This article by Stuart Adams appeared in Louisville Computer News April, 2001
In an earlier chapter (LCN July 2000, you do save them don't you), I talked about the decision to get into your own business by buying an existing business or buying into a franchise operation, rather than starting a company from scratch. I also discussed the advantages and disadvantages of buying into a franchise or non-franchise operation, as well as a little about how to find a business to buy, finding advice and advisors to assist you in the process, and how to determine the value of the target business.
In the Adotcom@ world, given the Acorrection@ which occurred in 2000 and the first part of 2001, there are lots of opportunities to buy an existing business. There are also lots of opportunities to buy some, but not all, of the assets of a business. Many companies are downsizing. Many are shedding what they consider to be unprofitable or less profitable divisions or subsidiaries. Some are simply trying to stay afloat by selling off assets, including intellectual property, such as patents, licenses, product lines, and the like.
There has not been a better time, in recent memory, for someone in e-commerce to walk through the yard sale that is today's marketplace. If you are interested in exploring that possibility, read on. In this chapter, we'll talk about some of the high points and the process of buying part or all of an existing business.
ASSEMBLE YOUR TEAM
As you've read in this book before, I like to work in a team environment on large transactions. Buying almost any business can be a complex undertaking. Because of our ever changing laws in areas such as taxes, labor, environment, securities and others, it's difficult or impossible for any one person to know everything they need to protect themselves in each area. For that reason alone, I like to assemble a team to assist the client in buying or selling a business.
A typical team might be composed of the client, an attorney, appraisers of real estate, equipment and other properties involved in the transaction, an accountant, building and equipment inspectors, insurance agent, business valuation expert and others. In some areas, such as legal counsel, it might be necessary to have several attorneys, who are specialists in different areas, at least review portions of the transaction. Some of these areas might include employee pension issues, environmental liability, securities, antitrust and other specialty areas.
The same might be true of the other professions, such as the need for an appraiser for a critical and perhaps unique piece of equipment upon which the business depends. These days, that expertise might also very well include a systems specialist who can analyze the adaptability of legacy hardware, software and databases. Many a buyer has left the closing table to take a first look at the financial records of the newly acquired company, only to find that the computers crash and are not able to operate well enough to even find out the status of accounts receivable or payable.
LAST MINUTE ADVICE
I'm often contacted by clients who are about to go to a closing to buy a business. Typically the first part of the call goes something like this:
AHey Stu, I've got a real estate closing this afternoon and I'd like you to look over some documents for me. Actually, I'm buying a business. (Insert various alternative scripts about how a business broker found a deal for the client, or how the client ran across a great opportunity.)
Would you mind looking over a couple of papers? I've got to be at the office of (insert script regarding bank closing, attorney for the business broker or the adverse party's attorney) later this afternoon, and I'm just not sure about a couple of paragraphs in this document that was just faxed to me.@
Unfortunately, I have to try not to laugh out loud at this point. I not only don't want to lose a client, but I do want to try to gain enough knowledge about what has already transpired, before I scare my client to death, so that I can determine if there is anything at all I can do at this late date. The investigation and structuring of a business acquisition is something that will typically take weeks if not months. The last minute review requested in the scenario above is not a good way to buy a business. Sure, you could buy a business in a day, just like you could buy a house in a day. People who are frequently transferred by their company do it all the time. They fly in, meet with a realtor, visit a multitude of potential residential properties, and write up a contract. Of course, when their spouse flies in later, they might want to be at work in some foreign country.
Let's presume, for the sake of argument (and also because I've covered it in another chapter) that you've already determined that there is a bona fide place for this new business in the business plan for either your existing business or for the new one you want to run. Let's also presume, for the same reasons, that you've done some valuation work on the property and it appears to be a good deal economically. By good deal, I mean that the ability to profitably resell the property, including land, good will (if any), equipment, etc., is present within a reasonable time.
Next comes the way you are going to buy Athe business.@ Let's presume this is a business with a physical location. If they have a lease, you have to consider whether their lease is transferrable to you. If you are buying only assets, this can be a major issue. If you are buying stock and assets, there probably will be no transfer of lease needed, so it should not be much of an issue. You naturally want to look at the remaining term of the lease and whether it is at market price. If it is above market, consider the lease price difference a liability. If it is below market, it may be an asset.
If the business owns the land on which it sits, you may have environmental liability issues (which can be huge), but you also have the possibility your property will appreciate in value while you run your business. Even if your business doesn't do too well on its own, you may profit from the land when you sell it. You may also be able to use the land and building as collateral to obtain financing for inventory, equipment or other business needs from time to time. This could give you a buffer in a cash flow downturn or be used to give a little extra push for an expansion at a critical time.
