Happy first day of December! NaNoWrimo is officially over and I am happy to report that I met the challenge, writing 50,100 words of a novel in 30 days.1 Now, it’s time to get back to the business stuff.
Throughout December, you may be thinking about your plans for New Year’s Eve and the resolutions that follow, but many business owners are taking this time to contemplate selling their businesses. Maybe they are getting tired of the long hours required, are dreading another tax year, cannot find quality employees, have inflation concerns, or maybe the holidays brought visits from adult children who have made it clear they do not want to join the family enterprise. Whatever the reason, December is often a time that decisions are made to put businesses up for sale.
If you’ve dreamed of owning your own business, the holiday season might create an opportunity for you to buy more than just video games and sweaters. But how do you ensure that you do not spend too much time and money on negotiations that fall apart (most do), and how can you avoid the pitfalls of buying someone else’s problems? Said another way, how can you make sure you heed the instructions of the Gambler himself, and “know when to walk away, know when to run.”
Step One: Assemble the Team
Just like they do in every Fast and Furious movie, when you have a big job to do, you must first assemble your team. You will be well-served to speak with a lawyer, accountant, tax professional, and if you plan to finance the purchase, a lender. This way, you have your experts at the ready, and if they have any market specific suggestions or requirements, you will know those up front.
Step Two: “Breakin” the deal early
Once you have your team in place, get a boombox and a big piece of cardboard. Just kidding. I typically advise clients to focus on areas where the deal is most likely to “blow up” first. This will save them time and money by seeking to resolve the “deal breakers” early in the process rather than going through extended conversations and then attempting to negotiate the more complicated areas as part of an already complex purchase agreement. If you are familiar with the concept of “fast fail,” the Agile term is really about accelerating execution to achieve a desired result or cut your losses. Same applies here. When you are talking about complex transactions, you will be better served to fail fast by focusing on problematic areas first.
Some of the most common deal breakers are:
a. Lack of alignment about what is being purchased
You would be surprised at how many deals fall apart when purchase agreements are being drafted because the parties were not aligned on what is included as part of the "business" to be sold. For example, is there intellectual property that comes with it, such as brand names, trademarks, any code or systems that support it, etc.? What about real property/tangible property? Does it include a building? Land? Inventory? Are there contracts that are coming with it (such as with necessary suppliers)? Leases? As we learned a few weeks ago, commercial leases are tricky, and if the location is critical to the business and its value, you will need to understand whether that lease will be assigned and what terms will apply to you. Your ultimate goal with this definition phase is to ensure that whatever you need to operate the business following the sale is actually something that you will be purchasing and will have the exclusive right to use after the sale.
Does it really ever happen where someone buys a company and then gets surprised by what is not part of the sale? It sure does, and more often than you might think. Consider the situation where someone is buying several highly profitable Airbnbs. Great business, right? What if the sale of the business was just the Airbnbs themselves, and not the five star Airbnb renter profile (including the great reviews and historical goodwill). Without that profile, the purchaser would have to rebuild the reputation and goodwill before filling nights on the rental calendar and getting a return on the investment.
Conversely, what if you were buying a popular retail store, but the seller owned the building in his or her personal capacity. You would probably assume the location came with the business. But without an express agreement to include the real estate, and possibly a separate sales agreement if owned by a different entity, the seller may have other plans for their physical location, like converting the retail space to condos. Thus, whatever the business is, think about what you assume would come with it and make sure it actually does.
Another aspect of what you are buying is whether the seller intends the structure of the deal to be a stock purchase or an asset purchase. Generally speaking, with an asset purchase structure, the buyer is just purchasing expressly defined assets and assuming defined liabilities. Thus, a narrower part of the overall business. With a stock purchase agreement, the buyer is purchasing the outstanding stock of the company, meaning all assets, liabilities, and rights, including those not known or disclosed at the time of purchase. As you can imagine, the structure of the purchase not only affects what you are buying, but has significant accounting, tax, and legal implications (and thus why you already have a team in place).
b. Are the business licenses, contracts, or leases that are necessary for the business to operate transferable?
Does the business require any licenses or permits to operate? Are there any critical suppliers that have to be able to provide items without interruption? What about service providers or contractors engaged to sell the products? What does the company lease today, like equipment or space? Do any consents or approvals need to be obtained from third parties?
c. Customers are a fickle crowd, are you able to guarantee they stay through the transition?
Is this a retail establishment? Or is it something where customers sign contracts? Does the company have a good customer list that is coming with the sale, and how current is it? Is there anything they are doing that makes customers "stick" with them? Think of it this way, if it’s a retail establishment, how will you be sure that you can maintain the cash flow without having to completely replace the customer base.
d. Transition assistance
Just like in a contract, sometimes you need to negotiate how the business or services will be handed off. For example, will you offer or need an ongoing role for the seller or certain key employees post sale? What about once they’ve gone away, what if you have questions?
e. Post sale competition
Typically, a purchase agreement will also include a period of time when key employees of the seller are prohibited from working for or starting a competing business (which will be especially important if the seller is not retiring). If they can start the same business again without the dead weight of this one, and compete directly with you, the value of your purchase will likely be greatly damaged.
Step Three: Basic Due Diligence
The final step in early evaluation is some basic due diligence to find any other landmines that you might not be made aware of right away.
a. What other headaches are you buying?
Any business that has been in operation (even for a relatively short period of time) can have liens filed against their business, outstanding loans, or even potential litigation (from sources like third parties, banks, employees, or suppliers). Ask the seller about these things, and search public lien records and the secretary of state website in the state of incorporation to verify what you hear. Generally speaking, unless a lien is properly released or removed, it will remain lodged against the assets of the business post sale and will become the buyer’s problem.
b. Financial statements and tax returns
Everyone is profitable until you start to shine a flashlight in the corners. Gross sales are often touted when businesses start putting the word out that they want to sell, but gross sales are such a small part of the picture. For example, if you are purchasing a flower shop, and that flower shop has $200k in gross sales, but they spend $150k on supplies to support those sales, there is a profit of only $50k. To avoid financial surprises, you will want to see at least three years (and preferably five years) of financial statements. And, of course, "audited" financials from a reputable accounting firm are best if they are available. Same with tax returns, or if the business you are purchasing is an S-corp or sole proprietorship, they will have to share their individual returns too (and you can seek access to these returns directly from the IRS by having the seller give you a power of attorney).
c. Corporate governance records and insurance
Most entities require directors and at least an annual meeting. In addition, there are often annual filings that have to be done in the state of incorporation. You will want to ask for all the documentation concerning these topics, including any annual filings and minutes from all meetings. Also, it’s a good idea to obtain a copy of the commercial insurance policies (as well as workers comp) and to verify whether they have made any claims against their insurance in the past five years and the outcome of any such claims.
d. Employees and/or independent contractors
Does the business have employees? Independent contractors (with contracts)? If yes, who handles payroll and can they show you that they've complied with all of the applicable payroll rules and withheld appropriate taxes? Will the employees likely stay post closing? Do you need them? Sometimes, when an individual is planning to retire, they hold off making tough staffing decisions, especially for long-term, loyal employees. Thus, it is important to understand what staffing resources will be necessary to keep the business running. Of course, a collective bargaining (union) arrangement is its own animal and I will leave that topic for another day.
This may not be everything that you will encounter in the deal, but with your list of fast fail focus areas and your team of elite crimefighters (aka lawyers, bankers, and accountants), you may just have yourself a deal to buy all you want, or at least a business, for Christmas (or Hanukkah) this year.
And yes, all 50k words were written on these!