1. Nuts and Bolts of Buying a Small Business
By: Joshua M. Marks, Esquire
I. What types of questions should an interested buyer ask when contemplating the
purchase of an existing business?
It’s very important to be thorough in your “due diligence” when contemplating the
purchase of an existing business. You want to ask the right questions, examine the
right documents and look beneath the surface to determine if this business investment
makes financial sense---these are the common sense questions:
a. Why is the Seller selling? (Is he/she retiring; has he/she let the business run into
the ground; not equipped to handle changing trends in the industry; doesn’t have
the capital infusion needed to take the business to the next level).
b. Can I talk to current employees? (Will give you a good idea of worker morale and
personalities; see first hand who is responsible for what; who shares your
ideas/vision; who are the workers and who are the slackers).
c. Can I observe the operation for a few weeks and/or work in the operation? (Will
help eliminate surprises once you take over; a must if at all possible—if it’s not
possible, is the Seller trying to hide something?).
d. Will Seller help facilitate the transition of the business post-closing? (You can
work out an arrangement in which the Seller either works for free or gets paid for
certain period of time).
e. Will Seller provide 3 years of tax returns for the business, certified statements of
income, cash flow/balance sheets? (Obviously, you want to know the gross
revenue, profits, cash flow, assets and liabilities of the business).
f. What are the current working conditions? (Are you going to have to make interior
repairs, equipment upgrades, install HVAC, etc.--all which add to your out-of-
pocket investment).
g. Any existing environmental or other hazards in the workplace?
h. What are the existing obligations of the business including leases, accounts
payable, third party contracts, and other indebtedness? (Are there obligations that
you need/are willing to take on such as a lease OR are there some obligations that
you want satisfied prior to closing such as lines-of-credit that are secured by
equipment you need to run the business).
i. What are the existing employee salaries, bonuses, benefits, etc?
j. Does Seller offer financing for the purchase?
2. k. How did Seller determine the sale price of the business? (Is it merely a multiplier
of the Seller’s investment in the business, and if so, is that a true and accurate
measure? Is it a multiplier of actual profits, and is that industry standard? Seek
the advice of an accountant or business valuation expert!!)
II. What is a Letter of Intent (LOI) and is it recommended in the sale of a small
business?
A. Typically comes about once the key terms of the deal have been agreed
to;
B. Short letter setting forth some of the key terms of a proposed
transaction; Example: purchase price, financing terms, equipment
included, time frame for due diligence to be conducted, anticipated
closing date, liabilities to be assumed, etc.
C. LOI is generally non-binding (need to specify if any parts are binding)
and states that it will be superceded by the formal written agreement;
D. What are the conditions to getting to a final deal? What is the time
frame?
E. Does Seller have to provide anything to assist in due diligence?
F. Key representations and warranties of the parties;
G. Assists the Buyer in obtaining financing;
H. Specify what else the Buyer needs in order to conduct his due diligence;
I. “No shop” clause so that Seller can solicit competing offers for a
specified period of time.
III. Is it necessary to form a legal entity, and should I purchase the business in the
name of that entity?
A. Depends on several factors such as: potential personal liabilities in that
line of work, federal and state tax considerations, financing needs, and
the management structure;
B. Forming an entity shields the individual(s) from personal liabilities, and
typically only the assets of the business are subject to exposure in civil
suits;
C. Beware of the fact that lenders, landlords and vendors may require
personal guarantees if you are not yet established. Personal guarantees
do open your personal assets up to lawsuits;
D. An act of fraud or reckless conduct may expose the individual(s) to
personal liability.
IV. What type of entity should I consider forming?
a. Sole proprietor
1. Not incorporated;
2. Owned by an single individual;
3. 3. May be appropriate where liabilities of the business are not a
concern or are adequately covered by insurance;
4. No employees; example would be a home-based consulting
business;
5. Business income and expenses included on the individual’s income
tax return.
b. Partnership
1. An association of 2 or more people who will co-own a business;
2. Maybe appropriate for situations that are similar to that of sole
proprietor, but there happen to be more than one owner;
3. The partners are personally liable for all debts and other
obligations of the partnership;
4. Partners are generally considered equal in terms of management
authority and conduct of the business; if the partners want to
change this arrangement, then they must draft a partnership
agreement;
5. Property of the partnership belongs to the partnership and NOT the
individual partners;
6. Income and losses are taxed to the individual partners equally OR
as provided in the partnership agreement;
7. The partnership must file an information return with the IRS.
c. Corporation- “S” corp. v. “C” corp.
