Task List

For When a Client Wants to Buy a Business

The authors in this article share a checklist developed and provided to firm clients contemplating buying a business.

The following are key steps involved when a client wants to buy a business. Buyers and their advisors can use this list as a timeline and road map of the steps that are expected to occur, and what they should plan on doing. A companion posting for clients that want to sell a business can be found at: https://quickreadbuzz.com/2020/06/17/business-valuation-ed-mendlowitz-task-list/

• The buyer needs to make sure the seller wants to sell. The seller saying it, does not make it so. Many prospective sellers start the process but do not have the commitment to sell or desire to leave the business. Without that commitment, the deal will not close and then all the efforts and cost would have been for naught. We have found that the commitment is evidenced by the submission of requested data. Everything might not be provided initially, but the minimum is the financial statements or tax returns. People do not give these out unless they are serious.
• Ask the seller for assurances that his or her spouse or partner(s) are on board with what they will be doing, i.e. selling the business and paving the way for a “retirement.” Here also, added assurances equate to a serious seller. It does not mean the seller will go through with the sale, but it indicates that he or she might and that is the reason for proceeding.
• The seller needs to be made aware that they will have to provide complete financial, tax, compliance, and procedure information about their business.
• Seller also needs to understand that they will be required to spend considerable time on the entire process, and this might interfere with operating the business.
• The process starts with the seller providing the prospective buyer with a fact sheet with some basic information about the company; in effect that is the admission “ticket” that starts the process.
• If the buyer is interested, and before signing anything or proceeding, they should engage a transaction-based attorney to assist them in the purchase.
• The seller would be requesting that a confidentially or non-disclosure agreement (NDA) be signed by the prospective buyer. This can be before or after the fact sheet is provided. Included in this agreement should be definitions and descriptions of what constitutes confidential information and what sensitive areas might require special access or arrangements.
• It has been our experience that keeping these negotiations confidential is best for all parties. Concerns and questions from others, including customers, suppliers, or key personnel, can be stressful in the pricing, timing, and negotiations of the deal.
• The buyer needs to engage a strong accountant with experience in M&A transactions and who is comfortable in the industry that the business is based.
• The buyer should possibly engage (based on transaction size and circumstances) a M&A advisor, investment banker, business broker, and a valuation specialist who would provide an indication of the business’ value and to help the client decide on a fair price to pay, a negotiating posture, and the amount they should not go above.
• If the buyer engages an investment banker or business broker, the contract should contain provisions that commissions or performance fees would not be payable if the transaction does not close for any reason. Usually, this is somewhat offset by upfront retainers that are paid.
• Based on the fact sheet, the buyer would present a letter indicating an interest in acquiring the company with broad parameters, but with no details, of a purchase transaction. This should be sufficient so that the buyer would know there could be a deal they could agree to. We have seen some of these letters of interest that were so-off base that the seller felt it would be useless to proceed. Ed once received such a letter at a meeting on behalf of a client that wanted to sell his business and he just stood up and left the meeting without any reply or remark other than “good-bye and don’t call me.”
• If the preliminary letter of interest indicates that there could be a final meeting of the minds, the buyer would present the seller with an entire shopping list or document request of information that is needed so that a formal offer could be made.
• This is the start of the serious negotiation process. Actually, the negotiation process started when the buyer and seller agreed to meet. Everything from that moment forward became part of the negotiation. Responsiveness, hesitancy, indecision, holding back essential information, a comment about the warehouse cleanliness, who picks up the lunch check, whether the employees smoke, inventory that appears to not be in order, answering a phone call during a discussion, or delaying the next meeting all send messages and become something that is factored in during the negotiation. Ed once used an opposing principal’s stop at an ATM to withdraw what Ed thought was a very small amount to make a much lower first offer that was eventually the basis for the agreement. That ATM withdrawal benefitted his client by many hundreds of thousands of dollars. Everything counts in a negotiation.
• As early in the process as possible, the buyer needs to know how and when they will need financing, the source and terms, and have a reasonable idea of how the deal can be structured. Most sellers start out by asking for all cash, but most deals end up with some deferred payment terms. The buyer should have their accountant run some models so they could have a plan of how they would proceed.
