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Five Steps of Buying a Small Business in New York

Buying a small business in New York usually follows five distinct phases.

  1. Finding a Business
  2. Negotiating the Terms of the Deal
  3. Due Diligence
  4. Documenting the Deal
  5. Closing of the Deal

Let’s work through the process and how your attorney can help you make this a success.

Step One: Finding a Business

You can find businesses to buy in New York in many places: on the internet, through business brokers, or your own networking efforts. Lawyers are usually not involved in this process unless they act as a broker or they happen to know someone who wants to sell a business. While it can be easy to find a business for sale, it is not easy to find out whether the business is a worthwhile acquisition and just the right business for you. Once you have identified a potential target, you will start a period of investigation of the business to determine the worthiness of the business and the appropriate terms of the purchase. Investigation of the business (known as “due diligence”) and negotiation of the business terms are intertwined, so the next two steps do not occur strictly one after the other.

Step Two: Negotiating the Terms of the Deal

Once you have found a business that seems like a worthwhile acquisition (a “target”), you are ready to negotiate the terms of the transaction.  But what are the typical terms of a small business purchase?  What is there to consider? In other words, what are you in for?

Enter:  the “term sheet,” also known as a “letter of intent” or “memorandum of understanding.”

A term sheet sets forth in writing the basic terms of the deal before the drafting and negotiating of the sales agreement begins. After parties have done a lot of talking and investigation of the business, they will usually come to a basic understanding of how the business is going to be sold.  To have everybody on the same page, they often execute a term sheet.  By looking at a typical term sheet, you will understand the terms of a small business purchase.

The term sheet is rarely longer than a page or two and should expressly state that it is non-binding on both parties. In other words, the terms could later change without either party being in breach of any agreement, and you and the seller could even walk away from the transaction altogether. Nonetheless, term sheets have some weight in the further negotiation of the transaction. It will be harder to convince the seller to deviate from points already set forth in a term sheet. An attorney may or may not be involved in the drafting of the term sheet. More experienced business people usually hash this out for themselves and bring in their attorneys after the term sheet has been prepared.

In addition to getting everybody on the same page, a finalized term sheet:

  •   shows the seller that you are serious about the business purchase.  While you could still walk away from the deal, you are now committed to bringing the purchase to completion and will stop looking at other potential targets;
  •   prevents future negotiation roadblocks about major points at a time when the parties have already spent a lot of time and money on the transaction;
  •   serves as a roadmap for the attorney drafting the sales agreement and saves you money by not having to explain everything to the attorney.

While there is no limit to the terms that you could put into a term sheet, the following items are the usual suspects:

  1.   Names and Contact Information for all involved parties, such as a seller, buyer, attorneys, business brokers, and accountants
  2.   Purchase Price
  3.   Payment Terms

Do you have to pay the purchase price in one lump sum or several installments?  If you have to pay in installments (also known as “seller financing”), what amount of interest is the seller charging you?  What is the amount of the down payment, and when is it payable?

  1.   Security for the Purchase Price

If the seller is financing your purchase by letting you pay the purchase price in installments, he or she will not be content with your promise alone.  Not that the seller doesn’t trust you, but things can and do happen to the best businesses out there.  Thus, sellers usually take a “security interest” in some of the business property you are buying or some other valuable property you own.  If they hold a security interest in the business assets and you do not pay your installments, they can then repossess those assets and get what is owed to them.

  1.   Structure of the Deal: Asset Sale or Stock Sale

If the business target is a limited liability company (LLC) or corporation, you have basically two options in structuring the purchase. You can do an asset sale or a stock sale.

Let’s step back for a moment to understand.  A corporation is considered a legal entity separate from the owners of such entity, who are called shareholders (the same is basically true for an LLC, but to keep it simple, I’ll limit this explanation to corporations).  That means that the corporation owns all of the assets of the business, not Joe Seller, the shareholder.  It follows from this that you could take over the target by buying all of the assets of the corporation from the corporation or by buying all of Joe Seller’s shares in the corporation.

