Buying a business is an exciting but scary time. It’s a big investment but one with potential for big returns. You want to do things the right way but may not have the first clue of where to start.
Here’s the good news: you’ve probably already started. If you’re looking for help now, it’s because you’ve learned enough about the target business to believe acquiring it may be a good investment. Now is the time when investigating, negotiating, and documenting the deal with the help of a lawyer will protect you and your potential investment.
While the basic mechanics of buying a business in Washington State will be the same as in other states, there are some state-specific elements—notably, state tax issues—that should send you looking for a Washington business lawyer.
This post is meant to preview for you the component parts of an acquisition, primarily from the perspective of an interested buyer, so that you’ll be better equipped to work with your lawyer. It is not meant as a substitute for engaging a lawyer. There are some legal tasks where DIY is a viable option, but buying a business is not one of them.
It’s somewhat misleading to list due diligence first on this list. That’s because you’ll be doing due diligence—i.e., scrutinizing the health of the target business—at every stage of the transaction. Remember that until the purchase agreement is signed, everything is up for negotiation, and so even if you’re convinced you want to buy the business, finding blemishes can give you leverage to negotiate the purchase price down or gain concessions on other important terms.
With that said, if you’re reading this, chances are you’ve already begun your due diligence even if informally. You may have done a Google search for positive or negative headlines about the business. You may have gone to the Washington Secretary of State’s website to see if the business is in good standing. Maybe you’ve gone to the business if it’s consumer-facing just to see what it’s like to be in the space.
While these are valuable things to do, they’re just the tip of the iceberg. You’ll need to get access to the company’s detailed financial records to have any sense of what a fair purchase price would be, as well as determining whether you run the risk of inheriting tax liabilities. Depending on the type of business, it may be critical to confirm that the business has full rights to its intellectual property. You’ll also want to know if the business is (or is at risk of) facing any lawsuits. In certain highly-regulated industries you’ll want to know the company’s history of compliance.
Tip: Before you’ll be granted access to the company’s internal documents, you’ll almost certainly be asked to sign a non-disclosure agreement—that way if the deal falls through you won’t be able to use or disclose what you’ve learned about the business. In fact, if you’re not asked to sign an NDA, it should raise questions about the sophistication of the business you’re considering acquiring.
This is just a small sampling of the many things you’ll need to get access to and then—with the help of your lawyer and accountant—scrutinize thoroughly. You’ll want to work with your lawyer to come up with a comprehensive checklist of the items for which you’ll be conducting diligence.
Valuation can be tough. It’s probably the most subjective element of this process. But it can also be one of the most important. Typically you’ll rely on financial advisers to help establish a valuation, or at least a range of values, more so than on your lawyer. Given that, I won’t dwell on valuation here, but I will identify a few standard methods of valuing a business, which include:
- Discounted cash flow
- Asset value
- Comparisons to similar sales in the industry or similar companies
Keep in mind too that while establishing a valuation or at least a range of values is important, the price you’re willing to pay may differ—in some cases dramatically—from the valuation. That is, at the risk of stating the obvious, because the actual value of something in the marketplace is the price someone is willing to pay.
Letter Of Intent
The letter of intent (or “LOI”) is usually the first attempt by the prospective buyer and seller to outline the proposed deal in writing. It’s very important to remember that an LOI is generally non-binding, meaning that it’s not an enforceable contract. Instead it’s an informal way to ensure the parties understand the basic terms of the deal before they spend time and money negotiating, conducting additional diligence, and drafting the agreement.
Tip: An LOI may also be used to prevent the seller from shopping the deal to other buyers during pending negotiations using something known as a “no-shop” clause; note that a no-shop is typically a binding term of an LOI.
Please don’t mistake an LOI for a binding purchase agreement and go on a spending spree for the “new business” you’re sure will be yours. An LOI is a step in the right direction but much of the negotiation is still to come.
As far as what content you should expect to see in an LOI, it can vary considerably, but you should expect to see at least the following:
- The purchase price
- How the price will be paid (e.g., cash, promissory notes, stock, earn-outs)
- How the deal will be strutured (e.g., a stock or asset sale)
- Restrictive covenants on the seller (e.g., non-competition and non-solicitation agreements)
You may see several terms designated as “binding” in an LOI. These include things like “no-shop” provisions, which I mentioned above, and several others like confidentiality and non-solicitation provisions. You shouldn’t necessarily be alarmed to see these but it’s important to clarify with your attorney and with the other party which terms of the LOI are binding and which are not before signing.
