Buying a Business or Buying Trouble? - 4 Tips to Minimize Risk
Buying a business should not be like buying a used car. While it may be common for someone to buy a used car “as-is,” it would be highly unusual for someone to buy a business with that disclaimer. Instead, when purchasing a business, buyers will want to avoid assuming responsibility for the existing problems and liabilities associated with the business – except for those liabilities that the buyer specifically agrees to assume.
So what should a buyer do to avoid (or at least minimize) the risk that he or she will be unexpectedly saddled with liabilities of the acquired business?
1. Buy the Company’s assets and not ownership of the Company itself. There are two ways to buy a business – you can either: (i) buy the seller’s ownership interest in the business itself (meaning the seller’s stock if the seller’s business is a corporation, or the seller’s ownership units if the business is a limited liability company); or (ii) buy only the assets of the business (the equipment, inventory, furniture, intellectual property and even the name of the business).
- Buying ownership of the company. A change in the ownership of a company in no way affects the company’s liability for its debts and other liabilities. As a result, if you elect to acquire ownership of a company by purchasing the stock or ownership units of the company from the seller, you are not only acquiring its assets, but also any and every obligation and liability of the company. This includes readily identifiable obligations and liabilities, such as the company’s bank debt and trade payables, as well as every potential or even concealed liability arising out of the seller’s prior operation of the business, such as income or sales tax deficiencies (or even tax fraud), potential product liability, warranty, environmental, and employment claims, and others. While a well-written stock/unit purchase agreement might give the buyer the right to file suit if the seller fails to disclose existing or potential claims, and the buyer might also have rights against the seller under applicable federal and state securities laws, those rights may be little comfort to the buyer after he realizes that he may be required to spend several years and tens or hundreds of thousands of dollars in litigation to obtain a judgment against the seller – a judgment that might not even be collectible. Because of the hidden liabilities that exist when a buyer acquires ownership of the company itself, buyers overwhelmingly prefer to acquire only the assets of a company.
- Buying the assets of the company. In connection with an asset purchase, the asset purchase agreement will generally include a clear statement that the buyer is NOT assuming any liabilities of the seller, with the exception of liabilities that are expressly assumed by the buyer under the terms of the agreement. As a result (with certain exceptions discussed below), a buyer of assets has the option to pick and choose what debts and liabilities of the company he wants to assume, if any. For example, it is common for a buyer to assume the seller’s liability for current trade payables and current payroll obligations (so as not to disrupt relationships with the company’s vendors and employees), as well as any leases for the seller’s equipment and facilities – all of which are items that should be readily identifiable and quantifiable at the time of the acquisition. However, it would be extremely unusual for a buyer to agree to assume the seller’s tax liabilities, or any potential product liability, warranty, environmental, or employment-related claims, or to assume any other claims or liabilities that are not specifically identifiable and quantifiable.
2. Do your due diligence. Imagine that two weeks after your closing you were to discover that the assets you bought were subject to lien by your seller’s lender, or that a court case involving your seller had been decided a month ago in which the court had ruled that the seller’s principal product violated a competitor’s patent, or that the biggest customer of the business had notified your seller a month earlier that the customer was placing its final order and would be taking its business to a competitor. To prevent those sorts of costly surprises, your goal in a business acquisition should be to learn as much as is reasonably possible about the business, its assets and its liabilities before concluding the sale. That process is typically referred to as “due diligence” and has two primary components:
- Undertaking a comprehensive lien/judgment search. As most experienced business people know, the holder of a lien has the right to seize the property that is subject to the lien (real estate, equipment, accounts receivable, intellectual property rights, bank accounts, etc.) to satisfy the debt that the lien secures. Liens can be granted voluntarily by the owner of the property (such as a mortgage lien), or imposed involuntarily by law, such as a tax lien or a judgment lien. If a buyer purchases property that is subject to a lien, the lien stays on the property irrespective of the transfer. Moreover, in the case of a voluntary lien, it is almost always the case that the document creating the lien (a mortgage in the case of real estate, or a security agreement in the case of most other types of property) will state that any sale of the property by the seller is itself a “default” that allows the lienholder to seize the property. Although the law requires a public notice to be filed for nearly every type of lien, the problem is that different types of liens are filed in completely different government offices, and a court judgment may only appear in the records of court where the judgment was rendered (which could be anywhere in the country). As a result, identifying the liens and judgments to which a business is subject can be a very complicated task requiring the services of a professional lien search company.