What is the difference for you, the buyer?

Liabilities

In a stock sale, you buy the entity with all of its debts and liabilities—obviously, a perilous undertaking, which requires a lot of probing into the business’ history and records.

In an asset sale, you buy only the assets of the corporation. The debts and liabilities stay with the corporate shell after all of the assets have been transferred to you. While there are some exceptions to this rule, when you buy all or substantially all of the assets of a business in New York, the chances are low that you will be held responsible for the debts and obligations of the business incurred before the transfer of the business to you.

Tax Consequences

In an asset sale, you, as the buyer, have the chance to deduct the entire purchase price you paid for the business assets from your tax bill.  You may be able to deduct some immediately and some over the course of several years.  Your attorney may talk about a “stepped-up basis” in the business assets.

In a stock sale, your ability to deduct the purchase price for the corporation’s stock is basically non-existent.

Technicalities of Transfer

In an asset sale, you have to be concerned about transferring each individual asset you are buying.  The transfer of equipment may be different in requirements and concerns from transferring the lease for the business space.

In a stock sale, all that has to be transferred are the stock certificates which evidence ownership of the corporation.

 Flexibility

In an asset sale, you have the ability to pick and choose the assets you want.

In a stock sale, you automatically acquire with the entity all of the assets that are owned by the entity. So, for example, if the seller wants to keep a certain item of equipment, the corporation must first transfer the equipment to the shareholder before transferring all of the shares to you.

What’s the bottom line for a buyer?

You might have guessed it: an asset sale does sound more advantageous for the buyer.  While this is generally true, be aware that sellers favor stock sales for a variety of reasons.  In the end, everything has a price, and you might adjust the purchase price to reflect and compensate for the disadvantages of a stock sale.

  1.   Assets Included in the Purchase

Unless you are structuring your purchase as a stock sale, you must be very specific about which assets of the business you are buying. However, in the term-sheet phase, the parties usually limit the description to “all of the assets of XYZ business,” or “or all of the assets of XYZ business, except for ________.”

  1.   Covenant not to Compete

In most cases, the past success of the business you are buying had to do with the owner, who was heavily involved in the day-to-day management of the business.  As if it weren’t difficult enough to convince your customers that the business will be the same or better under “new management,” what you really want to avoid is that the old owner opens a new shop right down the block and siphons off his old customers.  The way to prevent this dilemma is to obligate the seller not to compete with you for a certain amount of time in a specific radius around your business.  This “covenants not to compete” is legal under New York law, so long as it is reasonable.

  1.   Confidentiality

Some sellers don’t want the public to know that they are about to sell or have many trade secrets and other confidential information that they don’t want to be disclosed to you without being sure that they are not going to leak beyond this transaction.  Since the term sheet is non-binding, they might even want to enter into a separate confidentiality agreement or make only this part of the term sheet binding.

  1.   Procedure and Timeline

Parties usually try to agree on a time frame for the conclusion of the transaction, if only to keep everybody on track.  This section may also have a list of items that still need to be investigated by the buyer.

  1.   Non-binding Nature of the Term Sheet

Even though the term sheet is in writing, you do not want it to be a binding agreement.  There are situations where you might have to walk away from the deal or where circumstances change dramatically, and terms need to be adjusted. Thus, make sure that any kind of term sheet contains language similar to this: “this term sheet does not constitute an offer or commitment on the part of the buyer or the seller.  All of the terms herein are subject to the completion of due diligence and the execution of a sales agreement.”

  1.   Obligations of Seller and/or Buyer after the Sale

Should the seller have ongoing obligations?  Since the seller probably used to be the main force behind the business you are buying, it might be a good idea to keep his services for some time while learning the ropes of the new business.  Then again, you might have seen enough of the business while investigating it before closing to make this unnecessary.

Step Three: Due Diligence

Due diligence is the process of investigating the business inside and out when buying a small business in New York. You want to know that the price you are paying for the business is fair and that there are no hidden secrets about the business that could haunt you after you become its owner. You also need to make sure that the transfer of the business does not interfere with any third party’s contractual rights or that it is made impossible by another agreement. For example, if you buy a business that leases its business space, and you would like to buy the lease, you had better make sure that the lease allows for a transfer to the buyer of the business.

