Success and financial fulfillment are at your fingertips. Do not undermine your potential with an avoidable mishap at the starting line. In this legal report, our Colorado business lawyers outline 10 common mistakes made by buyers and offer suggestions on how to avoid making that mistake yourself as you start your own business buying adventure.
Letting the Seller Handle the Paperwork
When buying a business there are numerous documents, agreements, and contracts involved. That paperwork is the foundation of your new-to-you business. One of the cardinal sins of buying a business is to allow the seller to draft and control the content included in the paperwork.
The seller might seem reasonable and nice. But their ultimate goal from the transaction does not coincide with your goal as the buyer. Typically, the seller wants to sell the business for a good price and with the least amount of residual liability. As the buyer, you want the lowest possible price while only accepting the necessary liabilities.
As such, an important part of purchasing a business is to be as active as possible in the process. Draft documents whenever it is possible. When the seller drafts a document, scrutinize the document and negotiate all terms that do not further your interests. This diligence and active participation stops the seller from inserting terms or provisions that will ultimately undermine your success.
Remaining a passive participant in the construction and content of the paperwork in the negotiation of the sale can have detrimental effects on the buyer’s overall success in the business world. Even terms and provisions in the preliminary paperwork effect your position and ability to exit the sale if you decide to not continue the transaction. If you do proceed to purchase the business, the paperwork involved in the transaction lays the groundwork for your future. Do not let the seller control your future—participate in the paperwork!
Tips for Active Paperwork Participation
- Draft paperwork when possible
- Scrutinize paperwork drafted by the seller or a third party
- Remain vocal about interests and negotiate until those interests are adequately represented in the written paperwork
Inadequate or Harmful Paperwork
Paperwork plays an important role in the purchase and sale of a business. The contents of the paperwork memorialize the agreements between the buyer and the seller in written format. In the event of any problems or discrepancies, the written documents are infinitely more important than verbal understandings between the parties.
Another big mistake that buyers make is to draft inadequate paperwork or sign paperwork that contains harmful terms. Inadequate and harmful paperwork can have seriously dire effects on the overall transaction. The buyer could purchase something or take on a liability that they had no intention to purchase or take on. Or, the buyer could become legally obligated to the seller before officially making the decision to commit to the purchase.
Success in buying a business can depend on ensuring that all necessary terms are in each document. Many documents will have numerous parts and terms that need to be included so that your interests are adequately protected. For instance, an initial purchase agreement should include terms like: representations, warranties, price, payment terms, indemnifications, personal guarantees, etc. In addition, the agreement might need other terms like: non-compete provision, confidentiality provision, etc. Paperwork needs to be detailed and thorough in business transactions so that nothing is left to the assumption or discretion of the parties involved.
Additionally, the terms included in the paperwork can sometimes have unnecessarily harmful effects on a buyer. The seller or a third-party, like a broker, can sometimes slip in terms or words that will unnecessarily bind the buyer. As such, reading the paperwork for these tricky provisions can mean the difference between success or financial ruin.
Tips for Ensuring Adequate and Non-Harmful Paperwork
- Know the provisions and terms that need to be included in each document.
- Include any provisions and terms that you want included in the agreement.3
- Carefully read and interpret each provision in a document to ensure that your interests will not be harmed.
Signing a Unilateral Confidentiality Agreement
When buying a business, you will likely need to know a lot of information about the business before you decide that it is a transaction that you want to complete. However, a lot of the information that you will need to make this decision is probably not information that the seller wants to give out freely. As such, the seller might require you to sign a confidentiality agreement before giving you the information.
A confidentiality agreement is an agreement that prevents you from revealing information deemed confidential to anyone outside the transaction. This gives peace of mind to the seller when revealing confidential information because the agreement will keep you from disseminating that information to the public or the business’s competitors.
When signing a confidentiality agreement, good practice dictates that you know exactly what information the seller wants to keep confidential. This will ensure that you do not accidentally reveal information that did not seem confidential to you. Knowing exactly what the confidentiality agreement covers keeps you from facing a lawsuit.
