Buying a business via an asset sale means that you are not just buying THE Business as a concept; you are in fact buying all furniture, equipment, inventory, names, phone numbers, contracts, and everything else that makes the business operate. Your purchase agreement may state that you are buying “substantially all the assets of business XYZ.” Thus, there comes a time in your small business asset purchase when you need to look under the hood of the to-be-purchased business and all of its assets.
Why should you conduct Due Diligence?
You perform due diligence for a couple of reasons.
First, you want to find out what assets you are dealing with and whether the assets are really owned free and clear by the business owner, be it an individual, corporation, or LLC.
Second, you want to determine how to transfer each asset included in the sale.
Third, you want to look at the business’s financial and tax records to verify the purchase price.
Fourth, if you are dealing with an LLC or corporation as the owner of the business, you want to determine whether the entity is in good standing or if there are any issues with the entity’s equity owners, who have to consent to the sale. The results of due diligence may influence your transaction and how your asset purchase agreement is drafted to circumvent any issues found during due diligence.
Fifth, you want to look at the recent history of the business to determine if any facts could derail the future success of the business or anything that could expose you to liability long after the transaction closes.
1. What are the assets and are they free and clear of any liens or encumbrances?
What are all the assets in the first place? Understand that “assets” are not only furniture, inventory, and equipment. Assets are also contracts of the business with a third party, permits and licenses, leases, real estate, cash, bank accounts, social media accounts, domain names, customer lists, phone numbers, intellectual property, accounts payable, accounts receivables, and so forth. You should have a good understanding of what assets constitute the business and what assets make it run and generate revenue.
You want to be sure that all the assets are owned free and clear by the business owner, be it an individual or a corporate entity. Some of that you can find out via searches, for example, whether anybody filed any financing statements (UCC-1s) against the business. For other assets, you sort of have to rely on what the owner represents to you, but then you would make sure to also have a representation in the final purchase agreement.
2. How do you transfer the assets and do you need consent?
Some assets are easy to transfer. If it is furniture, for example, you just hand it over. But other assets require some legal thought. If contracts are part of the to-be-transferred assets, you want to make sure to read them to determine whether those contracts require consent by anyone before the contract can be assigned to the purchaser. Typically, a business lease for the premises of the business requires the consent of the landlord before the lease can be transferred to the purchaser. This has to be worked out before the transaction can close. Also, since a favorable business lease is often the major reason a business gets bought, you have to make consent by the landlord a condition of the closing of the transaction. If the landlord says no, there is no deal.
You want to look at all permits and licenses necessary to operate the business. Some permits and licenses may be transferable; others are not. A typical example is a liquor license. The new business owner will have to apply for a new liquor license.
If motor vehicles are part of the assets, you will have to follow the rules applying to the transfer of title to transfer those assets.
3. Financial and Tax Records
You will want to look at the business financial and tax records to evaluate if the purchase price negotiated makes sense and to find any irregularities that may suggest that the books are “cooked”. Run if someone tells you there is no need to look at the financials because you’re just buying the assets. Unless you are a seasoned business person with solid accounting knowledge, I always recommend getting an accountant to help you analyze the provided statements and records.
4. Corporate Records
You want to look at the corporate setup of the business. Even though you’re buying only the assets, irregularities in the corporate housekeeping of the business that is selling the assets could create problems later on. For example, there may be shareholders who are unlikely to agree to the sale or have other rights that interfere with the sale. You need the full picture.
5. Prior Issues that could affect the future success of the Business and expose you to Liabilities
You have to look at the history of the business with respect to its employees, prior or threatened lawsuits, and environmental concerns. Often you will have to rely on the honesty of the seller and ask for a binding representation, but if you don’t ask for these things in the first place, you may be surprised to find out problems later. Again, if someone says that you shouldn’t worry about all of this because you are “only” buying the assets, run away from this deal. Yes, in theory, buying the assets of a business does not automatically make you liable for other liabilities of the business. But there are important exceptions. One important exception is the so-called “successor liability” recognized by New York courts.
When you are buying all of the business’ assets and are running the business basically as before, using the same name, retaining the same employees, you can be found liable and having assumed the seller’s liabilities as a mere continuation of the prior business. For this reason, you want to make very sure that you know what you are buying.