Due diligence is the process of investigating the business you are planning to buy inside and out;  lots of files to look at, numbers to crunch, and agreements to review.

Here is a list of the most common issues for investigation when doing due diligence for a small business purchase:

Due Diligence Checklist

1.  Tax Returns

Federal, state, and local tax returns for anywhere from 2 to 5 years past; if the business is subject to sales and use tax, sales and use tax returns for several years.  Know this:  In New York, if you are buying substantially all of the assets of a business, you can be made liable for any sales tax outstanding from the seller.

2.  Financial Statements

Detailed financial statements (income statements, balance sheets) for 3 to 5 years past;

Don’t expect to be presented with “audited” financial statements. “Audited” financial statements are a company’s financial statements that have been prepared and certified by a certified public accountant.  Smaller businesses rarely have audited financial statements since they are expensive and are not legally required.

Get your accountant to help you with interpreting the tax returns and financial statements.  He or she should check whether there are any questionable accounting practices. You may want to ask the seller for approval to request the tax returns directly from the IRS, state, and local tax authorities.  That alone will prevent the seller from cheating on you.

The seller may ask you to enter into a confidentiality agreement with respect to the disclosures in due diligence.

3.  Agreements

Lease;  Typical issued to be investigated: Can the lease be transferred?  Do you need the consent of the landlord?  Are the terms of the lease (remaining term, rent) favorable to the buyer?

Supplier contracts, licenses, sales agreements, distributor agreements, non-compete agreements;

Insurance contracts;

Equipment leases.

4. Corporate Documents (or LLC Documents)

Corporation:  Certificate of Incorporation, by-laws, minutes of shareholder and director meetings;

LLC: Articles of Organization, operating agreement, minutes of membership meetings;

If you are buying the entity rather than the assets of the business, you need to check whether the entity is in good standing, i.e., has filed all necessary reports and paid applicable taxes.  In New York, you can order a good standing certificate from the Department of State, Division of Corporations.

5. Licenses and Permits

What licenses and permits does the business require?  If you are buying the assets of the business rather than the entity, check whether licenses and permits that are being transferred are assignable.  For example, liquor licenses are not transferable per se, the new operator of the restaurant has to fulfill all requirements for a liquor license and apply for a new license.

6. Asset List

When you are buying the assets of the business, you want to be sure of what is included in the asset transfer.  In an entity sale, you similarly want to know what assets there are and what potential liabilities are transferred with them.

Assets may include:

Equipment
Inventory
Intellectual Property
Accounts Receivables
Real Property

7. UCC Liens

Check with the Department of State whether there are liens on any of the seller’s assets being transferred.  Liens are preferential rights of creditors in the assets.

8. Tax Liens

If the seller hasn’t paid taxes, the IRS may have tax liens on the seller’s property.  Check if there are any tax liens in the business’ name.

9. Pending or threatened lawsuits

Look for any past or pending lawsuits.  Also, the seller should let you know if anybody has threatened to bring a lawsuit and make a corresponding representation in the sales agreement.

10. Dun & Bradstreet Report for the business

Check the business’ credit report at Dun & Bradstreet.

11. Violations, Customer Problems

You should find out about violations or customer complaints that have been brought against the business.

12. Employees

List of employees with salary, benefits, other relevant information;

Closing Remarks:

Remember that due diligence varies according to the type of business you are buying and the structure you choose for the deal. If you are buying the entity in a stock or membership interest sale, you will step into the shoes of the business.  This requires a lot of investigation into the business and its obligations.  If you are only buying the assets of the business, due diligence is somewhat more limited.  For example, if you are only buying the rights to the lease from the seller, there is no need to look at the other agreements of the business.  Similarly, in an asset sale, you are less concerned about the legal status of the entity.

