Planning for the Purchase of a Business

To some, purchasing a business may be the realization of a life long dream. To others, it may be the most practical means of diversifying or expanding existing operations. Regardless of the reason or need, planning is essential. Failure in this regard will, at a minimum, lead to the loss of time and money, and may even condemn the business to inevitable failure.

The following thoughts are offered as examples of areas to be considered in planning the purchase of a business. They are not presented in any order of priority or significance and should be viewed in light of the circumstances surrounding each business. They are not intended to be all-inclusive, but only to demonstrate the benefits of planning. Tax matters will not be addressed but should also be considered when purchasing a business.

Establish Acquisition Objectives

A fundamental step in acquiring a business is to identify its purpose. Understanding the underlying reason for the transaction will provide the purchaser with a focal point from which to plan and make important decisions. Will the new business be used to complement ongoing operations? Is the acquisition being used to provide a career for the next generation or a new career for the first-time business owner? Recognizing the real purpose for the purchase will help focus on the needs and desires of the purchaser and lend consistency to the decision-making process.

Locate the Business

Surprisingly, one of the most difficult aspects of buying a business is finding it. Searching by word of mouth, trade publications and business brokers are just a few means of locating acquisition possibilities. The needs and desires of the purchaser most often dictate the approach used to identify available alternatives. Care should be taken when using a business broker to understand the expectations of the parties, including those related to compensation.

Understand the Industry

Two of the main reasons a new business fails are lack of adequate capital and making too many mistakes before the business becomes self-sustaining. Both of these are highly dependent on the ability of the owner to operate the business. Lack of knowledge can lead to unnecessary expenses and mistakes that could have been avoided if the owner had a good working knowledge of the business and its industry. This concern is not limited to the “first-time” business owner. Many experienced business operators have made the mistake of believing their business skills developed in one industry could be easily, and as successfully, applied in another. Every opportunity should be taken to learn about the new business and industry before making the investment decision.

Identify the Acquisition Team

The sophistication of today’s business world demands that anyone purchasing a business obtain the advice and counsel of skilled professionals, with the size and complexity of the business dictating the team members. They should, at a minimum, include an attorney and an accountant. These individuals can assist in analyzing legal, tax and valuation aspects of the purchase. Consideration should also be given to enlisting the services of an insurance agent, environmental engineer, business broker, benefits or labor consultant and appraiser. Each of these advisers can help meet specific objectives of the purchaser.

Form the Purchase Entity

It will be important to select the appropriate form of business entity to be used in the acquisition of the new business. It can be operated as a sole proprietorship, general or limited partnership, limited liability company or a corporation. Each of these forms has advantages and disadvantages. A detailed discussion of those attributes is beyond the scope of this article, but each should be considered in the acquisitions process.

Understand Resource Limitations

Purchasers must recognize the financial limitations under which they are operating. The extent of finances available for acquisition and operation will be very important and a question that will need to be answered early in the process. There is no need to spend time looking at a business that is completely out of the purchaser’s price range, or to stretch the budget so far in the acquisition phase that there will be insufficient funds available for operations. Some fiscal restraint can go a long way in avoiding wasted time and resources.

Identify Necessary Assets

Every business has a core of assets essential to its successful operation. The key element may be a unique concept, a trademark, a marketing plan, a patent, a certain location, a group of employees or a combination of tangible assets. Regardless of the asset mix, it is critical that the purchaser understand the nature of those assets and make plans to “capture” them. This may involve negotiation with third parties, in addition to the seller or its employees.

Structure the Transaction

There are a number of ways to structure the purchase of a business. It could be as simple as buying several strategic assets or just enough voting stock to give the purchaser a controlling interest in an existing company. It could also be more complex, as in a like-kind exchange or a triangular merger. Structuring a purchase is most often driven by the particular facts and tax circumstances surrounding the parties. Their bargaining position may also play an important role in this regard, and every effort should be made to understand the alternatives and to structure the purchase in a manner that will best suit the purchaser’s current and long-term goals.

