Buying a Business: Legal Due Diligence
10 July 2023: Buy a Business: Legal Due Diligence
“Buying a business requires knowing what you’re buying.”
That would seem to be an exercise in stating the obvious but our more than 20 years of experience in advising business buyers and sellers suggests that it may not be so obvious after all.
There is, of course, the “obvious stuff”: inventory, furniture, fixtures and equipment, customer or client lists, financial statements and the like. We’ve written at length about this aspect of due diligence in the past. But there are many more aspects of a proper due diligence, some of which is not “obvious” to the inexperienced or unrepresented or poorly-represented buyer.
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If you’d like to learn more, email me at jo*@Wo*******************.com
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It doesn’t matter whether you’re a financial buyer targeting a Main Street business or a strategic buyer targeting planning the acquisition of a US$10M-$20M dollar competitor, there are legal liabilities present in any business, regardless of size. If you fail to include legal due diligence in your overall due diligence process, you incur significant risk at any point during your ownership of the business and eventually when you plan your own exit.
Benefits of Legal Due Diligence
When buying a business, legal due diligence enables the buyer to better understand the target company’s make up, culture and operations. This provides the buyer guidance in determining the acquisition price and helps in the preparation of a clear, concise and solid purchase agreement.
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Our course, “Learn How to Value and SUCCESSFULLY Sell Businesses“, teaches you how to accurately value and successfully sell businesses.
But more importantly, it allows the buyer to identify the legal risks and liabilities the acquisition of the target company would entail – and to consider whether the assumption of such risks would make the acquisition worth proceeding with.
Components
Here are some of the more important categories of legal due diligence.
- Contracts: Most businesses will be party to contracts among which will be those with customers and suppliers. But there will often be others such as employee contracts, franchise agreements, licenses that have been granted to or by the company.
- Leases: Most businesses have an operating “nexus”; that is, where they do business. As most business owners prefer to lease their operating premises, this means a lease for the business’ operating location(s). But there are also many other leases that businesses become party to including vehicle leases, heavy equipment leases, office equipment leases, furniture leases. Get a copy of all of them.
- Lawsuits: Is the target company suing or being sued? Are any suits pending? Are there any potential lawsuits?
(The Brokers Roundtable℠, an online community created and hosted by Worldwide Business Brokers, has scheduled a live interview with Roland Davis, of Davis Business Appraisers. We’ll be discussing the ins and outs of business valuations and equipment appraisals including what’s needed for a business valuation and how a valuation can be used when marketing a business. Be sure to join this informative discussion – 3.00 PM (Eastern/New York) Thursday, 20 July. At the conclusion of that discussion there will be a Q&A during which attendees can get their questions answered by a pro. But you’ve got to be a member to attend. You can sign up for The Brokers Roundtable℠ here.)
- Intellectual Property: Has a list of such assets been provided by the seller or its broker? If you acquire the company, do you acquire the unfettered right to the trade name, proprietary marks, systems, etc.?
- Property and Tax Liabilities: Are all taxes paid? Is any property included in the sale encumbered by liens or other claims?
- Environmental: Do the business’ products or premises entail the potential for an environmental issue? (This issue is overlooked too often.)
- Organizational Documents: Is the business “in good standing”? Are its registrations, certifications and licenses current? Do the owners need any third-party approvals to sell?
- Warranties and Representations: What is the seller stating about the business’ condition, particularly with regard to its potential downsides? How are those statements to be worded in the purchase agreement?
Due diligence on each of these items can feel like a decent down into a rabbit hole but each must be considered.
Deal Structure
As we’ve previously written, when buying a business the acquisition can be structured in two general ways: as an asset sale and as a stock (equity) sale. The former gives the buyer a great deal of flexibility in determining what the transaction will include.
For example, the buyer is unlikely to want to acquire – or at least pay for – outdated inventory such as last year’s trendy clothing or the mufflers for ’79 Pintos that have been sitting in the warehouse for 20 years.
Likewise, a buyer is unlikely to be interested in any receivables that are over 90 days past due.
In a stock or equity sale, the buyer buys everything; the good, the bad and the ugly. All liabilities transfer with the business. Are there unpaid employment taxes? Was the premises home to a small chemical manufacturer 50 years and three businesses ago? Has new legislation raised the risk of a possible class-action lawsuit?
Any and all issues attached to the business, its products, its premises, its hiring practices and everything else are transferred in a stock sale.
The Bottom Line
Financial due diligence is but one aspect of the overall due diligence process. Legal due diligence is at least as important. Unless you know what you’re buying – unless you know the seller can freely sell everything you believe you’re buying – a buyer leaves itself open to many potential hidden liabilities.
A thorough evaluation of the target business should be able to be completed in 60 days – or less if the business is small and not overly complex. But this requires not only the cooperation of the seller but the pre-sale preparation of the business and the seller. However, the process can be extremely time-consuming and drag on if the seller goes into the deal unprepared.
If a seller has not prepared their business for a sale – including putting together the documentation a buyer will likely need for due diligence – that seller is either not motivated or poorly represented.
I’d like to hear from you. What topics would you like me to cover? How can we tailor these posts to be more useful to you and your business. Let me know in the comments box, below, or email me at jo*@Wo*******************.com.
If you have any questions or comments on this topic – or any topic related to business – I’d like to hear from you. Put them in the comments box below. Start the conversation and I’ll get back to you with answers or my own comments. If I get enough on one topic, I’ll address them in a future post or podcast.
I’ll be back with you again next Monday. In the meantime, I hope you have a safe and profitable week.
Joe
Searching For…
NOTE TO READERS: This is the final month our “Searching For…” feature will be included in our blog posts. We’re moving it to our online community, The Brokers Roundtable℠ and it will appear there exclusively beginning 1 August.
We’ve been contacted by a search firm seeking opportunities in commercial services (maintenance/cleaning, HVAC/electrical/plumbing, logistics), compliance and testing services, and physical therapy, rehabilitation and home healthcare services with cash flow of between US$750,000 and $3 million in the United States.
If any of you know of something that might fit, please let me know.
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The author is the founder, in 2001, of Worldwide Business Brokers and holds a certification from the International Business Brokers Association (IBBA) as a Certified Business Intermediary (CBI) of which there are fewer than 600 in the world. He can be reached at jo*@Wo*******************.com