Your attorney’s role in due diligence:

Your attorney is there to help you overcome roadblocks to the transactions that surface in the course of due diligence. For example, if you find that there are liens on the business’s assets, your attorney could incorporate a provision into the sales agreement that requires the seller to pay off such liens on or before the closing of the transaction.  Similarly, if one or more of the agreements to be transferred require consent from a third party, your attorney should make the transaction conditioned upon receiving such consent.

Step Four: Documenting the Deal

An attorney will draft and/or review many agreements and documents that are instrumental in transferring the business to you and buying a small business in New York. The most important document in a business sale is the “purchase agreement” (also known as the “sales agreement” or “acquisition agreement”).  Often, the seller’s attorney will prepare the first draft of this document. Unfortunately, that doesn’t always mean that your attorney has less work to do. If the seller’s attorney is inexperienced or just plain unreasonable, the review of a bad or one-sided agreement might take more time than preparing it in the first place. The draft and review of the sales agreement may also involve a fair amount of negotiating over the specific terms of such an agreement. The attorneys will also prepare a “closing checklist,” which is a list of all of the documents and agreements that need to be drafted and executed and of all actions that need to occur on or before the closing of the sale.

The purchase of a small business requires many legal agreements and documents to effect the transaction.  Obviously, you need an experienced attorney to draft and/or review all of these documents and explain their significance to you.

While you were the one to negotiate and reach an agreement on the business terms with the seller, it is your attorney’s job to document such a deal. In addition, he or she should advise you of legal issues and devise agreement provisions that protect you from any problems that may have surfaced during the due diligence and negotiation processes.

I am sure that you have heard the notion that attorneys can be deal-breakers. While attorneys have to be cautious and warn you of pitfalls in the transaction – which is why you might perceive them as deal-breakers – they should not advise you on the purely business issues of the transaction. A good attorney advises you about potential risks and gives you strategies to minimize those risks but allows you to go forward with the transaction if that is your informed decision.

What are the documents likely to be encountered in a typical small business asset purchase?

Usually, there will be a sales agreement, documents relating to the financing of the purchase price, documents relating to the transfer of the assets, and corporate documents authorizing the transaction.

Sales Agreement

The sales agreement (also known as the acquisition agreement or purchase agreement) is the most important document in the transaction. The sales agreement sets forth all of the major terms and conditions of the transaction and is often executed by the parties days or even weeks before the closing.

The sales agreement usually has provisions dealing with:

  1.   The assets being sold

If you are not buying all of the business’s assets, an attachment to the agreement should specifically list all assets included in the purchase.

  1.   The purchase price and terms of payment

An often-overlooked term is the “allocation of the purchase price.” The allocation of the purchase price to the different types of assets has consequences for your and the seller’s future tax bills.

  1.   The liabilities assumed by the buyer

In an asset sale, liabilities are generally not transferred unless the buyer specifically assumes them. In New York, however, be aware that in a purchase of all of the assets of a business, the buyer can be made liable for unpaid sales tax due from the seller.  (For more information, see New York State Tax publication 20 on page 33).

  1.   The representations made by the buyer and the seller

The seller should stand behind all promises made and facts represented in the course of the negotiation by expressly representing such promises and facts in the sales agreement. If it turns out later that the seller made misrepresentations, you may be entitled to damages.

  1.   The covenant not to compete

The seller should agree not to compete with you and your new business after the purchase has gone through.

  1.   Contingencies

For example, if you need the landlord’s consent to buy the lease of the business, the agreement should be made contingent upon the receipt of such consent. In other words, if the seller fails to obtain consent, you can walk away from the deal.

  1.   Indemnification

The seller should indemnify you for all claims resulting from the operation of the business before closing and for any breach under the sales agreement, such as a breach of the representations made in the sales agreement.

Documents Relating to the Financing of the Purchase Price

If the seller finances the purchase price for you by allowing you to pay in installments, he or she will most likely require the following documents:

  1. Promissory Note

The promissory note sets forth the purchase price owed, the dates for the remaining payments, interest on any outstanding payments, and any other terms of payment you agreed with the seller. The promissory note makes it easier for the seller to collect from you if you default on payment.

