Buying A Business: Do Your Due Diligence

In the previous post, What to Think About When Buying a Business, among the topics raised was the importance of doing due diligence.  In this post, I drill down on several key areas that should be the focus of the due diligence review:  (1) financial, (2) legal, (3) product/services, (4) customers/clients and (5) employees.

1.  Financial Review

Obviously, when buying a business you need to review the financial books and records of the company, and you will likely have an accountant to assist you.  However, as an entrepreneur, you should understand what are the major financial aspects that need to be examined.

   (a) Revenues.  Certainly it is important to look at the revenues of the business, but also you need to understand what is the source of those revenues and how stable are those sources.  Thus, consider:
      
         (i) Are the revenues primarily from one/only a few customers or accounts?
         (ii) Are the revenues growing, stagnant or worse yet, shrinking?
         (iii) How are the revenues derived?
         (iv) Were there extraordinary events that negatively/positively affected revenues?

  (b) Expenses.

       (i) Is the overhead high and can anything be done to lower it without negatively affecting business?
       (ii) What are the costs of the goods or services sold?
       (iii)  Is the business burdened by expensive debt service/interest liability?
       (iv) What are the sources of the expenses and are they in line with revenues?

   (c)  Assets.  Consider, what does the company really own?

      (i) Does the business own any assets, and what are they?
      (ii) Asked a different way, are you sure the business owns the key assets and not one of founders or a third party?
      (iii) Are the key assets licensed, and if so how long is the license, and how stable is the licensor?
      (iv) Who owns the intellectual property?
      (v) Who owns the domain names?

   (d) Liabilities:  What are the long and short term liabilities?

   (e) Taxes:  What is the structure of the company and is it structured in a tax efficient manner?


2.  Legal Due Diligence.  Below are just some of the legal issues to consider.

  (a) Is the ownership of the assets properly documented?
  (b) If there are licenses, are they properly documented?
  (c) What type of entity owns the business?
  (d) Are the formation/governing documents of the business entity properly drafted and do they include an provisions a buyer should be concerned about; have all minutes/resolutions been reviewed?
  (e) Does the company have all the necessary permits and licenses?
  (f)  Has the company met all compliance obligations, including with respect to corporate matters?
  (g) Does the company own the intellectual property it needs to operate the business, and what is the status of any applications or registrations?
  (h) Are the assets encumbered in any manner?
  (i) Are there any claims, lawsuits, proceedings, defaults pending or judgments/awards outstanding?
  (j) What contracts/licenses/undertakings has the company entered into and do you understand them?
  (k) Are the important contracts/licenses/customers assignable?
  (l) Are there any environmental or other regulatory issues particular to the business?
  (m) Did the company grant any rights, options, warrants or the like to third parties?
  (n)  Has the company made any warranties and what are the obligations thereunder and does it hold any rights under any warranties?
  (o) Are the the website policies properly drafted?
 

3. Products and Services.  This may seem a ridiculously obvious point, but before buying a business make sure you understand the products or services being offered by the company.  A business may seem attractive from the outside looking in, but drill down and become an expert as to that business before deciding to become financially responsible for it.  One way to address any lack of expertise is to requires the prior owners to help your transition the business to the new owners.

4. Customers/Accounts. 

  (a) Are the customers/clients transferable either by contract or otherwise?
  (b) Are there privacy issues that may create issues as to transferring customers/accounts or data about them, including credit card information.
  (c) Who has the relationship with the customers?  For example, if the old owner(s) leave the business, will the customers stay or leave as well?
  (d)  Non-compete/Non-solicitation.  Try to obtain a non-compete from the sellers of the business.

5.  Employees. 

  (a)  Review any employment/consulting agreements and understand the obligations thereunder.
  (b)  Make sure all employees/consultants have signed confidentiality agreements and invention assignment agreements.
  (c)  Are there collective bargaining agreements or particular issues failing under Labor Laws?
  (d)  Is there an employee option plan?
  (e)  Are you sure the key employees will stay with the company if sold?

The above is by no means an exhaustive list of due diligence issues and, without a doubt, there are many others that should be included.  However, what the list demonstrates is the importance of conducting proper due diligence when buying a business.  The more you understand the business, the better you are able to not only determine if you should proceed with the transaction but address any concerns in negotiating the purchase price as well as draft the purchase agreements. 

When you buy a used car, you look under the hood and may even have it inspected by a mechanic. When you buy a house, you walk through it many times and usually get a home inspector to do a thorough inspection.  So, if you are considering the purchase of a business, don't overlook the importance of obtaining experienced counsel to assist you with the due diligence because it is not what you know, but what you don't know that can create material business issues down the road.      

Disclaimer:  Nothing herein constitutes legal advice, and is for discussion purposes only.
  