- Undertaking a detailed review/inspection of the company’s records and operations, with supporting warranties and representations in the purchase agreement. Most law firms who represent business clients have developed a standard “due diligence checklist” that is used to assist clients with business acquisitions. These checklists detail the information and documents that the seller should be requested to provide regarding every facet of its business, including copies of the seller’s tax returns and financial statements for at least the last five years; copies of all contracts relevant to the operation of the business (such as leases, customer contracts, software and other intellectual property licenses, vendor contracts and employment agreements); a roster of employees together with wage rates, copies of commission programs, bonus programs and the seller’s employee handbook; a description and copies of all pension, health and other employee benefit plans and programs; customer lists and sales records and forecasts; vendor lists and records; equipment lists and depreciation schedules; an inventory listing; a listing and copies of all licenses and permits; a description and documentation regarding any past, existing, threatened or potential claims and litigation involving the company, and much more. The buyer’s legal counsel and accounting firm typically assist the buyer in reviewing and evaluating the information provided by the seller from the due diligence process. Additionally, a well-written stock/unit purchase agreement will then include “warranties and representations” by the seller, in which the seller assures the buyer that all of the information and documents provided to the buyer are accurate and complete – such that the seller would potentially be liable for “fraud” (including a possible award of punitive damages) if false or misleading has been provided to the buyer.
3. Watch out for liens and liabilities created by law as a result of the sale! Although a buyer is not generally responsible for the seller’s liabilities (except as to any liabilities that the buyer expressly agrees to assume), various state or federal statutes can create: (i) liens that automatically arise by reason of the seller’s cessation of business; and (ii) liabilities that are automatically imposed on the buyer. As a result, it is imperative that the potential imposition of these automatic liens and liabilities be identified before the purchase of the seller’s assets is consummated, so that the buyer can decide whether to proceed with the transaction, or to perhaps negotiate an adjustment in the purchase price. These statutory liens and liabilities include the following –
- COBRA. Employers who employ 20 or more employees and provide a health insurance program are required to give employees (and their covered dependents) the option to remain on that health plan for a period following the employee’s termination of employment or after certain other circumstances where coverage would otherwise be lost. Under the Internal Revenue Code, a buyer who “continues the business operations associated with the assets purchased from the [seller] without interruption or substantial change” is required to allow anyone who has elected COBRA continuation coverage under the seller’s plan to continue that coverage under the buyer’s plan, if the seller discontinues its plan (which generally happens after a company’s assets are sold).
- Retirement Plan Liabilities. The Pension Benefit Guaranty Corporation (“PBGC”) is the federal agency that insures workers’ pension benefits under certain types of pension plans. If a company sells its assets and ceases business without fully funding any pension plan insured by the PBGC, a lien on the seller’s assets will be automatically imposed under federal law in favor of the PBGC. Additionally, a company that employs union employees and contributes to a national or regional union pension plan on behalf of its union employees may incur “withdrawal liability” if it sells its assets and ceases operating. This withdrawal liability represents the amount of the accrued pension liabilities attributable to the company’s former employees, and can be hundreds of thousands of dollars. The federal courts have held that in appropriate circumstances, where there has been a continuity in the operations before and after an asset sale, the buyer can be held liable for the seller’s withdrawal liability.
- Unemployment insurance. Indiana law provides that a buyer who acquires substantially all of the assets of another company becomes liable for any deficiencies in the seller’s historical unemployment insurance payments. In addition, the buyer becomes subject to a higher unemployment tax rate until the seller’s deficiency is eliminated.
- Wage-Hour laws. The federal courts have held that in certain cases where there has been a continuity of operations before and after an asset sale, the buyer can be held liable for the seller’s violations of the federal minimum wage and overtime laws (the “Fair Labor Standards Act”).
