for when you’re studying a business:
• The business may owe money to a bank or other commercial lender.
• The business may owe money to a supplier or to a service company.
• The business may have unfulfilled contractual obligations.
• The business may owe money to someone who’s been injured or whose property has been damaged by the negligence of the business.
• The business may have potential liability for injuries or damages in the form of pending lawsuits or lawsuits that may be filed later.
Whether you take on the obligations of the business will depend primarily on whether you buy the business entity or just its assets—as well as on the language you put in your sales agreement. Chapter 14 has more about liability issues and sales agreements.
The Liability Rules for Buyers
The basic rule is that after the sale of a business entity—a corporation, an LLC, or a partnership–the entity continues to be responsible for past liabilities. This means that if you buy an entity, you’ll have to continue paying off the debts that the business has at the time you purchase it. By contrast, if you buy the assets of a business rather than the entity itself, you won’t be responsible for old liabilities; the seller will keep them. (Sales of sole proprietorships are always asset sales. But as explained earlier, if you buy a business that’s currently being run now as a corporation, a limited liability company, or a partnership, your purchase can be structured as either an asset sale or an entity sale.)
Even in an asset sale, it’s possible to get stuck with old obligations of the business. Here’s how that could happen.
There’s an existing lien on business assets. A bank, a supplier, or some other creditor may have placed a UCC lien on business assets as security for a business debt. If the creditor doesn’t release the lien at or before closing, you’ll need to pay the debt or face the risk that the creditor will seize the assets to satisfy the debt.
The seller failed to comply with the bulk sales law. A handful of states still have bulk sales laws that apply primarily to the sale of a retail business. These laws require that creditors be notified before the business is sold. If the bulk sales requirements are not met, you face the possible loss of the assets if the creditor isn’t paid. The bulk sales laws—and how to deal with them—are explained in more detail in Chapters 8 and 19.
Your business is subject to successor liability. This legal quirk applies primarily to someone who buys a manufacturing business—a rarity among small businesses. But if you are considering buying such a business, know that some states recognize a legal doctrine called “successor liability.” If so, then in certain circumstances, even in an asset sale, you may be financially responsible if someone is injured by a product that was manufactured before you took over the assets. So if you buy a manufacturing business, you’ll want to deal with this risk by getting appropriate insurance and having the seller agree to indemnify (protect) you from injury claims.
The seller left behind some toxic wastes. A gas station or dry cleaner may have caused environmental harm—knowingly or unknowingly—in, under, or around the business site, that you’ll be expected to deal with when it’s discovered. And in asbestos cases, lawyers will often go after everyone involved in the construction that included asbestos—including, for example, the current owner of a roofing company that installed a roof 40 years ago. Be extremely careful to include in your sales agreement a clause stating that the seller will indemnify you for any harm of this nature.
Ways to Deal With Past Liabilities
Whether you’re buying an entity or its assets, you’ll want to get as much information as you can about the business’s obligations. This lets you evaluate the amount of risk you’re exposing yourself to. Then you can negotiate with the seller over how those liabilities—actual or potential—will be handled. The seller may agree to remain responsible for some or all business liabilities, even in an entity sale—and your discussions may even result in an adjustment of the sale price. But a seller’s commitment to stand behind business liabilities will work only if the seller has deep pockets. A promise to pay may be meaningless if the seller lacks the cash to make good on the promise because, in many instances, the person with the lien or legal claim can then proceed against you.
Your arrangements with the seller about how to deal with past debts should be included in your sales agreement. That all-important document may say, for example, that the seller—and perhaps certain well-heeled guarantors as well—will be legally responsible for debts and obligations that arose before the closing, and that you’ll be responsible for all debts and obligations that arise afterwards. These commitments can be accompanied by indemnification language in which, for example, the seller agrees to handle any lawsuit for past debts, and you agree to handle any lawsuit for future liabilities.
Do a careful assessment of potential liabilities. Liens are easy to find because you can check on them quickly and easily. But for manufacturing businesses, those located in old industrial areas, or businesses that deal with toxic substances, you need to be more thorough. Guarantees by the seller are fine, but to be safe, you should also take soil samples and do whatever else is necessary to protect yourself.
If either the seller or your business is a corporation or LLC, you need to consider whether the individual owners (old or new) are personally agreeing to protect the other party from liability. Remember the general principle that a corporation or LLC is legally separate from the people who own it. An indemnification signed by a corporation or LLC doesn’t personally bind the owners of the entity. The owners themselves must sign if they’re to be held liable.
