Don’t Buy a Business Without Looking Under the Hood

Due Diligence
looking under the hood

Before you buy a business be sure you’ve done your due diligence. Even in the days of Carfax, you wouldn’t buy a used car without looking under the hood to make sure the car’s in good condition. You’d probably also take it to a mechanic to have it examined by an expert. If you’d do this for a car purchase, why would you making a life-changing investment without making sure the business you’re buying is in good condition?

If you’re smart, you won’t.

You’ve probably heard the phrase caveat emptor — “buyer beware.” It means that it’s the buyer’s responsibility — not the seller’s — to ferret out issues that could affect whether the buyer wants to go through with the deal. The onus is on the buyer to ask questions and challenge assumptions.

If the seller and the seller’s broker have done a good job of getting the business ready for sale, they will have put the best face possible on the business to make it look attractive to potential buyers. As a savvy potential buyer, it’s up to you to look more deeply into the business to make sure the beautiful sheen isn’t just a coat of whitewash on a shack.

Here are a few legal-related areas you’ll want to investigate:

Liens: you can’t sell what you don’t own

A basic principle of property law is that a seller can’t transfer more rights to property than it holds. Thus, a seller can’t sell property free of liens if the property is encumbered. If, for example, the seller has granted a blanket security interest in all of its assets to secure a loan from a bank, the security interest remains in place after the business is transferred to the buyer unless the bank releases its security interest. Of course, the bank won’t release its lien until it’s been paid in full.

As a buyer, you can protect yourself from unreleased liens. The first step is to identify liens that currently encumber the purchased assets by searching public records. The main areas of concern are liens granted as security for debt, judgment liens, and tax liens. Security interests in personal property can be found by searching the state records. Prudent creditors record their security interests in personal property by filing UCC financing statements with the state. The purpose of these records is to provide notice to purchasers of the property that the property is encumbered by a lien. Judgment liens and tax liens can be found by searching relevant state and county records.

Taxes: you will be responsible for the seller’s taxes

Unpaid state taxes are the seller’s problem because the seller retains all of its liabilities, right? Not so, according to state taxing authorities. In every state I’m aware of, there is a law that allows the state to assess the buyer of a business for unpaid taxes. This is true even in the case of an asset sale where the purchase agreement provides that the seller retains these liabilities. If you receive an assessment from the state for unpaid taxes relating to a business you buy via an asset purchase, you’ll probably have a breach of contract claim against the seller, but you’re better off making sure this isn’t an issue in the first place.

Contracts: is that key contract transferrable?

Does the business have key contracts that are so important that you wouldn’t buy the business if you couldn’t also have the contracts? If so, you should make sure the contracts will come with the business.

As I noted in Asset Sale Vs. Stock Sale: Pros and Cons, you’ll probably want to structure the business purchase as an asset sale. In an asset sale the contracts of the business you’re buying are transferred to you by assigning the contracts. However, a lot of contracts contain provisions that don’t permit the contracts to be assigned. This means that you won’t be able to enjoy the benefits of the contract after you buy the business unless you obtain the consent of the other party to the contract. You should make sure the seller obtains consents before you buy the business.

Corporate matters: who owns this business anyway?

If you’re buying a small camera shop, you can probably walk into the store and talk to the owner, right? Are you sure? Who really owns the business? If it’s a sole proprietorship, the owner running the shop probably is the person who actually owns the business. More likely, the owner operates the business through a corporation or limited liability company. If so, the company is the actual owner. Also, the owner’s spouse might also have an interest in the business.

Before you part with your cash to buy a business, you should make sure you know exactly who owns the business. If a corporation or LLC is the owner, who owns the company? Who has the right to authorize the sale of the business?

Real estate: don’t assume you can operate the business at its current location

Unless you’re buying the real estate, you shouldn’t assume that you’ll be able to operate a business at its current location after you buy the business. Similar to the issues relating to assigning important contracts, leases normally can’t be assigned without the landlord’s permission. So before you buy the business, you’ll want to either negotiate a new lease or make sure you have the landlord’s consent for you to take over the existing lease.

Environmental matters: what you don’t know can hurt you

If the real estate where your new business operates has environmental contamination, you can be in for a long, expensive cleanup operation. Thus, whether you’re buying the real estate or merely renting, you should make sure to investigate whether there are any environmental issues. This is an area where due diligence can really pay off.

You won’t necessarily be on the hook for the cleanup, however, if you follow the correct procedures. My Evans & Dixon colleague Gene Schmittgens has written a couple of posts detailing the legal requirements, How to Buy Property and Avoid the Cost of Cleanup (Maybe), and Part 2. If you’re leasing property that might be contaminated, you should read So By Renting I Am Insulated from Environmental Problems, Right?

I’m hopeful that I’ve given you some food for thought. Whether you’re a do-it-yourselfer or are engaging a professional to help you buy a business, don’t buy the business without looking under the hood.

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