However, the biggest mistake that buyers make when entering confidentiality agreements is to enter an agreement that only protects the confidential information of the seller. When a confidentiality agreement only protects one party, it is called a unilateral confidentiality agreement.
When purchasing a business, the buyer might also want to keep certain information confidential. For instance, the buyer might not want another business to know how much the buyer offered for a prospective business. Or, the buyer might not want to let people know that they are interested in purchasing a business in this area.
As such, it is important that when signing a confidentiality agreement, to make sure that it protects you, the buyer, as well. A confidentiality agreement that protects both the buyer and the seller is a bilateral confidentiality agreement. With a bilateral confidentiality agreement, both you and the seller can rest assured that any confidential information remains confidential.
For example, a seller might decide to not accept the offer of a prospective buyer. That buyer might then decide to go to purchase a competing business. The buyer probably does not want the competing business to know certain information, like how much the buyer offered to the first business prospect. In a unilateral confidentiality agreement, the seller can feel free to disseminate that information to the other business. With a bilateral confidentiality agreement, the buyer can stop the seller from revealing that information to any third parties.
Tips to Signing Confidentiality Agreements
- Understand obligations under the confidentiality agreement—i.e., what information does the seller want to keep confidential.
- Ensure that the confidentiality agreement is bilateral and will protect information that you want to keep confidential.3
- Negotiate any aspects in the agreement that do not favor your interests
Over Involved Broker
Often a broker will be involved in the purchase and sale of a business. A broker works as an intermediary between a buyer and a seller. The seller will often use a business broker to help find and secure a buyer for the business. The important fact to remember about business brokers is that they are typically paid a “success fee” when the business sells. Generally, this fee will consist of a specified percentage of the sale, e.g., 10% of the sale price. Sometimes, this can make the broker biased towards the speed of the transaction and the ultimate sale price of the business.
A mistake that a lot of buyers make is to allow the broker to become overinvolved in the process. Sometimes, brokers will attempt to insert themselves in agreements. For instance, brokers might insert themselves into a confidentiality agreement and force the buyer to become liable to pay the broker’s fees.
A broker might also try to stop direct communication between the buyer and the seller, forcing all communication to go through the broker. The buyer can then be liable to the broker if they communicate directly from the seller. The sale of a business should be a transaction between the buyer and the seller. There are many points where the buyer and the seller might need to communicate, and to force that communication to go through a person whose payment is contingent on the success of the transaction is unnecessary and can have negative effects for the buyer.
Overinvolved brokers can be avoided through carefully reading all documents. Ultimately, the transaction is between the buyer and the seller. The broker should not be included in any part of that transaction. Allowing the broker to become overinvolved in the process can create liability where the buyer does not want liability.
Tips to Avoid the Over Involved Broker
- Ensure that you are able to maintain open communication with the seller.
- Read all documents and agreements carefully.
- Keep the agreement between you and the seller.
When deciding whether or not to purchase a prospective business, the buyer will need a lot of additional information. In accordance, the seller will prepare documents and disclosures for the buyer to supply them with necessary information. Based on the information received, the buyer will either decide to purchase the prospective business or to not purchase it. An ideal situation for the buyer would be to not face any liability for deciding not to buy the business after receiving the necessary information to decide to buy the business.
Unfortunately, a buyer can sometimes do, say, or act in a way that will create an obligation between the buyer and the seller, forcing the buyer to face liability to the seller for pulling out of the transaction. The seller will argue that they spent time and energy to create the documents and disclosure under the belief that the buyer was going to purchase the business. The seller will attempt to force the buyer to pay for the time and cost of the preparation of those documents.
As such, it is important when learning about the business to ensure that you do not become obligated to the seller until you are ready. Avoid any language in agreements or communications that could be construed as an offer or intent to commit to the purchase of the business. It is also a good idea to include language in agreements like “no offer for sale” and “no financial obligation” until you are serious about you commitment to purchase the business and are ready to commit to that particular business.
However, obligation can occur even when non-committal language is in preliminary documents if the buyer acts or communicates an intention to be bound in subsequent communications. Thereby, it is also important to act and communicate as if you have no intention to be bound until you have committed to the purchase.
