BUYING/SELLING A SMALL BUSINESS

  

Finding a Small Business to Buy
 
It is generally a bad idea to just go shopping for a business. The vast majority of small businesses fail, oftentimes as a result of the business owner knowing nothing about the business he has purchased or started. It is generally not a good idea to get into a business you know nothing about. If you are interested in a particular type of business, get a job in the field for a year working in the trenches before you invest your hard earned money. Once you know a business and have a passion for it and see the right opportunity, then you are ready to buy. Your first stop should be to those who are already in the business who are perhaps ready to retire or sell as a result of a death in the family or other issues. If you know the business well enough to invest, you should not have a difficult time identifying potential sellers. If all else fails, you can go to business broker listings.
 
Valuing a Business for Purchase or Sale 
 
We are often asked by clients, “What’s my business worth?”  Clients asking this questions usually don’t like the answer. Every type of industry tends to have its own preferred method of assessing value, but in general, the following process is not a bad rule of thumb for valuing a business:

 

1 First, ask how much money does the business generate from all sources for the owner each year, including salary, bonuses, distributions of profit, etc.
 
2. Second, ask how much would it cost to replace the owner’s work in the business with competent substitute management.
 
3. Subtract the cost to replace the owner from the total amount of money generated to the owner and you have the investment return from the business. Multiply this number by five and ten and you have a range of values of the business as an investment.
 
4. If it would cost the owner as much or more than the owner is taking home to replace the work done by the owner, then the owner does not own a business, the owner owns a job and in some cases, it may not even be a very good job.
 
5. When the going concern value of a company is zero, then the value of the company is just the market value of the fixtures, furniture, equipment, inventory, and accounts receivable less the company’s obligation, what you might call the “net asset value” of the company. The closer the purchase price is to the net asset value just described, the safer the investment. But if you don’t know the business, why do you think you will be able to run it more profitably than the former owner.
 
Structuring the Deal
 
The vast majority of small business purchases are done on the basis of an asset sale and not on the basis of a stock sale. This is a disturbing fact to sellers who have been operating as a “C” corporation since they will be subject to a double taxation upon sale of the business. That is, the corporation will be taxed on the sale of its assets to the buyer and then the owner will be taxed again when the corporation distributes the profit in liquidation of the company.  If the seller is an “S” corporation, there is no double tax.
 
The main reason buyers want to buy the company’s assets rather than the company itself comes down to the issue of latent or hidden liabilities.  No matter how effective and thorough the buyer’s investigation of the company being purchased, the buyer can never eliminate the possibility of a devastating law suit rearing its ugly head from past acts of the company and its employees. Even if such past acts are covered by insurance, the buyer may be stuck with a time consuming and diverting litigation that can also be destructive to the good will of the company as a result of unwanted publicity. For these reasons, buyers are seldom interested in buying the entire company. The key exception to this rule is where the company is the owner of a highly valuable but not easily transferred contract or license.  In such a case a buyer may be more open to purchasing the “company” (shares, member interest,  partnership interest, etc.)
 
Other issues need to be dealt with including: seller financing, key employees, non competition, non solicitation agreements, and personal guarantees which will be dealt with below. Every agreement needs to deal with buyer’s and seller’s obligations and those things that the buyer and seller are representing and warranting. Buyer and seller will need to warrant that they have the authority to sign the documents. Seller will need to warrant title and to the extent negotiated a level of repair and operation of furniture, fixtures, and equipment. A method will need to be negotiated for determining the amount, value, and status of any inventory and supplies transferred. These issues tend to be specific to the nature of the industry and business being sold.
 
Seller Financing
 
From the seller’s perspective the less seller financing the better. From the buyer’s perspective the more seller financing the better. Even if a buyer can pay cash for the business, the buyer should insist on enough seller financing to guarantee the warranties made by the seller including the seller’s covenant not to compete, sellers covenant not to solicit employees, seller’s covenant to train, seller’s warrantees with respect to operating equipment including HVAC of leased premises or anything else that a lessee may be responsible to repair, etc.  A little bit of seller financing is a little bit of seller’s skin in the game and keeps the seller focused on buyer’s success which can be indispensable for most buyers. 
 