1. Shields the owners from debts and obligations of the entity;
2. Management is vested in a board of directors who are elected by
the shareholders;
3. Board of directors appoint officers to manage the day-to-day
operations;
4. Same person can be on the board and hold a position as an officer;
5. Must file a certificate or Articles of Incorporation with the State;
6. Board of directors adopts by-laws;
7. Must follow certain formalities to maintain its corporate status:
hold regular meetings, file annual reports, pay corporate taxes, etc;
8. The corporation is a tax-paying entity subject to state and federal
tax on income unless it elected “S” status in which case it’s treated
as a partnership;
9. Advantages: limited liability of shareholders, centralized
management, free transferability of shares of stock, ability to raise
capital by selling stock;
10. Disadvantages: corporate formalities, expenses, tax consequences.
d. Limited Liability Company (LLC)
1. Considered a hybrid entity incorporating features of partnerships
and corporations;
4. 2. For state and federal taxes, the LLC is treated as a pass-through
entity and taxed as a partnership;
3. Owners of the LLC are called “Members”;
4. Members do not have personal liability for the debts/obligations of
the LLC;
5. Management is determined by way of an operating agreement;
6. Formed by filing a Certificate of Formation;
7. Advantages include: limited liability, flexibility in structuring
management and;
8. Profit/loss allocations, taxation as a partnership.
V. How do I manage the relationship between my partners and myself?
a. Partnership Agreement (not required under law but is a very good idea!!)
1. Address: partnership name, purpose of the partnership, contribution of capital,
division of profits and losses, limitation on a partner’s authority, management
issues, dissolution by death, retirement or involuntary withdrawal.
b. Operating Agreement (not required but strongly advised)
1. Capital contributions of members, allocation of profits and losses, allocations
of distributions, management, transferability of interest, voting rights, admission
of new members, and dissolution.
c. Shareholder’s Agreement
1. Percentage ownership of each shareholder, transferability of shares, death or
resignation of a shareholder, insurance provisions (buy-sell), etc.
VI. What type of agreements will be needed to consummate the sale of the business?
a. Asset Purchase Agreement
1. Purchasing the assets of an existing business only rather than its
stock;
2. Usually applies to sole proprietorships, partnerships and LLCs;
3. Key provisions include: identification of assets to be sold (and/or
excluded), purchase price, method of payment, additional,
assignment of leases, non-competition clauses, representations and
warranties, indemnifications, place and date for closing, an exhibit
identifying all fixtures, equipment, furnishings that are included in
the sale, documents to be delivered at closing;
4. Make sure to obtain shareholders consent or consent of members
from Seller.
b. Stock Purchase Agreeement
1. Similar items as those in asset-purchase agreement are included,
however the transaction is usually a bit more complex since the
corporation retains all of its liabilities. Purchase has additional
due-diligence that is necessary.
5. 2. More extensive representations and warranties dealing with title to
assets, corporate stock, capitalization, financial statements.
c. Bill of Sale- Evidences the sale of the tangible property to be sold such as
fixtures, furnishings and equipment.
d. Bulk Sales Transfer- In NJ, there is a requirement for the buyer to give notice to
the Division of Taxation ten days prior to closing. Division will reply indicating
if seller has any remaining tax liabilities. Highly recommended in Pennsylvania
as well—application for tax clearance certificate.
e. Assignment of warranties- Equipment
f. Assignment of lease- Do you need landlord’s approval?
g. Assignment of Intellectual Property- Are you utilizing tradenames, marks,
systems?
h. Agreement of Sale, Deeds, Affidavits- If purchasing real estate in conjunction
with the business.
VII. Miscellaneous
a. Consult an attorney before finalizing the purchase;
b. Consult an accountant to discuss tax implications;
c. Be thorough in due diligence;
d. Assess financial risk/exposure in the event that you lose your entire investments
and the business goes under.