Tips for Avoiding Premature Obligation to Seller
- Avoid definitive phrases in negotiations and agreements
- In preliminary agreements & documents, ensure language is present indicating buyer’s intention not to be bound financially.
- Watch language in communications that could be construed as a commitment to the purchase.
Providing a Binding Letter of Intent
When a buyer is ready to enter into negotiations to purchase a business, they will often submit a letter of intent, or a similar document to the seller. A letter of intent is a document where the parties memorialize the initial part of their agreement. The document will outline key terms in the agreement: price terms, expected date of closing, liabilities to be assumed, closing date, and other contingencies.
However, buyers will sometimes make the mistake of entering a letter of intent that binds the buyer unnecessarily. A non-binding letter of intent will help ensure that the buyer does not get forced into buying the business or paying damages to the seller for not buying a business if the buyer decides that the opportunity is not one that the buyer wants to fully pursue.
A binding letter of intent can be extremely problematic if the buyer is not completely sure that they want to purchase the business. If the letter of intent binds the buyer, the seller can take the buyer to court and pursue damages against the buyer if the buyer backs out of the purchase.
Unfortunately brokers will often attempt to make the letter of intent binding on the buyer. As previously mentioned, a business broker is paid when the business sells. Thus, binding a buyer in the letter of intent guarantees the broker a fast pay day even though the buyer’s interests are compromised.
Tips for Letters of Intent
- Clearly describe what terms in the letter of intent are meant to be binding.2
- Specify what terms in the letter of intent are not to be considered binding.
- Ensure that no additional terms or liabilities are included in the final letter of intent.
Mistake # 7:
Failure to Obtain Exclusivity Agreement
One of the most frustrating things that can happen to a buyer is to enter into negotiations with a seller, submit a bid, and then have that seller turn around and use the bid against the buyer. Or, to have the buyer to do due diligence in an attempt to purchase a business and have the seller disregard the buyer’s efforts by accepting a competing bid.
As such, it is vital to ensure that the seller is dealing exclusively with you and not searching for or dealing with other buyers. Buyers can ensure this exclusivity with an exclusivity clause. The buyer can include this exclusivity clause in an agreement, like the letter of intent.
An exclusivity agreement will give you the peace of mind that the seller is negotiating only with you for a specified time. They will not be receiving and responding to other bids while you are trying to work out the details of the agreement. So, there will be no competing bids that you will have to counter. With an exclusivity agreement you will not have to worry about third party interference
Tips for Obtaining an Exclusivity Agreement
- In the Letter of Intent, or other preliminary document, get the seller to agree to an exclusivity agreement.
- Ensure the exclusivity agreement stops seller from working with any other potential buyers.
Failure to Secure Non-Compete Agreement
When buying a business, the buyer might assume that the seller no longer wants to participate in the industry. The idea of the seller staying out of the industry is generally an attractive idea for buyers After all, nothing would be worse than buying a business from the seller, only to end up competing with the seller before you are able to establish your own credibility and reputation in the community. This would give the seller an unnecessary advantage over you.
However, buyers should never make the assumption that once the seller leaves the industry that they will stay out of the industry. Rather, the buyer should ensure that the seller will not compete with them until the buyer has an opportunity to establish his or her own place in the community.
In Colorado, non-compete agreements are allowed when made pursuant to the purchase and sale of a business A non- compete agreement will restrict the seller from competing with the buyer. The non-compete agreement must still be reasonable in terms of the duration and geographic scope of the agreement. The agreement will be considered reasonable so long as it is no more restrictive than necessary to protect the buyer.
When creating a provision to restrict the seller’s ability to compete with the business you are buying, consider how long it will take for you to establish your own reputation in the community. Also, consider any confidential information that the seller knows about the business and determine how long it would take for that confidential information not to give the seller an unfair advantage over your new business competitively.
Tips for Non-Compete Agreements
- Get the agreement not to compete in writing.
- Make sure that the Non-Compete agreement is reasonable in terms of duration and geographic scope.