• In many transactions, the terms can be as important or more important than the actual transaction price, so the buyer should consider the cash flow for paying for the acquired business.
• After the information is received, the buyer would then prepare a letter of intent (LOI). This is a pretty formal document and would give the price and terms, based on representations the seller made. These representations would come from the financial statements, schedules, tax returns, and whatever other information was provided to the buyer. At that point, everything presented is assumed to be accurate and reflective of the financial condition and operations of the company. It is suggested that the buyer do not try to verify any of the information but wait until the due diligence process. The more knowledgeable the buyer becomes at this time, the less wiggle room they will have to change their offer when they find out the reality during the due diligence process.
• Before making the offer, the buyer must consider the projected earnings, cash flow, balance sheet, and bank loan covenants for any financing they will be getting. It is our experience that the owners of most acquisitions will not be able to meet all of the financial and ratio covenants until, at least, the second year. This must be integrated into the bank loan agreement and should either have delayed target dates or waivers for the initial operating period.
• The buyer could provide that their offer is subject to consummation by them of suitable financing arrangements (which are almost always subjective). Sellers do not like this, but typically would go along with this if they could be otherwise assured of the financial viability and strength of the proposed buyer. The buyer should be prepared to demonstrate this. Usually it is done by a letter from a bank that says the buyer has a substantial line of credit or creditworthiness to consummate a transaction of the size indicated in the LOI. Occasionally, the buyer would produce a personal financial statement or a brokerage statement indicating the size of their net worth or marketable assets in their name. Sometimes nothing is necessary because of the reputation of the buyer. We do not think that Warren Buffett would need to present a personal financial statement.
• A full recitation of the payment terms are usually not in the LOI, but enough to indicate if there will be deferred payments and the approximate period. More details arise later on, usually during the due diligence and contract writing process. When we represent the buyer, we try to make this as vague as possible. When we represent the seller, we want it as detailed as possible. Sellers usually go along with reasonable terms unless there is an overriding need for all cash.
• Typically, any seller financing is unsecured and subordinated to all other financing facilities.
• A suggestion of what a buyer could ask for would be the seller retaining notes for about 30% of the total price. The buyer puts up, as equity, about 30% to 40% of the purchase price and there is commercial financing of the balance. The buyer’s equity indicates “skin in the project.” Too little and they could have less equity than the seller (or the bank)—that is usually not acceptable.
• Once the LOI is signed by both parties, the buyer would need to start their due diligence process. This is where the claims made by the seller are verified or tested for validity, where undisclosed liabilities are looked for, or where weaknesses in the supply chain or with key customers or major products are discovered. The due diligence should start as soon as possible. The document request should be given early on to the seller and the seller should start organizing the information even before receiving the LOI.
• A good accountant will have a long list of elements to consider in the due diligence process, including financial, tax, compliance, and operational factors. These include the need for the buyer to review employment contracts, independent contractor and consulting arrangements, tax compliance filings, leases, licenses, trademarks and patents, vendor or customer contracts, warranties, insurance policies and claim history, regulatory issues, and myriad other items.
• If the financial statements contain inaccuracies or noncompliance, the price in the LOI will be nothing more than a starting point which would be reduced based on the buyer’s due diligence. If too many differences result, the buyer could withdraw his or her offer.
• The LOI will also state who is responsible to pay investment bankers, brokers, or anyone else involved in introducing and assisting the two parties.
• To be considered in the LOI is whether an earnest money deposit should be made by the buyer or the seller to be paid if either party seller backs out for reasons other than those involving the transaction. For example, if the seller simply decides at the last minute that they do not want to sell.
• The LOI will also include the length of the due diligence period and conditions as to access to records and any assets to be reviewed and if suppliers, customers or key personnel will be interviewed. In today’s digital environment, much of the due diligence can be done virtually, but depending on the business, site visits can be important.
• Whether it is a stock or asset purchase transaction is always an important issue. The difference between an asset and stock sale could result in added taxes for the seller or reduced tax deductions for the buyer, and would determine the treatment of intangible assets and allocation of the purchase price. The buyer and seller would need to agree on the purchase price allocation.
