Laws in buying and selling a business

1. Introduction:

Do you want to start a business? Why not you think of acquiring an established business instead starting from scratch.

But please note that it will not come to you as a free lunch. You have to put time, money, effort into finding the business that’s right for you.

The buyer should aware there are too many process to be under taken before an acquisition of any business.

This process includes how to assess and value an existing business, employing professionals like attorneys, accountants to help you in this regard, how to move further and conclude the deal successfully.

The benefits always outweigh the demerits in buying an existing business for the following reasons. But Caveat emptor principles always apply as the buyer needs to be aware of every aspect of the business he wishes to buy.

2. Advantages in buying a business:

1.A completely set up is being offered as a hot cake and most of the ground work will already have been completed in getting the business up and running .

2. In case if a buyer go for a business with a proven track record, it will be easier to source the finance for purchasing the business by the buyer.

3. In the case of existing business, there always be an assured market and well demonstrated.

4. Accrual of additional advantage such as established customers, a reliable income, a reputation to capitalize and build on, and a useful net work of contacts.

5. The buyer will have ready made business plan and established marketing method in case of acquisition of well established business.

6. Availability of well trained and experienced employees.

7. Most of the critical issues might have been cracked up and solved already.

2.1 Disadvantages:

1. Considerable upfront expenses such as professional fees for attorneys, surveyors, accountants have to be incurred.

2. In case the business which is proposed to be acquired is not performing well, the buyer has to inject additional investments over and above the purchase considerations to give it a best chance of success.

3. The buyer has to honor or renegotiate any outstanding contracts of the previous owner leaves in place.

4. It is better to investigate the reasons why the current owner is offering the business for sale.

5. Try to get the feed back from the current employees of the business and try to ascertain their reaction for the sale and if they are disgruntled, the reasons for the same.

3. LEGAL COMPLIANCES:

Identify whether there is any pending or threatened litigation and obtain attorney’s opinion on the possible outcome.

Escrow accounts or warranties offered can not be adequate in certain cases.

Pitfalls can be avoided if you have some professional help in this regard.

Assess that any charges is pending against company by government (in U.S, by Federal or State Agency)

Inquire whether company is handling the suits either by in-house attorneys or decide on merits of the suit to have an outside attorney to conclude the case successfully.

It is to better to confirm whether anti trust violations will be invited because of the acquisition.

Always vouch whether any of late legal representation letters that has been forwarded to Company Auditors.

Also ensure that whether the company is complying with the environmental, equal opportunity employment and OSHA requirements .In case the reply is negative, assess the cost of such compliances.

While drafting the Buy or sell agreement, try to assess and include the outstanding legal matters to be dealt in the acquisition agreement.

Try to assess the competitors experience in such legal problems .It is useful to find out that they will eventually confront the company.

3.1 Transfer of Owner ship and or Title to property.

Buying and selling a business involves a conglomeration of assets – inventory, fixtures, vehicles and equipment, all of which are movable and assorted contract rights under leases, sales agreements, patent licenses, which are intangible.

Internal sources of legal information are copies of contracts, evidence of ownership and organizational documents which has to be obtained and thoroughly examined.

Outstanding contracts with the buyers and sellers, creditors, employees, lessors etc should be carefully assessed.

Under sale, only contract rights and not the contract obligations is being transferred to a third party with the consent of the other party to the original contract. Sublease arrangements and mortgage assumptions are example for this.

An example involving a lease.

A grocery store owner sold his business at a relatively a good profit .Out of this , he  earned a profit of say $1,00,000 in excess of the cost of acquisition two years back.

Since the building was leased, the seller was not able to assign the lease to the purchaser of the business. However the seller permitted to sublease the building for the remainder of the lease. The lease amounted to $ 10000 per month.

A year later, the buyer decided to give up the business and ready to take his loss. In such a situation, the seller, the former owner will be liable for the remaining years lease. He will loose all the notional gain what he had earned if he can not find another tenant.

3.2 Assignment Contracts:

The buyer of the business in most cases wants any contractual rights of the seller that are needed in order to maintain the business as a going concern and it is termed as assignment in legal terminology .It is to be noted that thought the contract rights are assignable , but the original contract may expressly prohibits its assignment .

Usually these negative covenants are common in the lease agreement.

It is to be prudent to see that the loan agreement contains any clause that prohibits the sale or other changes in ownership during the pendency of such loans.

The buyer should obtain the copies of the important contracts and better to vouch any non assignment clause is included in such contracts during due diligence.