  1. Security Agreement

The seller may ask for a security interest in the assets being sold to you. By doing so, the seller may foreclose on the business assets in case you default on payment. The security agreement creates the security interest and sets forth the terms applying to such security interest.

  1. Guaranty

If the buyer is a corporation or a limited liability company, the seller may personally ask you to guarantee the purchase price.

  1. UCC Statements

While the security agreement creates the security interest in the business assets in favor of the seller, the seller will want to ensure that such a security interest is also properly recorded (“perfected”) by filing the necessary documents with the appropriate New York filing office.  A proper recording protects the seller from other creditors who may claim rights in the business assets.

Documents Relating to the Transfer of the Assets

  1. Bill of Sale

The bill of sale transfers ownership of all of the tangible assets of the business from the seller to the buyer. Tangible assets are furniture, supplies, inventory, equipment, and the like.

  1. Contract Assignments

If the assets you are buying include contracts, licenses, and permits, these documents will assign all of the rights and obligations of such contracts, licenses, and permits from the seller to the buyer. Be careful, though, to ensure that all licenses and permits are freely assignable to you. The Assignability of licenses and permits must be investigated in each case and is highly dependent on local laws and regulations. Similarly, contracts may contain provisions requiring the consent of any non-selling party to the contract or prohibit their assignment altogether.

  1. Documents Transferring Trade Names, Intellectual Property, Phone Numbers, and Other Intangible Property

If the assets you are buying include intangible property such as trade names, trademarks, copyrights, and so forth, there will be documentation transferring ownership of such property to you.

Corporate Documents

If the buyer and or the seller are official “entities” (i.e., a limited liability company or a corporation), both parties have to execute the appropriate corporate consents to the transaction. This could be in the form of a shareholders’ consent, directors’ consent, or members’ consent. In addition, you will want to see the corporate authorities of the person executing all legal documents on behalf of the seller.

Step Five: The Closing

The closing consummates the transaction and concludes the process of buying a small business in New York. The parties and their attorneys get together to exchange money and property and take care of all remaining paperwork. Some closings are uneventful. Others can include last-minute negotiation of agreement terms, waivers of representations, temper tantrums, and so forth.

Usually, the sales agreement sets forth when and where the closing is to occur; often, this happens at the seller’s attorney’s office.

In addition to the purchase price, there may be a final adjustment of operating expenses, in which the seller is reimbursed for certain expenses that ultimately benefit the buyer. For example, the seller may have paid a certain bill for the entire month at the beginning of the month, while the buyer begins reaping the payment benefits upon closing in the middle of the month.

When executing agreements and documents, it is best to ask for duplicate sets of originals so that you and the seller each have an original set of documents.

The best closings are uneventful, thanks to good preparation and the cooperation of all parties. At times, however, there may be some negotiations about last-minute changes to the documents, or there may be waivers concerning certain closing conditions that could not be met, but the parties are willing to go ahead with the deal anyway.

Your attorney must be fully aware of all aspects of the transaction because last-minute changes and adjustments to a business purchase require quick thinking, sound risk assessment, and good judgment. Similarly, you should be familiar with the transaction to make informed decisions about the business deal. While you should rely on your attorney, it is ultimately your deal and your business at stake.

Your Attorney’s Role in buying a small business in New York

A good attorney in a business acquisition acts as a project manager, intermediary, and –last, but not least – a legal expert. As a project manager, he or she oversees the deal, orchestrates and manages the players, moves the transaction along, and brings it to a successful close. As an intermediary, he or she keeps conflicts away from the buyer-seller relationship by negotiating directly with the seller’s attorney. Finally, as a legal expert, he or she drafts or reviews the necessary legal documents, knows about the relevant legal aspects of your business purchase, advises you on the legal consequences of changing facts and circumstances, and devises strategies to circumvent legal roadblocks.

If you are buying a small business in New York, contact us today to be your legal counsel 212 253-1027

We are lawyers for buying or purchasing a small business in New York!