• Introduction
  
• Demand Full and Complete Disclosure
  
• Investigate Employee Matters
  
• Investigate Potential Tax Liability
  
• Review All Existing Contracts
  
• Review the Account Receivable and Payable
  
• Set Parameters For New Orders For Future Business
  
• Three Ways The Buyer Can Protect Against a Seller's Default on an Obligated Payment
  
• Conclusion
  

Return to Articles and Legal Updates

Introduction

When purchasing a business, the buyer often acquires several types of assets, including: real estate, personal property, and the ongoing business itself. A buyer can protect himself against claims concerning the real estate by purchasing title insurance. However, title insurance will not protect the buyer against claims arising from the operation of the seller's business on the property before the sale. This article discusses seven (7) types of seller liabilities that should concern a buyer when negotiating the purchase of a business, and suggests how the buyer might limit his or her exposure in a Purchase and Sale Agreement, or similar agreement between the parties.

1. Demand Full and Complete Disclosure

A buyer should insist that the seller disclose all liabilities concerning the operation of the seller's business. This should be done even if the buyer does not intend to assume the seller's liabilities. The Purchase and Sale Agreement between the buyer and seller should also contain representations and warranties by the seller regarding:

(1) contracts which affect the property, such as: equipment leases, maintenance contracts and similar agreements;

(2) taxes relating to the operation of the property, including: income taxes, payroll taxes, sales taxes, and real property taxes;

(3) employee wages and other benefits;

(4) amounts owed to suppliers; and

(5) existing obligations to both present and past customers.

Disclosure is the first step towards obtaining an accurate picture of what the seller owes and what the buyer might be responsible for upon purchase.

2. Investigate Employee Matters

The seller should provide the buyer with a list of employees, including job title, social security number, wages, salaries, bonuses, vacation, sick pay and any other benefits payable to the employee at the time the Purchase and Sale Agreement is signed, and at the time of closing. The seller should also be made responsible for all of the accrued wages, salaries, bonuses and benefits that relate to the period before closing.

The buyer should also investigate whether there is a union or collective bargaining agreement in effect with respect to any of the seller's employees, and if not whether there have been any past attempts or efforts to organize any of the employees into a union. The union status of a business is critical to establishing a budget for future expenses which the buyer will weigh when determining the value of the seller's business. A collective bargaining agreement may be binding upon a buyer, even if it has been negotiated by the seller. If there is a collective bargaining agreement in place, it should be carefully reviewed.

3. Investigate Potential Tax Liability

Obviously, the buyer does not want to assume any of the seller's tax liabilities. However, it is often difficult to determine what those liabilities are, particularly where the seller has been paying taxes on an estimated basis or has not yet filed an applicable tax return. At a minimum, the buyer should obtain the seller's representation and warranty that no lien exists, and no lien can be asserted against, the real estate being purchased by the buyer due to the seller's failure to file any tax return or report or pay any federal, state or local taxes. In addition, the buyer should demand that the Purchase and Sale Agreement contain a provision obligating the seller to pay any taxes which relate to the seller`s prior ownership of the assets, but are not assessed until after the closing. Many states and municipalities issue lien certificates, or other documents, from which the buyer can verify a seller's tax liability.

The buyer should also be particularly wary of the types of taxes that run with the land or business being acquired, as these may become the buyer's obligation, by law, if unpaid by the seller. Many states have "bulk sales" laws, which must be complied with when a buyer is purchasing all, or substantially all, of the seller's assets. Failure to comply with the bulk sales laws may lead to the buyer being liable for any liability owed by the seller. A lawyer can be particularly valuable in this setting, as compliance with such "bulk sales" laws falls on the buyer, not the seller.

4. Review All Existing Contracts

The importance of reviewing existing contracts cannot be overemphasized. Many businesses routinely enter into contracts for almost everything, including: (1) furniture and phone rentals; (2) equipment leases; (3) telephone book, and other advertising; (4) maintenance; (5) additional office, storage and warehousing space; (6) , etc.... A prospective buyer should analyze every contract to determine whether they are acceptable.

If the buyer finds a contract acceptable and wants to assume the contract, then the buyer should review the pertinent contract to ensure it can be assigned to the buyer without the vendor's approval. If the vendor's prior approval is required for a valid assignment of the contract, the Purchase and Sale Agreement should obligate the seller to obtain that prior written approval prior to closing.