Check out the zoning, research the possibility of road closings (I've had more than one client suffer from highway work at their front door) the direction the neighborhood is going in (crime, values of comparable properties in the area, etc.) just like you would if you were buying a home. Instead of looking for playgrounds in the neighborhood (except for your employees) look for the ability of your customers to find you and the ability of your sales force and delivery vehicles to access their destinations.
Beyond the land issue, there are other assets and liabilities to deal with. The point of the negotiation and documentation is to make sure, to the extent that is possible, that you end up with those things of value you thought you were buying and that you don't end up with liabilities which you didn't bargain for. Part of that strategy involves making a determination about what exactly you are going to buy. In many situations you have the ability to buy either the stock or ownership units, such as in the case of a limited liability company, or you can buy assets only. There can be many huge differences.
STOCK vs. ASSET ONLY PURCHASE
There are a number of ways to structure the purchase of a business. You can buy the stock. You can buy all the assets. You can buy some of the assets but not others. You can buy a combination of some stock and some assets. If you have an existing business, you may be able to merge in any one of several ways. You can buy the business on an installment. You can enter into a management agreement as a part of the acquisition process, running the business from the inside while conducting your due diligence investigation. There are a multitude of other ways to Ado the deal.@ Making this determination is a delicate process where you should rely heavily on several members of the team of advisors you have assembled to help you.
An Aasset only@ transaction has the advantage of allowing you to pick and choose, to some extent, those assets which you think are offered at a good price and which will be useful to you in conducting your business. Just like you may have a basement or attic full of old clothes you will never use again, many long term businesses have acquired aging machinery and vehicles, uncollectable accounts receivable, environmental liabilities, employee pension funds, union issues, and other Aproblem properties.@
Unless someone is holding a gun to your head, you don't have to buy some else's problems. The seller, of course, will probably feel that it is a take it all or leave it all proposition, because he or she knows the aggregate may bring a better price than a piecemeal sale will produce. This is a point you can negotiate.
Another major point favoring an asset only sale in some situations, is the ability to buy the good stuff while walking away from liabilities, such as stockholder discontent, litigation, warranty claims, bad leases, tax problems and other legacies. The seller will often prefer to sign you up for a stock transfer, where they sell you Athe whole thing.@ In that way, they stand a much better chance of taking the money while relieving themselves of any need to look over their shoulder at the problems they created. These could include workers' compensation or unemployment claims, pension disputes, sexual harassment charges, and any number of other horrors. On the other hand, buying the stock as well as the assets may allow you to avoid the need to refinance a favorable business loan or mortgage, a lease of equipment, a supplier agreement or a customer contract. This is a matter of weighing the pros and cons of the present options, as well as trying to predict tax and other consequences when it is your time to sell the business and move on.
In addition to many other ways to do it, you may be able to Amerge@ the target business into a company you already own. This form of transaction has its own set of pros and cons, but involves, at its most basic level, a situation where you start out with two companies, and end up with one. The acquiring company typically retains its name and control, while the target company is divided up into basic assets to be distributed around the organizational chart of the acquiring company.
A merger can be much more complicated than either an asset or stock purchase alone, requiring shareholder approval from both companies. Problems with minority shareholders and the potential to have to buy them out at a premium warrant careful planning, but the flexibility in assessing valuation issues and the possibility of reducing tax consequences, can make this the most desirable tool in some business acquisition situations. There are triangular mergers and a whole host of other beasts out there, so this is an area that deserves a great deal of research and professional guidance.
THE PROCESS OF BUYING THE BUSINESS
When I have the Aluxury@ of having a client come in to see me about acquiring a business in the early stages of the process, I often suggest starting the formal discussion with the seller by drafting a letter of intent. The alternative (aside from getting the first call as the client is on the way to the closing) is to start with a purchase agreement.
I prefer, in many situations, to use a letter of intent (LOI) for several reasons. One is that it can broadly describe elements of the proposed deal, such as the structure, purchase price, method and timing of payment, condition of assets and liabilities, warranties to be given by the seller, allocation of purchase price, and even more delicate matters. Another reason to use the LOI is because it can typically be drafted much more quickly than a lengthy and detailed purchase agreement, where the attorneys and accountants must have already dotted every Ai@ and crossed every At.@ It is also much less expensive for the buyer, by itself, because of the relative informality required in drafting and negotiation. If the parties cannot get over the basic structure of the deal from the LOI, the client can escape the experience with minor expense and in short order.
