United States: Purchasing A Business: Making The Acquisition Work For You

When the opportunity to purchase a business arises, the prospective purchaser is typically enthusiastic and excited about the acquisition. While optimism is clearly a valuable resource for a new business owner, the prospective purchaser must move carefully to avoid catastrophic surprises after the purchase. The purchaser must consider many issues, including cost or value of the target, tax aspects of the purchase, liabilities that may be intentionally or unintentionally assumed, and a myriad of other issues with the purchase of a business conducted in corporate form. This article provides a general overview of the many issues that a purchaser should consider for a successful acquisition. The size of the transaction and other factors may limit the applicability of some of the issues raised, but these issues should at least be considered by all purchasers.

After initially identifying a potential target business, the purchaser must consider its value. While detailed information may not be available at this stage, an analysis of the value is imperative prior to beginning negotiations. A certified public accountant (CPA) with valuation expertise can provide the purchaser with an idea of the range of value of the target business using industry standards and available information. The CPA may also offer valuable assistance in negotiating a purchase price.

After the initial negotiations regarding purchase price and other terms, the terms of an agreement to purchase the business may be put in a term sheet or letter of intent. While all business purchases should be completed with a written purchase or acquisition agreement, the term sheet can provide an initial road map for the transaction. An attorney should be consulted at this point to consider the legal ramifications of the term sheet or letter of intent and help the purchaser consider additional issues that can be addressed, such as escape clauses, confidentiality and no-shop provisions. It is also at this point that the purchaser and seller, along with their CPAs and attorneys, should consider the tax and accounting structure of the acquisition.

An escape clause in a term sheet or letter of intent is a provision that allows the purchaser to walk away from a transaction in the event that negative information is uncovered during the purchaser’s "due diligence" review of the business prior to entering into a final contract. While term sheets and letters of intent are typically nonbinding, without an escape clause there is increased risk of liability if the purchaser terminates the transaction. A due diligence review includes a detailed review of the business, financial, accounting and legal areas of the target business from the beginning of negotiations to the close of the transaction by the purchaser and his or her professional advisors. An important start to any due diligence review of a target business is a thorough analysis of the business’s financial statements. A CPA can be used to review and analyze historical financial statements and to prepare projected or pro forma financial statements to help the purchaser evaluate the target.

Both parties in an acquisition should enter into a separate confidentiality agreement. In performing a due diligence review of the other party, each will likely learn nonpublic information about the other. If the transaction falls through, both parties will want to keep any disclosed information confidential. A no-shop provision is also very important. It provides that the target business will not look for other bidders during the purchasers due diligence review. A no-shop provision prevents the target from using the purchaser’s offer to entice other bidders.

The tax and accounting structures of the acquisition are very important considerations at the early stages of the negotiation. If the transaction is structured such that the seller receives or realizes tax benefits, these benefits should be reflected in the purchase price. The tax treatment to the seller may also have tax effects to the purchaser. If the purchaser and the target are corporations, a merger should be considered. A corporate purchaser in a merger can potentially recognize significant benefits by using the "pooling of interests" method versus the "purchase" method of accounting for business combinations.

The form of consideration to be paid to the target business may be guided by tax and accounting issues. If not, the purchaser may choose to pay in cash, with a note or with equity, if a corporate purchaser or any combination. Payment with debt or a note provides some leverage in the event of unexpected liabilities after the close of the acquisition. To protect a purchaser after the acquisition, forming an escrow account should be considered. An escrow account provides that a portion of the purchase price is put into a special account for a specified period of time. In the event of unassumed post-closing liabilities, the escrow funds are used to compensate the purchaser or pay the liability. If any of the money remains in the escrow fund at the end of an agreed upon escrow period, it is returned to the seller.

Another consideration is the use of an "earnout." An earnout provides additional consideration to the seller if the purchased business meets certain predetermined financial goals or if other agreed upon events occur. The earnout can also be used to keep the former owner of a purchased corporate business or the selling individual working in the acquired business. As an example of other agreed upon events, an earnout can provide the former owners with a bonus if certain key nonowner employees remain employed in the purchased business for two years after the sale. As an incentive to keep the nonowner employees working, the former owners merely promise the nonowner employees a share of the earnout bonus if they remained employed at the surviving business. An earnout can also be used to overcome an impass between purchaser and seller over price where the seller feels the proposed price is inadequate. The seller may agree to wait to be paid a portion of the purchase price until the business produces the results the seller has told the buyer it can or will achieve. So, a portion of the purchase price is earned after closing based on the business performance.

Whether the sellers of a business or its employees remain employed with the business after the acquisition, it is important to negotiate noncompete agreements with key owners and employees. It is common for an owner to sell a business and shortly thereafter decide to start the same or similar business near the location of the business the owner sold. A competing former owner can severely limit the value of any goodwill purchased and introduce a new, proven competitor. The noncompete agreement provides that the sellers will not compete with the remaining business either directly or indirectly, for a specified period of time in the geographic area of the purchased business.

Once the initial considerations are examined and agreed upon in principal, the transaction should be memorialized in a purchase agreement. It is important to have the assistance of an attorney in drafting the purchase agreement. The major issues addressed in the purchase agreement are: (i) the purchase price and the method of payment; (ii) representations and warranties of the seller and purchaser; (iii) covenants both before and after closing; (iv) indemnification provisions; (v) details of the closing; (vi) termination provisions; and (vii) various other legal provisions. In some small business acquisitions, the purchase agreement is signed at the closing or consummation of the transaction. In larger transactions and more complicated small business transactions, the purchase agreement is signed first and the closing of the transaction occurs at a later date.

The representations and warranties of the seller provide important assurance to the purchaser regarding material aspects of the target business. The representations and warranties provide that the seller represents and warrants that the business actually is as it is portrayed by the sellers (or its owners, if a corporation.) For instance, typical representations and warranties discuss due organization and authorization if a corporate target, ownership and title to the assets of the target, and accuracies of financial information provided to the purchaser. The representation and warranties also address no adverse events having occurred since the purchaser inspected the business, that there are no environmental or labor problems, and that there is no current or threatened litigation.

Typically, the representations and warranties will continue after the closing of the transaction for a period of time. The seller will try to terminate the representations and warranties at the closing or soon thereafter, or limit any liability for breach to the funds held in escrow, if any. If there is a breach of the representations and warranties, the purchaser can recover its losses or damages either from the escrow or directly from the seller.

The indemnification provisions in the purchase agreement provide that the seller will indemnify the purchaser for breaches of the representations and warranties and for any liabilities incurred by the business prior to the close of the acquisition. The other provisions deal with specific issues for each deal and some general legal provisions common to most acquisitions.

A final issue is the termination provisions in the agreement. Termination provisions can be placed in the term sheet or letter of intent or in the purchase agreement if it is to be signed prior to the closing. A termination provision may include a break up fee to be paid by one party in the event it decides not to go through with the transaction under certain circumstances.

In conclusion, the acquisition of a business has many obstacles, but with careful planning and assistance from professional advisors, such as financial and management planning from CPAs, and legal advice from attorneys, most of these obstacles are easily avoided.