If the buyer does not want to assume the contract, the buyer should determine whether the contract can be terminated early by the seller. If the contract in question is for a specific term and cannot be terminated early, the buyer should negotiate this point in the Purchase and Sale Agreement. The buyer may require the seller to either buy out the contract, or simply agree to remain responsible for the payments required by the contract (even if the buyer does not want to assume the benefits of the contract).

5. Review The Account Receivable and Payable

Assume the seller is leasing equipment for the business, but is several months behind in his rental payments at the time of closing. Further assume that the Purchase and Sale Agreement states that the buyer is not responsible for the seller's liabilities arising before the date the buyer acquires the business. Is the buyer adequately protected? Well, Yes and No!

From a legal standpoint, the buyer may not have any legal obligation to the equipment lessor after closing. But, from a practical standpoint, the buyer may be left in a difficult position. If the buyer is unaware of the amounts owed on the equipment lease by the seller before closing, the buyer may receive a call from the lessor after closing, saying that he will confiscate the equipment unless the buyer pays the amounts owed by the seller. This leaves the buyer in the precarious position of either having to pay the seller's charges, or risk business interruption if the lessor retrieves its equipment before the buyer can replace it.

To avoid this situation, a buyer should thoroughly audit the seller's books and records before closing, and try to force the seller to provide evidence that all obligations have been paid in full. The buyer should request this, even if the buyer is not going to assume any of the seller's obligations that arose before closing.

6. Require Minimum Requirements on Acceptance of New Orders

If the business being acquired has future orders or works-in-progress, there are probably orders booked for which the seller has previously received a deposit. Some of these orders may have to be filled or completed by the buyer after closing. Before entering the Purchase and Sale Agreement, the buyer should therefore try to obtain a complete list of future orders and works-in-progress, which should be updated periodically and at closing.

In addition, since the buyer will most likely be obligated to honor the seller's prior commitments, the buyer should be certain that the future orders and work-in-progress is profitable. If possible, the Purchase and Sale Agreement should: (1) require the seller to assign to the buyer all deposits received for works-in-progress and future orders not fulfilled at closing; (2) set minimum requirements on the seller's acceptance of new orders, and (3) require the seller get the buyer's prior consent before accepting new orders that deviate from those requirements.

7. Three Ways The Buyer Can Protect Himself Against a Seller's Default on an Obligated Payment

Although a buyer can obligate a seller to pay for the liabilities incurred by the seller during the seller's ownership of the business assets, what happens if the seller simply does not pay? What can the buyer do to protect himself?

First, the Purchase and Sale Agreement can require the establishment of an escrow to last for a certain period of time after closing to pay for all known and any unknown liabilities of the seller that may arise after closing.

Second, the Purchase and Sale Agreement can contain a clause obligating the seller to indemnify, defend and hold the buyer harmless from and against the seller's liabilities. This indemnity clause will allow the buyer to recover his or her losses from the seller in the event the buyer pays the seller's liabilities.

Third, the buyer can attempt to obtain a guaranty from a financially responsible party of the seller's continuing obligation to pay his liabilities. In many instances, the seller will be comprised of one or two "single purpose entity(ies)," whose only assets are the real estate and business being sold. Once the assets are sold, the seller will likely cease doing business, liquidate the proceeds from the sale, and dissolve any entity that once held the business assets sold. In this situation the seller entities would no longer exist and it would be very difficult for the buyer to obtain compensation from the selling entities if the buyer were to pay the seller's liabilities after closing. However, the individuals who own the selling entity(ies), or another financially responsible entity controlled by these individuals, can provide the the buyer with a guaranty that they will remain responsible for the seller's liabilities. This would provide the buyer with the added protection of knowing that a party with real assets will be available to compensate him or her for losses if the seller defaults on an obligated payment.

Conclusion

When buying a business, examine the past performance of the seller's business and the seller's assets from both an income and expense standpoint. Examine the current status of the seller's liabilities and how you are going to deal with them. Demand full disclosure by the seller and demand that the seller accept personal financial responsibility. If you do, the risks assumed upon acquisition of the property, business assets, and ongoing business will be minimized.

Back to Top

Return to Articles and Legal Updates