Structuring The Deal: Asset vs. Stock
There are two basic ways to structure buying a business: you can purchase the assets of a business, or you can purchase its stock.
Note: Merger is a third type of structure but is used in more limited circumstances and so will be dealt with in a future blog entry.
Generally speaking buyers prefer the asset purchase structure, while sellers prefer the stock purchase structure. The main reason buyers often favor an asset purchase is that it allows the buyer to purchase the company’s desirable assets without necessarily having to assume undesirable liabilities.
Tip: Some buyers also assume that if they purchase assets they won’t be responsible for any of the seller’s tax liability; however, that is not always the case in Washington and buyers in an asset purchase deal should work with their attorney to protect themselves from unwittingly assuming the seller’s tax obligations. The Washington Department of Revenue has some additional information on this which curious readers can find here.
A stock purchase, on the other hand, doesn’t allow the buyer to pick and choose which parts of the business to buy. Instead, the buyer purchases the stock of the company from its shareholders, effectively acquiring the entire business.
There is one feature of the stock purchase structure that makes it appealing to both buyers and sellers—it’s almost always an easier deal to get done, meaning you’ll spend less time negotiating and less money on lawyers.
Note: If you’re purchasing an LLC, rather than a corporation, then the name of the agreement will be a “membership interest purchase agreement” rather than a stock purchase agreement, as the LLC equivalent of a corporation’s stock is a membership interest. The main difference here is in the terminology, rather than the structure itself.
It should be mentioned here before leaving this section that how you choose to structure an acquisition is often a complicated and fact-specific choice; the summary provided here is meant to introduce you to these concepts, not equip you to make the decision for yourself. Work through this with a lawyer and an accountant.
Most sellers want to be paid in cash at the time the deal closes. However there are a variety of other payment methods that may be considered in a given deal.
One common example of this is deferring part of the payment to some time after the closing. This often takes the form of a promissory note and effectively allows the buyer to pay some of the purchase price in installments over a period of time after the closing date. Conceptually this is like financing a vehicle or home or other big ticket item, and so the buyer will typically be required to pay interest on these deferred payments.
Another payment method (of sorts) is an earn-out provision, which is usually used in tandem with a cash payment. With an earn-out, the buyer will be obligated to pay a certain amount of the purchase price only if the purchased business hits certain performance objectives. Earn-outs are buyer-friendly, but sellers may agree to them as a way to increase the valuation of the deal. This is especially true if the seller’s business is relatively new and lacks a proven record of success. Earn-outs, if used, are heavily negotiated terms.
Finally, sometimes the buyer will pay the seller using the buyer’s own stock. If the buyer is a publicly traded company with a clear market for its stock to be sold, then this may be an attractive payment method to the seller; however, if the buyer is a closely held company its stock may be illiquid and therefore likely not an attractive form of payment to the seller.
The first draft of the purchase agreement, along with any ancillary documentation, is typically prepared by the buyer’s lawyer. This should be done reasonably promptly after the parties have signed an LOI, assuming that there’s been time to conduct adequate diligence.
Unlike the LOI, the purchase agreement, once signed, is binding on the parties. Given the magnitude of most business acquisitions, that means it’s critical that the purchase agreement be written to reflect the parties’ agreement as accurately and precisely as possible. As a buyer, you should expect to see a substantial portion of your lawyer’s fees incurred in drafting, negotiating, and revising the purchase agreement.
Several important terms in the purchase agreement to look out for and discuss with your attorney include the following:
- Purchase price
- Transaction structure
- Representations and warranties
Related: Common Contract Clauses: Indemnification
Unless there are “conditions precedent” to closing—i.e., things that need to be done before the deal can close—the actual closing process is often straightforward. It may be as simple as having the parties electronically sign the purchase agreement (and any related documents) and then wiring the purchase price to the seller.
In more complex acquisitions, the lawyers will often prepare a closing checklist to ensure all the necessary steps are taken to consummate the deal.
If you’re prepared to spend hundreds of thousands (or millions) of dollars to buy a business, don’t cut corners on investigating, negotiating, and documenting the deal. Work with a lawyer who you like, who takes the time understands your objectives, and who works diligently to accomplish those objectives.