Unsure about Purchase Options when Making Offer
Another common problem buyers face is not knowing the ways they can purchase a business. Not understanding these options ultimately weakens the buyer’s negotiating position after the offer has been placed on the table. If a buyer primarily chooses an options that is more favorable for the seller, it would be hard to convince the seller to agree to an option more favorable to the buyer.
Some common options for purchasing a business include:
- Cash. In a cash transaction, the buyer provides all of the money upfront for the business. Sellers often like this option because it provides for an easy, quick transaction.
- Promissory Note. With a promissory note, the buyer promises to pay a certain amount over a particular time. Generally, sellers require security that the buyer will make do on the promise to pay. Typical forms of security include: guarantees, collection costs, and collateral.
- Contingent Consideration/Earnouts. A contingent consideration, also known as an “earnout” is a purchase option where the buyer needs to transfer more assets if certain contingencies are met. So, the buyer will pay a certain amount upfront; however, if the buyer does well and the business succeeds, they will have to pay an additional amount once they reach a certain predetermined success threshold. Earnouts, when drafted properly, can be very favorable to the buyer. An earnout will shift some of the risk back to the seller, who will only earn contingent consideration if the buyer meets certain financial goals.
- Earnout Promissory. Note With an earnout promissory note, the buyer promises to pay the seller, but the amount adjusts up or down based on the actual results of the business. Similar to contingent consideration, the risk is shifted back to the seller since the amount the buyer pays for the business is contingent on the buyer’s success with the business.
- Cashless Sale Buyer and seller swap stocks. These are not very popular transactions in small business purchases.
- Escrows are holdbacks that the seller does not get until a certain occurrence happens.
Understanding these options when making an offer can help the buyer to enter negotiations with a better position. Also, when making an offer, the buyer should insist on an offset if a promissory note, earnout, or earnout promissory note is used. The offset will allow the buyer to modify the amount owed if the agreement is breached.
Tips when Making an Offer
- Understand your options when making an offer so that you do not get stuck with an option that seriously disfavors your interests as a buyer.
- If applicable, insist on an offset in case the seller breaches the agreement.
Unsure How to Purchase a Business
Purchasing a business is not a straightforward, one-size-fits-all transaction. There are three main ways to purchase a business: asset purchase, mergers and equity purchase. Each way presents unique benefits and difficulties. The way you choose to buy a business will depend on a variety of factors: tax consequences, consents needed to sell business, the number of owners, regulatory law, etc.
Understanding the ways to purchase a business can help you in many ways. You can decide whether you want to purchase a business based on how you would have to purchase it. It allows you to learn more about the history and structure of the business you are purchasing based on how you need to buy the business.
Some common ways to purchase a business include:
- Asset Purchases. In an asset purchase, a buyer will buy all or part of the assets possessed by the seller. An asset purchase has favorable tax implications because it allows the buyer to receive a step-up in basis. This allows the buyer to depreciate the assets and the level of liability protection. This is generally a disfavored method if there are numerous consents required, or if those consents cannot be obtained. Additionally, regulatory law will consider the business “new” and the buyer cannot use the seller’s history.
- In a merger, the buyer and the seller will merge two companies together into one company. There are a variety of ways to accomplish the task of merging two companies. With a merger, there are no real tax implications. The benefit of a merger is that it can squeeze out a minority partner or holdout shareholders or owners. However, sellers will not always be interested in a merger because the business is not sold; rather, it still exists; it just exists in conjunction with another company.
- Equity Purchases. In an equity purchase, the seller sells its equity (shares, membership interest, etc.) to the buyer. In equity purchases, the company is not directly involved. The buyer from a tax prospective does not favor equity purchases. Additionally, the buyer becomes liable for all of the seller’s liabilities. However, equity purchases are fast and avoid obtaining consents for many contracts.
In conclusion, purchasing a business is an important step in an individual’s life toward personal and financial fulfillment. However, it is also a risky endeavor. If not done properly, the individual could face financial ruin. Fortunately, some of those risks can be eliminated by avoiding these 10 aforementioned mistakes.
Often, it is a good idea to be represented by legal counsel throughout the process. An attorney can help draft documents, negotiate your position, and ensure that your interests as the buyer are represented and served throughout the process. Contact us at 303-688-0944 for a consultation.