In  case of real estate lease agreements , the buyer should thoroughly go through the provisions relating to rental amount , payment terms  , expiration , renewal , sub-leasing , repair , improvement , insurance  etc .

The buyer should be very specific regarding the duration of lease agreement. If the period happens to expire shortly, efforts should be made to renegotiate the lease agreement before the purchase or an option should be obtained to renew for an additional period.

During due diligence , copies of the trade mark , patent , trade-name and copy right registrations should be obtained in order to decide the legal status of the right and to know whether it can be transferred .

If the seller turns to be an exclusive agent , dealer or distributor of a product or line of products , or right under license to use a patented process , trade name , or trade mark. Copies of such contract should be obtained to determine the precise nature of the rights, its limitations, and the seller’s power to power and special emphasis should be given to the exclusiveness of the right.

On labor related legal matters , during due diligence it should be ensured to verify the copies of employment contracts and union agreements should be examined for terms relating to compensation , working conditions , duration of employment , termination, pension and profit –sharing plans , stock-option, insurance programs etc. The buyer should also ascertain whether it is possible to retain the key employees after acquisition.

On commercial legal matters, particular attention should be focused on outstanding Sale and Purchase contracts. Trade credit, discount, installment payment, and security arrangements should be carefully examined by the purchaser.

Seller should also forward the copies of conditional –sale contracts , purchase-money chattel mortgages , chattel leases , lease –purchase agreements , consignment contracts , and sale –on-approval and sale –or-return contracts to which seller is a party.

Copies of the financial arrangements entered into by seller with the commercial banks , financial institutions and other third party money lenders should be thoroughly examined by the buyer to understand the terms of the loan , repayment provisions , interest rates , finance charges , insurance requirements , acceleration provisions , security requirements , and recourse rights .

The buyer should also verify whether  the business risks are covered by the insurance policies and if so , he should ascertain the adequacy and cost of coverage of such risks as liability arising from manufacture or sale of defective goods ,liability to customers for injuries sustained on the premises , liability for property damages and bodily injuries arising from negligent operation of company’s vehicles , liability to employees for injury under workmen’s compensation laws , and property hazardous such as fire , windstorm and theft .

3.3 Verification of Title Deeds:

The abstract of title for each parcel of the real estate involved in the buy or sell transaction should be verified by the buyer’s attorney. The scrutiny will disclose any defects in the title deeds, examination of abstracts and the abstractor’s certificate to reveal whether there are any unreleased mortgages, judgment, liens, mechanics liens, tax liens or un-paid real estate taxes and special assessments.

3.4 Verification of organizational documents:

In case of partner ship, the buyer should get a copy of the partnership agreement.

In case of Companies , the buyer should get a certified copy of the resolution of the shareholders authorizing the sale of the corporate assets ,Further the buyer should also obtain the copy of the certificate of incorporation , copy of the Memorandum and Articles of Association , corporate bylaws, share transfer books , and minutes of shareholders and directors meetings.

As regards to real estate, emphasis should be given as to its compliance with building codes and other related ordinance. A real estate survey can be organized to determine whether buildings are located within the boundaries in compliance with the setback lines and whether there are any encroachments by adjoining buildings or driveways etc.

A down-to-date abstract of title will reveal the existence of liens against a particular panel of real estates, but liens against personal property of the seller can be discovered by a search of the office of record. Separate filing systems may exist for Chattel mortgages, conditional sales contracts, trust receipts, assignment of accounts receivable etc and each of such files is to be thoroughly verified.

3.5 Taxation Compliance:

In case of  the buyer assuming liability for the payment of taxes of the seller , status of the Federal , State and local income taxes , social security and income withholding taxes , Federal excise taxes , state and local taxes , license taxes , and real-and personal –property taxes should be examined .

Special emphasis shall be given whether tax returns have been reviewed and approved by the taxing authority.

3.6 Verification of Background:

The trend of Market share and the extent of government regulations ( including Environment Protection Act and OSHA ) , market share in the industry ,capital purchases commitments , cyclical factors affecting the business , has the company  been involved in criminal proceedings , regulatory commission violations or significant civil court litigations , real reason why the company is being offered for sale , ascertain whether aspects of the business that appear to be dominant in the industry , technology , product design , marketing .production etc should be thoroughly verified .

History of the business, any predecessor companies and changes in capital structure, capitalization or insolvency proceedings, organization chart, and terms of acquisition also should be considered by the buyer.