Ten Legal Mistakes Made by Start-Ups: Bringing in a Partner Without a Proper Agreement (#8)

Often start-ups are so excited about bringing in a partner who can offer financing, desperately needed services, or play an advisory role/provide professional advice that the start-up brushes aside the need for a proper agreement detailing the rights and obligations of the new partner.

Myth #8:  "This is a start-up and we should be happy to have this new partner so let's not worry scare the partner off by demanding a formal agreement."  

If you are involved with a start-up you certainly understand the pressure to attract partners who can offer financing, professional services, or even play an advisory role.   All too often, however, this anxious desire to attract such a partner will lead founders to opt to put aside the need to document the rights and obligations of the partner; it may be because of the desire to avoid additional legal costs or simply feeling that asking the potential partner to sign an agreement will scare the partner off.  So instead the founder decides to have a simple handshake and issue the new partner shares or membership interests representing a percentage in the business.  In no uncertain terms, this is a serious mistake for a number of reasons, including the following:

    1.  If this is an LLC, do you have an Operating Agreement?  If this is a corporation, do you have detailed by laws/shareholder agreement?  If this is a partnership, do you have a partnership agreement?  If the answer is no, then the new partner has financial and voting interests based on the interests granted in the entity; and any rights and obligations are otherwise governed by the relative state LLC, Corporate or Partnership law.  Do you know what the governing law says as far as the financial and management rights of members (LLC)/shareholders (corporation)/partners (partnership)?  If not, you may be very surprised later if a dispute arises, at which point it will be too late. 

  2.  What if the new partner fails to do what was promised, dies or becomes disabled?  You could have avoided this issue by having the interests vest over time (see http://mybizlawyer.blogspot.com/2011/10/ten-legal-mistakes-made-by-start-ups_28.html) and/or giving the entity and other partners a buyout right (see http://mybizlawyer.blogspot.com/2011/10/shareholder-agreements-define-buyout.html).  If you do not attend to this issue, you could be stuck with a non-performing partner and perhaps hanging your hopes on the expensive and time consuming process of proving an oral agreement in court.

  3.  The partner decides to sell or transfer its interests to a third party you don't know or don't like (or both).  Can the partner do this?  It depends what the governing law says, but if you had a clear statement of the rights of the partners and a right of first refusal there would be no issue.

  4.  The new partner just signed a contract binding the entity, one which you would not have approved.  In New York, an LLC is deemed to be member-managed unless the Operating Agreement states otherwise, and a s a result each member has the authority to bind the entity.  Solution, an Operating Agreement setting forth that the entity is manger-managed, naming the manager, and thereby removing the authority the new member to bind the entity.  (See http://mybizlawyer.blogspot.com/2011/09/management-of-llc-member-or-manager.html).  Also, LLC and Corporations (but not SCorps) are very flexible structures allowing for the creation of different classes of partners, and therefore you can create a class that has only financial rights and no management/voting rights.

  5.  You just learned the new partner is starting a competing business or offering services to a competitor and is also trying to solicit your employees, customers, and business partners.  If the partner is using trade secrets you still can take seek legal recourse, but again proving the claim is costly and regardless does not address some of the other concerns, like solicitation of your employees.  While enforcing a non-competition agreement can be challenging and requires careful consideration before drafting, you should include confidentiality and non-solicitation provisions in the operating agreement/shareholder agreement/partnership agreement.

  6.  The partner developed services, an application or created products that include certain intellectual property rights and now claims ownership of those products/services or of the underlying intellectual property.  In fact, the partner is filing patent claims and then plans on licensing the rights to third parties.  You could have avoided any issue with an  invention agreement agreement assigning the rights to the inventions and intellectual property to the business.  (See  http://mybizlawyer.blogspot.com/2011/10/ten-legal-mistakes-made-by-start-ups_24.html).                      

  7.  You have a dispute with the new partner, who files a groundless lawsuit in Buffalo, and the other members and the business are located in Long Island.  You realize the added burden of litigating a dispute in a court hundreds of miles from where the business is based, and while the your  lawyer explains there may be grounds for a motion arguing Buffalo is not a convenient forum for the dispute, the motion will create additional litigation costs.  You could have avoided this issue with a venue clause stating all disputes are to be filed in Nassau County, for example.  It also may have been beneficial to include a provision awarding attorney fees to the prevailing party, giving the partner pause before filing baseless claims.  

While the above is in some ways a recap of prior issues that have been discussed in this blog, the take away here should be that even a start-up has a right to demand a new partner sign an agreement clearly delineating the rights and obligations of the members of the entity.  If the new partner refuses or wants you to believe a handshake is enough, you should be very suspicious.  There is simply no substitute for a well-drafted agreement to avoid the myriad legal issues that can arise between business partners. 

Disclaimer:  The above is for discussion purposes only and does not constitute legal advice nor create any attorney-client relationship.  There is no substitute for legal advice from an experienced business/corporate lawyer.