Thomas Tusser is attributed with the astute observation — A fool and his money are soon parted. This holds true not only when you are trying to impress your 6 year old at the midway games at the fair, but also when buying a business. From my view as an attorney there are a number of basic legal issues that should be considered early in the process of buying a business and I’ll review two of these this month with more to follow:
1. Buy assets and leave the liabilities alone.
One important threshold decision is how to structure the legal form of the transaction. The two basic options are to acquire the assets of the business or to acquire the entity that owns the assets such as a corporation. As a buyer it will most often be preferable to buy the assets and not the entity. Buying the entity means buying the assets and liabilities of the business including unknown liabilities. Imagine a few weeks after closing, you get a call from an attorney representing a customer that slipped and fell on the icy stairs a few months before you bought the business; if you bought the entity you bought that law suit along with it. However if you only acquire the assets you can limit your exposure to the business liabilities and even if you agree to assume some liabilities you can establish a specific list so you understand your exposure.
In addition to liability protection, an asset purchase will give you, as buyer, a better income tax result. When you purchase assets you will establish a new tax basis for the assets which will allow you to depreciate the assets in the future for tax deduction purposes. On the other hand, if you purchase an entity the assets may already have been depreciated by the entity and your purchase will not allow you a basis increase, so you will not have the same tax depreciation opportunity.
Fair warning — an asset purchase can be a little more complicated than an entity purchase, because the assets and business relationships must be transitioned over to the buyer. For example, if there are numerous assets with ownership title (such as a fleet of cars); each title will need to be transferred to the buyer. If the buyer desires to continue existing customer and supplier relationships, the buyer will need to enter into new contracts for this purpose.
2. Don’t pay everything up front.
As a buyer, one big concern you have is how to recover against the seller if you have any claims arise after closing. Usually the seller is asked to make certain representations about the business and assets and if those representations are later found to be wrong (or even worse…lies) then you will have a claim against the seller for any loss incurred as a result. Also, even where you have limited liability exposure through an asset purchase, you can still be entangled in litigation associated with the seller which requires you to incur the costs of a defense attorney. If you have already paid the seller in full, you may have a hard time recovering especially if the seller is relaxing on some Caribbean island far from your concerns. By requiring that some portion of the purchase price be held in escrow for a reasonable period (sometimes a year or more), you will have a ready source to collect your claims against the seller. You can also reserve this leverage if the seller is willing to take a promissory note for part of the purchase price; however be sure you reserve the right to offset your claims against your note payments.
Next time we’ll look at a few other ways to avoid the “fool” rule.