One major issue in drafting a LOI is whether it will be binding or nonbinding. Unfortunately, I have many clients who come in after the LOI has already been signed. If it is not carefully drawn, it can be the whole contract between the parties. By design it is relatively much shorter and less inclusive of details than a normal purchase agreement. This has its purpose, as stated above, but should clearly only be a prelude to a formal and detailed purchase agreement.
The major problem with a carelessly drawn LOI is that it can become the only agreement between the parties but may not cover nearly all the areas where the parties absolutely need a Ameeting of the minds@ to avoid future disputes. The typical LOI I will draw up for a buyer will be binding in some areas, such as defining the general structure of the deal (ex. asset only, stock only or merger), duty of the seller to provide certain access to records and asset valuation, a Ano shop@ provision prohibiting the seller from negotiating with anyone else for a specific time period while the seller conducts some level of due diligence (i.e. kicks the tires), prohibition of public statements about the negotiations without agreement by both sides (usually insisted upon by the seller so as not to disrupt the business during negotiations), duty to act in good faith, and allocation of expenses for certain matters in the event the seller's representations don't hold up.
The LOI may be nonbinding in other areas, such as the timing of installment payments, the quality or quantity of inventory, the duty of the buyer to complete the purchase if favorable financing is not obtained, the results of investigation of environmental or other liabilities, etc. This can include a litany of escape clauses for the buyer, to allow complete freedom to examine the value of the business and timing of the purchase.
If the parties survive the LOI stage, there are again several ways to go about the next phase of the deal. Classically, one of the parties has their lawyer draw up a purchase agreement. This will involve pages of legalese which is incomprehensible to most laymen and many lawyers. The pages of boilerplate cause most to experience the agony of having their eyes glaze over pretty quickly, but each phrase can be the turning point in litigation, if something goes wrong later.
I won't get into the details of a purchase agreement here, but suffice it to say, it's time for the kitchen sink. If it's not in the purchase agreement, there is probably a clause near the end that tells you that you're out of luck. Make sure it contains everything you want and excludes everything you don't want. Also make sure it has real teeth to enforce this. After the seller gets your money and sets sail for Tahiti, all the warranties in the world will do you very little good.
Another alternative to a straight purchase agreement, and a favorite of mine, is the management agreement. Under this type of arrangement, the purchaser has the opportunity to essentially become the boss for a limited period of time. It is often used when the seller is in a hurry to retire or get out of town (read opportunity or red flag). Here, the buyer starts running the business from the inside, making day to day decisions (plus or minus contractual limitations). In some of these agreements, the buyer is responsible for costs but gets to keep net profits. In other situations, the seller will remain responsible for fixed costs, while the buyer may be entitled to some or all of the increased profit generated by the buyer's Anew management ideas.@
This management agreement type of deal can be drawn up in any number of ways, and is therefor very flexible. It allows the buyer to get inside and really see if he or she can run the business. It also can be a financing mechanism, letting the buyer make the purchase, to some extent, on an installment basis. This is a good way to see if the equipment is in good repair, judge the morale of the employees and test the loyalty of customers. This will not work in every situation, but I like it a lot because it allows my clients so much insight into the proposed acquisition before everything is put on the line.
Typically one of the next steps in the process, regardless of whether the buyer is proceeding under a management agreement or straight through a purchase agreement, is getting heavily into the due diligence investigation. At this stage, the seller should be required to give fairly free rein to the buyer's expert appraisers, accountants and attorneys. The books and records of the business undergo heavy scrutiny for inflation of assets and deflation of liabilities.
In addition to simply checking the cash in the bank and title to the real estate or equipment, the buyer will have a long list of regulatory concerns, such as licenses and permits, employment and tax related claims, potential warranty issues, environmental investigation and a whole host of issues we don't have room to cover here. This, however, is where the hard part comes in as you look under every rock. This is also where you are getting close to accepting or rejecting the deal. As Regis Philbin would say on the TV program Who Wants to be a Millionaire, Afinal answer?@
We've only scratched the surface of the topic of buying a business in this chapter. We'll go into greater detail in other chapters on issues, such as conducting due diligence, financing, valuation, letters of intent, buying into a franchise operation and integration of a new company into your existing business. Needless to say, however, with the bargains out there, you always should strongly consider keeping you eyes open to the possibility of jump starting your business plan by a careful and well researched acquisition of an existing business.
© 2001 by Stuart Adams
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