3.7 Product lines enquiry:

The buyer should also examine the customers response to company’s product , market share , quality , service , market life cycles , warranty terms , Is patent and trade mark production is available .

3.8 Markets Inquiry:

Demand , customers data ,segment of market , channel of distribution ,Past sales performance data for at least 10 years ,competitors and their strategy , feed back from customers and suppliers and distributors , advertisement strategy , sales promotion policies should also be investigated by the buyer .

3.9 Role of Industry and Competition:

The buyer should undertake  the  review of industry composition , review of recent mergers , acquisition and divestiture deals that have occurred in the Industry .principal bases of competition analysis – quality ( low gross margin ) service ( high margin to wholesalers ) Innovation ( high R&D expenses ) analysis of high production volume is to low cost , is any pending or existing  litigation affect the products in industry , governmental regulations affecting the industry , adverse political , social and economic conditions ( trade restrictions , higher interest rates , probability of nationalization or expropriation , currency revaluation.)

3.10 Operations Evaluation:

Evaluating the operations in the field of plant and facilities, production, purchasing and inventories, for example, the failure to uncover the need to replace technically obsolete or worn-out equipment may reduce the chances of a successful acquisition.

3.11 Evaluation of Plant and Facilities:

The buyer should analyze the location , availability of infrastructure like raw materials , labor supply , climate and natural hazards , transportation , Building Codes and zoning laws .list of principal machinery and equipment cost , age and condition , accumulated depreciation , location ,technological obsolescence , list of surplus building available , capitalization vs. repairs expenses policies for repair and maintenance ,industrial engineering assessment of the adequacy of auxiliary equipment –tools , patterns and material handling equipments .

3.12Production Analysis:

Nature of Manufacturing process ( e.g. assembly , machine shop , extraction ) identify the important elements in manufacturing process like capital investments , plant design , know-how, skilled labor , etc ,evaluation of production schedule , production methods , safety and security methods  , critical lead times for materials , quality control , industrial engineering etc should also be looked into.

Analysis of fixed and variable costs, break even point and the relation of volume to the break even level, effects of non cash costs, cost accounting for idle capacity and volume variance on analysis of production costs should also be taken into consideration.

The buyer should also pay his attention to defective production , idle time , waste and scrap , co-ordination of production planning with sales forecasts , evaluation of company production policy in relation to the industry ,

3.13 Purchase Procedures:.

The analysis of the following as regards to purchase procedures should be undertaken by the buyer.

Principal raw materials or products required, commenting on future price trends, market conditions, raw materials supply, competitors activity and general economic conditions in suppliers industries.

Evaluate the existence of inventory limits such as min-max level and number of months supply.

How purchases are made by competitive bidding process .make or buy analysis, operating costs earned compared to budget, waste, scrap and salvage disposals should also be considered by the buyer.

3.14 Inventories and Costing Aspects:

Analysis of trend in Inventory levels  e.g. raw material , work –in-progress , finished goods , seasonal inventory fluctuations , inventory turn over by product line , line of business , Basis of valuation ( FIFO, LIFO , average costing )  should be studied by the buyer .

3.15 Human Resources Aspects:

To ascertain whether employee cost will remain same , analysis of employee turn over ration , to study the union affiliates and contracts for important agreements , production incentives to employees ,to investigate any federal charges are pending before federal or state labor agencies , analysis of labor morale and handling of labor relations , working conditions ,evaluate the employee benefits program such as profit sharing , life insurance , medical benefits , travel , accident bonus , deferred compensation and severance plans and voluntary retirement scheme.

3.16 Financial Aspects:

Scrutiny on audited accounts  preferably on Form 10-k ,if the Company if public held company, tax returns for the last 10 years , IRS Reports , schedule of unused loss and investment credit carry forward, analysation of earning per share , dividends , return on stock holders equity , reviewing of all extra ordinary and non recurring expenses ,

analysis of legal expenses and consultant charges , analysation of important financial ratios such debt-equity ratio, current assets to current debt , net profit to net sales , tangible net worth , net working capital , net sales to net tangible net worth , analysation of bad debts should be undertaken before acquisition.

3.17 Environmental Regulation Aspects:

If the facility has a waste treatment, storage, whether disposal permit under section 3004 and 3005 of the Resource Conservation and Recovery Act (RICA) has been obtained shall have to be ascertained.

Whether the facility discharges waste water into something other than a public owned treatment works ( POTW) and if the facility uses POTW , whether pretreatment is required by the POTW and whether plant has general hazardous wastes as defined in section 3002 of RCRA and the environmental disclosures in the 10-k should also be taken into account by the buyer .