Obtain Financing for the Purchase

Once a business is located and financial needs determined, financing must be secured. Unfortunately, most purchasers are not lucky enough to be able to finance the acquisition “out-of-pocket.” Alternatives include a deferral of payments to the seller, a loan from a financial institution, debt or equity from some other third party, or a mix of those options. As noted above, one of the biggest reasons a new business fails is lack of adequate financing. Do not underestimate the financial needs of the new business. If anything, include a reserve for unforeseen, but inevitable, contingencies. Build into the financing some cushion for unexpected events and early mistakes that will undoubtedly be part of operating a new business.

It is also important to document the relationship of the purchaser and any third party investor or lender. If the lender is a financial institution, a lack of documentation will not be the problem. The regulated atmosphere in which financial institutions operate demands well documented transactions. If, however, the purchaser is dealing with some other third party, the tendency is to avoid confronting these kinds of issues and, in deed, every other aspect of the transaction that does not seem to be a good or necessary use of limited resources. This is, however, one of the areas where a little time and money spent up front may well save a great deal of trauma and expense later.

Identify Third Party Aspects of the Business

It is important to understand the various roles third parties play in the new business. Is the business operated as a franchise? Are there leases of real or personal property that need to be considered? Are there employment agreements involving essential employees? Are any licenses or permits necessary to operate the business? These are just a few areas of concern in evaluating third party relationships. The importance of this aspect cannot be minimized, since these factors are frequently out of the business owner’s control. Also, do not forget the customers or clients upon which most businesses rely. Who are they? Where are they? What relationship does the new business have with them? Do they pay their bills immediately or do they expect terms of payment? Finally, what relationship does the current owner have with them and others in the industry? The last thing a purchaser needs or wants is to take over a business, possibly even adopting the predecessor’s business name, only to find the prior owner had a bad reputation with its customers or others in the industry.

Consider Risk Management and Liabilities of the Purchaser

Consideration should be given to the risks attendant with the purchase. This is not a particularly positive or productive aspect of the transaction, but it is an issue that has risen in importance as the business world has become more willing to litigate its problems. An effort should be made to focus on the most significant risks and resulting liabilities of the purchaser. Once those are known, a plan can be developed to manage them. The foundation of any risk management plan will be to use an acquisition entity that insulates the owner from personal liability. This could be a corporation, limited partnership or limited liability company. Allocation of risk will also be important. Options here include making the seller represent and warrant as to certain matters (e.g., the environmental condition of purchased property) and indemnify the purchaser from related liabilities if those representatives and warranties are breached or discovered to have been untrue. The purchaser can also buy insurance to manage risk. This could be casualty insurance to protect valuable assets, business interruption insurance to deal with unexpected interference with operations or products liability insurance to cover faulty products. In any event, this component of the purchase should not be overlooked.

Determine “Post Acquisition” Activities of the Seller in the Purchased Business or Industry

When buying a new business, the “post acquisition” role of the seller and its representatives must be considered. First, what will be the role of the seller in the transition of ownership? Some assistance is generally necessary, but will some form of long-term relationship be important to the business? The transition of ownership and the attendant shifting loyalties is a very tricky aspect of buying a business. A strategy should be developed for the transition of management and the lines of communication and responsibility. The continuing employees need to understand who is in charge after the transaction is consummated, and this is many times not easily distinguishable, especially if a prior owner continues in some capacity in the business. Next, are any employees necessary or desirable in the continued operation of the business? If so, consideration should be given to employment agreements or some other means of insuring their continued participation in the new business. Finally, consideration must be given to competition. Most often the value of a business will be greatly reduced if the seller goes into competition against the purchaser. A covenant not-to-compete should be used to prevent this possibly devastating event. These must be written with great care, but can be invaluable to the protection of a new business.

Review Limitation of the Seller’s Liability

A well advised seller will always attempt to draw a “liability bubble” around continuing responsibility. There are many ways of accomplishing this objective, each of which limit the ability of the purchaser to impose liability on the seller. It is helpful early in the acquisition process to identify those aspects of the acquisition that are important and those the seller will be asked to stand behind. Since they will, in all likelihood, be contested, it will be helpful to select those that are particularly important and develop a strategy for the reasonable allocation of liability among the parties.

The purchase of a business can be a very rewarding and profitable activity for the first time business owner, as well as the seasoned merger and acquisition specialist. In all events, there is no substitute for careful planning.