Example: Evelyn is buying the assets of The Pet Stop LLC, a limited liability company owned by Bill and Marvin. In the sales contract, the LLC agrees that it will indemnify, defend, and hold Evelyn harmless from any debts or claims arising in the period before the closing of the sale. Similarly, Evelyn agrees that she will indemnify, defend, and hold The Pet Stop LLC harmless from and against any debts or claims that arise after the closing. Wisely, Evelyn insists that Bill and Marvin personally join in the indemnification so that she has another place to turn for protection if the LLC becomes insolvent.
Sometimes, the simple formula for past and future debts needs to be tweaked slightly to fit the situation. In the pet supply example, suppose that The Pet Stop LLC is expecting a bill for $7,500 from a company that sells pet food to the store. If the parties have agreed that Evelyn will be responsible for paying that bill, the sales contract will need to refer specifically to that bill as an exception to The Pet Stop’s duty to pay all past expenses.
Comply With State and Local Laws That May Affect Your Purchase
The sale of a business is not heavily regulated by state statutes or local ordinances. Within very broad limits, the courts will hold you and the seller to whatever contractual deal you agree to. But even though contract law usually controls in business sales, you may also encounter some state statutes or local ordinances. Here are the major areas of possible concern and the chapters where these are discussed:
• Usury statutes (Chapter 7). These are laws that limit the amount of interest that a lender can charge a borrower—or someone (such as the buyer of business) to whom credit is being extended. If you’ll be signing a promissory note for the balance of the sale price, the interest the seller can charge will be regulated by the usury statute in your state.
• Bulk sales statutes (Chapter 8). These laws—on the books in a small and diminishing number of states—set out procedures for notifying creditors when a business that has an inventory of goods—usually either a retailer or a wholesaler—is about to change hands.
• UCC-1 Financing Statement (Chapter 18). This form is filed with a designated state office—typically the secretary of state’s office—when a buyer has agreed to give the seller a security interest in assets of the business. The seller can then grab the business back if the buyer fails to make payments.
• Transfer of vehicles (Chapter 19). In an asset sale, the seller may be transferring one or more vehicles to you. Usually this can be accomplished by completing forms provided by your state’s motor vehicle department.
• Transfer of real estate (Chapter 19). Occasionally, the sale of a business includes the sale of real estate. Typically, this involves the seller signing a deed which you then file with the land registry office in the county where the land is located. There are precise technicalities to be followed, especially if the seller retains a security interest. You may want a lawyer’s help. To learn more about the process, you can check with the land registry clerk or a knowledgeable person at a local title company.
• Licenses (Chapter 19). Most businesses don’t need any license other than a city or county business license and, possibly, a sales tax permit. For the most part, only businesses that sell regulated products (like liquor), need to meet environmental laws (a dry cleaner or gas station), are subject to health laws (a restaurant), or must meet professional standards (a lawyer or doctor) need to worry about this. Even where a license is required, there’s wide variation from state to state and from business to business about what licenses are required—and what needs to be done when a business changes hands. It’s important to have the right licenses right from the beginning. Have the seller give you a list of the state and local licenses and permits currently held by the business. Next, contact each office that issued a license or permit and inquire about what, if anything, needs to be done when the business is sold. In most cases, this effort will suffice.
But if you want to be extra safe, check with state, county, and local officials to find out whether there are any licenses or permits that the business should have but doesn’t yet. At the state level, the department that works with small businesses can point you in the right direction. At the county and city level, the clerk’s official is usually the best place to inquire. The state and local chamber of commerce are also useful resources.
• Taxes (Chapter 3). Check with your state revenue office to find out about any state forms you need to file when you buy a business. Also check with your county and city tax offices about local tax filings.
• Entity matters (Chapter 19). If the business you’re buying is a corporation or an LLC, check with the state office —often the secretary of state’s office—where the original corporate or LLC documents were filed. Depending on the shape of your deal, you or the seller may need to file papers for a change of registered agent, or to change or cancel an entity name. The clerk will also be able to tell you about any other documents you need to file. With a partnership or a sole proprietorship that uses an assumed or fictitious name, inquire at the county office where such businesses are registered.
How to do your own legal research. If you have a specific legal question not covered in this book—for example, the requirements of the bulk sales law in your state (assuming that your state has such a law)—you may want to do some legal research on your own before calling your lawyer. Most states have a small business development office that can help you get started. Also, the closest branch of the U.S. Small Business Administration can be a useful resource. And the state and local chambers of commerce may have relevant information. Also check out Nolo’s website at www.nolo.com, for general background information on a wide variety of legal topics, and access to statutes of all 50 states, plus federal laws. In addition, check out the official website of your state for links to relevant business and tax agencies, such as your state department of revenue. To find your state website, see www.statelocalgov.net. Finally, if you still need help, we recommend Legal Research: How to Find & Understand the Law, by Stephen Elias and Susan Levinkind (Nolo). This nontechnical book gives easy-to-use, step-by-step instructions on how to find legal information.