4. PROCESS OF ACQUISITON:

The buyer once decides to acquire a running business, with help of his attorney, should undertake following steps for the smooth conclusion of business takeover.

4.1 Non –disclosure Agreement:

This will ensure the confidentiality in the initial discussion and investigation between the parties where each agrees to protect trade secrets and confidential business information of the other.

It binds both the parties and protects the proprietary information. It acts as a comfort that may be open and honest with the other for the purpose of exploring the merits and demerits of the proposed transaction with out fear of consequences.

NDA safeguards the trade secrets and know how that inevitably compromise significant portion of the value of sellers business and defend each party’s competitive business strategies and plans.

4.2 Letter of Intent:

At the advanced stage of discussion between the parties, it become essential for the parties to enter into a partially binding letter of Intent (LOI) to set the general parameters and time frame of the deal, including the intended final closing date.

It comprises of binding and non binding clauses and non binding will usually contain a sketch of the intended terms of acquisition itself. The attorneys will usually help the clients to conveyance it .The binding portion includes a) no-shop, b) break-up fee and c) confidentiality. This restricts the seller for selling the business for a certain period of time. This clause acts as deterrent for the seller as he could not sell to any body other than the buyer for a specific period.

The initial expenses such as legal and accounting fees spent will be lost if either of the party decides to back out of the deal. This loss will be safeguarded by a break-up fee payable by the party who wants to back out of deal  and this is payable during no-shop period as a form of liquidated damages.

4.3. Due Diligence:

With the LOI reduced to writing, the purchaser and the seller (in certain cases) start a due diligence analysis of each other’s business.

It has been defined as follows :” a measure of prudence , activity or assiduity , as is properly to be expected from , and ordinarily exercised by , a reasonable and prudent man under the particular circumstances ; not measured by any absolute standard , but depending upon the relative facts on the special case “ –Perry v. Cedar Falls ( cited in Black’s law Dictionary ) .

4.4. Term Sheet:

After the completion of due diligence , the parties must agree on the specific parameters of the deal .The term sheet will include the each intended document for finalizing the deal and it might be useful for the attorneys on the job. The Term Sheet may finally shape into document and it will serve as guidelines for the parties to proceed on the deal.

4.5.Final Preparations : This will consume a month or two where seller makes final batch up work such as accounts finalization and business as a whole for transfer and whereas the buyer is actively engaged in the identifying the schemes of finance for successful acquisition of business.

4.6. Closing Up – Closure takes place finally when all documents have been agreed upon by the parties and their attorneys.

Closure shall be made by a Business Acquisition Agreement which shall contain the following features:

1. Identification of assets or stock to be transferred, consideration to be paid and mechanics of the transaction.

2. Certain special condition shall be placed on the terms of transaction such as employment contracts.

3. The shares or stocks to be transferred for effecting the transfer of business, the agreement should mention about the terms relating to registration.

4. Assurance of good title and profitability through the representation and warranties of the seller should also be included in the agreement.

5. Sellers covenants as regards to certain promises to do or not to do some act before closing.

6. It should also include events that must happen for the seller to be bound to sell to the purchaser.

7. Assurance by seller to comfort purchaser’s fears should also be included as closing and termination provisions.

8. Money that can be claimed if something is wrong with the deal by way of inserting indemnity clause.

5. Selling a Business:

The seller before embarking the sales should organize all his financial documents and getting the business in order.

Seller should update his financial records hence valuation of his business can be determined from the financial status.

Seller should draft a sales contract with the help of an attorney and to decide the financial arrangements, such as how the buyer intends to pay for the business.

6. Conclusion:

Buying and selling a business engrosses many negotiations and contracts .It is always better to take attorney’s help even from the negotiation process itself. An attorney or a consultant can help you sift through financial documents to determine what is relevant to the sale transaction. A lawyer can also help you to draft the business acquisition agreement right from non disclosure agreement to conclusion of the buy or sale deal.

BIBILIOGRAPHY

1. Buying silence – Journal Article by Terry Morehead Dworkin , Elletta Sangrey  Callahan , American Business Law Journal , Vol 36 ,1998.

2. Buying and selling a Business – A step –by-step Guide – by Robert F. Klueger – Business and Economics -2004

3. The Upstart guide to buying, valuing and selling your business – by Scott Gabehart – Business and Economics -1997

4. Buying and selling a Small Business – by Verne A Burn – Business and Economics -2000.