- Bulk Sales law. In any case where: (i) the seller’s principal business involves the sale of inventory from stock, (ii) the buyer proposes to purchase of more than half the seller’s inventory, and (iii) the seller will not continue to operate the same business after the sale, the sale may be subject to Indiana’s “bulk sales” rules. These rules require, among other things, that certain notices be provided to potential creditors of the seller. If the buyer fails to comply with these rules, then the buyer becomes liable for the seller’s financial obligations to the seller’s creditors.
- General successorship principles. A court can impose “successor liability” on the buyer of a company’s assets, and hold the buyer responsible for any or all of the seller’s liabilities, where sale occurs under fraudulent or other suspicious circumstances. For example, courts have imposed successor liability on a buyer where the owners and management of the buyer were substantially the same as the owners and management of the seller. In addition, if the buyer is owned by one or more persons affiliated with the seller and the asset sale is made at a bargain price, the court may consider the transaction to be fraudulent.
4. Additional protections. Depending upon the size and complexity of the transaction, it is actually not uncommon for a buyer to have to satisfy one or more seller liabilities, whether as a result of an oversight or as a result of outright fraud on the part of the seller. Therefore, a well-crafted asset purchase agreement should include two protections for the buyer:
- A “hold-back”. One of the best protections a buyer can have to absorb the financial expense of a seller liability is to insist on holding back a portion of the purchase price. This hold-back is generally reflected in a promissory note payable to the seller after a period of at least one year. Both the promissory note and the purchase agreement would then contain language expressly stating that in the event that the buyer is called upon to pay any seller liability not expressly assumed by the buyer, the buyer will have the right to deduct the amount of that payment from the amount payable under the note. In effect, this promissory note becomes the buyer’s “insurance policy” against liability for the seller’s obligations.
- Comprehensive indemnification provisions backed by both the seller and its owners. A purchase agreement should contain indemnification provisions, describing in detail the seller’s obligation to indemnify and hold the buyer harmless with respect to any claims against the buyer (including the buyer’s attorneys’ fees) arising out of any seller liabilities that were not expressly assumed by the buyer. In addition, is important to make certain that the seller’s owners, are: (i) specifically identified as parties to the agreement in their individual capacities and sign the agreement in their individual capacities; (ii) specifically join in the representations and warranties being made by the seller; and (iii) specifically obligated, along with the seller, to fulfill the indemnity obligations under the purchase agreement. Why is this important? Consider what will happen as a result of and immediately following the closing. At the closing, the seller will convey all of its assets to the buyer for the purchase price, such that immediately after the closing the seller will have no assets other than the cash paid by the buyer. Then, either at or immediately after the closing, the seller will use the sale proceeds to pay off whatever obligations the buyer did not assume, and will immediately distribute the balance to the seller’s owners. That means that if the buyer subsequently has an indemnity claim, and the only one obligated by the indemnity provisions of the purchase agreement is the company that was the seller, the buyer will be presenting its indemnity claim to a company with no cash or other assets! The moral of the story is to follow the money: since the owners will end up with the money, they should be parties to the purchase agreement and be legally obligated under its indemnity provisions.
The process of buying a company is complicated and fraught with many risks. A cautious buyer will make wise use of competent legal and accounting professionals to assist with that process, and to help identify and minimize those risks.
Author John L. Egloff
John Egloff serves as trusted legal counsel for scores of local, regional and national businesses, providing a full range of legal services with respect to their operational and transactional needs. John’s more than 30 years of experience as a business attorney includes the formation, acquisition, sale and merger of business entities large and small, and the negotiation, drafting and/or review of virtually every type of business agreement and business-related documentation, including real estate and equipment leases and purchase agreements; financing documents (loan agreements, notes and mortgages); private placement memoranda; employment agreements (including non-competition agreements); licensing and franchise agreements; dealership and distributorship agreements; and routine customer and vendor documents (such as purchase order forms and warranty documentation).
John has served as the Firm’s managing partner and has continued to serve on the Firm’s Management Committee.
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Posted on Jul. 18 2018, by John L. Egloff