Pitfalls in Buying a Business

Posted on Posted in California, Updates, Washington

So you’re ready to own your own business, but want to have something a little more established?  Maybe you’ve been running your own business for a while but you’re looking to expand?  Either way, buying a an already-established business can be a good way to get off the ground, or get some more traction.  However, it is important to consider the deal carefully, and watch out for some common issues that can come up.

Who’s the current owner?

This is a good place to start, and includes knowing the personality and history of the owner(s).  You should be assessing how long they’ve been in business, what their experience and reputation in the community is like, and how they conduct the business.  This will give you valuable insight into what kind of business and liabilities you’re likely to take over.

Additionally, you should be paying attention to how the business is set up.  Is it a corporation, LLC, partnership, or sole proprietorship?  Will this work for you?  Whatever the type of organization, you should be able to see the internal documents governing the organization (bylaws, operating agreement, partnership agreement, etc.) as well as determine how many shares or units are issued and outstanding.  Needless to say, this information should be the same across the internal documents, tax filings, state and federal securities filings, etc.

How is the deal structured?

To be very brief, there are essentially two types of structures you can use to purchase the business.  You can purchase all the assets (the physical and non-physical “stuff” that makes up the business).  This would include machinery, computers, office furniture, real estate, and intellectual property.  Depending on how the deal is structured, you may or may not be taking some portion of existing liabilities as well.

Alternatively, you can purchase all the equity (ownership) of the company.  This allows you to take over as the new owner of the company without changing the name or day-to-day operations.  However, it does mean assuming both the assets and liabilities of the company.

Either structure can work, depending on what you’re looking for.  Each will have different tax liabilities, and can have an impact on certain licenses as well.  It is a good idea to make sure to consult both an attorney and tax counsel before making a decision about structuring the deal.

What kind of liabilities exist?

No matter what type of structure you’re looking at, or how much you trust the current owners, it’s a good idea to try to get a handle on what kind of liabilities the company is currently holding.  This does not mean only the obvious liabilities like debts to vendors or bank loans, but also includes things like employment issues, taxes, and securities issues.  Access to information about the internal workings of the company will be crucial to figuring out whether and what type of liabilities may be lying in wait once you take over.

All contracts the company has should be reviewed for change of control provisions, especially big contracts like leases or bank loans.  These contracts will sometimes include provisions that require notice to the other party before the company is sold.  If you don’t follow these provisions you could find yourself in default on a contract as soon as you take the business over.

What is the employment situation?

If the company you are looking at purchasing has employees, it is a good idea to attempt to audit the employment situation.  You’ll need to know whether the employees are paid properly and on time, whether any required trainings are done, and whether safety regulations are followed, among many other issues.  If the current owners have not complied with their employment obligations, you’ll need to know what that is likely to cost you.

You’ll also want to talk with the owner, and possibly some of the employees to assess how likely the employees are to stay on after a change in ownership, and whether there are any significant issues between management and workers that needs to get resolved before you take over.  A change in ownership often means new ways of doing things, and adequately preparing the employees ahead of time can be crucial to maintaining the business once you take over.

What does the internal documentation look like?

Finally, the internal documents of the company should be in order, as much as possible.  If the business is an entity (corporation, LLC, partnership) then there should be updated internal organizing documents, such as the articles, bylaws, operating agreement and/or shareholder’s agreement.  Minutes should be updated and complete, and any securities filings necessary should have been done.  It should go without saying, but there should be no confusion about who actually owns the company.  There shouldn’t be “ghost” owners still on the books that used to be involved but left for Tahiti years ago and totally sold off their shares but the paperwork can’t be located.

Taxes should be complete and filed, or updated and amended as necessary.  Employees should have all their documentation filed and up to date, including their employment agreements, employee handbook, and I9s.  The current owner should be able to tell you exactly what they own, including intellectual property, and ownership should be clear.

It is exciting to dive into a business that’s already up and running, but it requires a lot of thought and homework to make sure it’s a good deal.  Don’t skip really looking into a company because you trust the owner or are excited about the opportunity.  If red flags start popping up, it’s a good idea to step back and reevaluate, to make sure you understand both the potential profit, and the potential drawbacks.