If you are a seller, finance as little of the purchase as you can, require the buyer’s personal guarantee, and secure your financing with a security agreement and the pledge by the buyer of all of the assets of the business.  If you are going to be the bank, act like a bank. You know the drill: financial statements, credit reports, and collateral.
 
Key Employees
 
In many businesses, the value of the business is largely contained in certain key employees. Do enough due diligence to know whether the seller’s good will lies with the owner or certain employees, typically sales reps. If the key employees won’t stay or sign covenants not-to-compete, the company may have no going concern value. A non-compete with key sales employees may be unenforceable. You will need to go over this one carefully with your attorney.
 
Non-Compete Agreements
 
A seller should always be ready to sign a covenant-not-to compete with a buyer. No buyer wants to be the victim of the unscrupulous seller who sells his business and then starts it up again down the block in a better location in his wife’s name. (This happened to one of my clients.) Covenants not to compete are usually enforceable against a seller, but not necessarily against a seller’s employees. The enforceability of covenants not-to-compete in the state of Utah with regard to employees is covered by two Utah Supreme Court cases.  One holds that covenants not-to-compete are not enforceable against your common employee and the other holds that covenants not-to-compete are enforceable against a typical employee under certain conditions. Even where a covenant not-to-compete is not enforceable, you may be able to get 80% of what you need from the employee by having them execute a covenant not-to-solicit your other employees to leave your business, and a covenant not-to-disclose confidential information. 
 
Business Brokers
 
There are pluses and minuses to using a business broker to sell your business or to buy a business. Business brokers only get paid if the deal closes.  
From a buyer's perspective, the business broker is not your friend.  As a buyer of a business, you are not buying a piece of real estate that has a long established market with relatively reliable valuation processes. You may be asked to pay a substantial amount of money for an intangible value called “good will.”  Unless you have thorough knowledge of an industry, how are you going to know if the sale price is a good deal. The tendency is to rely on the opinion of the business broker. No matter how the business broker comes across, do not rely on his or her opinion. They have an unreconcilable conflict of interest.  You must rely on your own professionals to evaluate the business. Your CPA should go over the books and you should discuss the purchase with your attorney.  Yes, they will charge you for their time but the probability of you getting ripped off without their help is about 90%.  Further, If you have ever bought trinkets in Tijuana or other third world cities, you know that you have to be willing to walk away from a deal in order to negotiate the best price.  A business broker will almost never suggest you walk away.  Your CPA and attorney will be much more objective and will stiffen your spine to walk away when appropriate. 
 
Never rely on a business broker or his attorney to draft an agreement.  In real estate, I find good and experienced real estate agents are pretty competent at constructing agreements using the preapproved REPC forms when the buyer and seller are represented by different real estate firms. The same is not true with business brokers. They do not have your interest in mind. The agreement will be designed to insure that their fee gets paid, that the deal closes, and not that your interests are protected.  These deals are complicated and should not be undertaken without an attorney.  
 
From the seller’s prospective, a business broker can also be a mixed bag.  As the seller you know your business.  You know the firms in your industry that might want to acquire your firm.  You know the firms in your industry outside of your market area who would want a presence in a new market or access to an important customer of yours.  These are the buyers from whom you might receive a premium price for your company.  Exhaust these options before you sign your life away with a business broker. The internet provides a whole array of selling options that were not available a few years ago.  Exhaust these also before signing up with a business broker.  A business broker will take 10% of the purchase price and that will come out of the buyer's down payment.  If the buyer defaults on his contract and you take the business back, the broker is not going to refund his 10% of the defaulted amount. Keep in mind that an unscrupulous business broker may be making subtle misrepresentations about the business to the buyer to get things closed.  This is going to come back to haunt you when the buyer decides to back out of the deal six months after closing.  You will have a law suit on you hands.  See the “Making Deals” tab above for the process by which you make a good agreement that avoids litigation.  If you have exhausted your other options, have your attorney look over your agreement with the business broker before you sign it.  Many provisions are negotiable and you don’t want to get stuck with a do nothing broker. Having said the foregoing, some brokers are pretty aggressive sales people and can earn their money, provided you protect yourself by having your own attorney review all documents. 
 
 
 

Brought to you by Business Law Associates, L.C., Utah's Small Business Law Firm, 8170 S. Highland Dr, Suite E5, Sandy UT  84093, 801.944.5255.