• For a stock sale, the buyer must consider any potential or contingent liabilities, such as product warranties, and return, discount or advertising agreements or conventions, or long-term understandings with customers. There would be descriptions of what would be excluded and a guarantee by the seller of the capital or working capital amount at the closing.
• For an asset sale, the buyer would require a more detailed description of the assets and liabilities and what would be excluded from the transaction.
• Occasionally, the character of the business would dictate the necessity of one method over another. For example, non-transferrable leases, long term contracts with customers or suppliers, or the nature of the customers such as a governmental agency required to agree to any change in organizational structure. Many of these reasons are legal issues that are best handled by the attorneys for both sides. The seller’s attorney should be familiar with these issues and not wait for the buyer to bring them up.
• Also, to be considered in the offer is whether there will be compensation or consulting agreements with the seller, what health insurance and fringes would be continued, and whether there would be an earnout of a portion of the purchase price. Comment: An earn out is a contingent payment for the business based on attaining certain predetermined targets.
• Soon after the LOI is signed, either the seller’s attorney or buyer’s attorney would start preparing the contract of sale. While this is being done, issues will need to be addressed. As buyer, you might want the seller to remain in the business, or have some of the purchase price conditional on meeting certain benchmarks such as final working capital amount, inventory valuation, key employee, customer and supplier retention, severance pay costs, and possible regulatory approval. Some of these should have been covered in the LOI but they also can develop as the attorney draws up the contract or underlying issues are revealed during the due diligence process.
• Businesses are sold without any debt, other than typical accounts payable, accrued expenses, payroll taxes, customer deposits, and possibly warranty reserves. If there is any bank debt, the seller would have to pay this in full at the closing. Usually this payment comes out of their proceeds.
• The buyer needs to determine during due diligence if any employees will be let go, the timing, and who will be responsible for severance payments.
• The LOI would also define post-closing arrangements, calculations, and events and time limits for this, and who covers the costs.
• The contract drafting will cause a new round of negotiations—not as serious as the previous negotiations, but the price or cash flow could be affected by the results of this. If there is an earn out or deferred payments or some ownership that is retained, that will be covered more thoroughly in the contract, and this is usually negotiated as part of the final purchase price.
• The contract will contain arrangements for the amount that will be held in escrow, who the escrow agent will be, the costs of this, and how payments would be released and paid out.
• The contract will include covenants not to compete, details of notes payable by the buyer, and lease assignments or if the premises are owned by the seller, then a new lease to the buyer.
• The LOI should refer to pending litigation against the seller, so this information would need to be provided beforehand. Occasionally, companies do not want to disclose this information before they know that the buyer is seriously interested.
• Buyer along with the seller will have to decide which of the personnel, if any, they will inform about what is going on, or if they will want to not disclose the transaction to anyone.
• When the buyer commences the due diligence process, seller will need a “team” to assist with this. The due diligence process should be as smooth as possible.
• There will always be some more negotiations and contract amendments, and seller should be aware of this.
• If there will be bank financing, the bank will want to perform its own due diligence. This is usually a good thing for the buyer since the bank’s team should be pretty adapt at assessing the underlying value of the assets that will serve as collateral.
• The contract could be signed before the due diligence starts, during the due diligence process, afterwards, or at the closing. This depends on the thoroughness of the letter of intent and dynamics and timing of the sale.
• When the closing takes place, the buyer will pay their money, usually a certified check, attorney’s escrow check or a wire to seller’s bank, and sign any notes for the deferred payment.
• There likely will be some post-closing adjustments that will need to be calculated and possibly negotiated.
• Usually the contract would call for indemnification of undisclosed liabilities in excess of a base amount.
• If the assets of the business were sold, rather than the corporate stock or ownership interests, the seller’s existing company usually would need to wind down and eventually be liquidated. This can take a few months or a few years, depending on the circumstances. This should usually not affect the buyer but may affect any personnel tied to both the new and old company.

Some deal facets that come up that may not be discussed or negotiated initially:

• Software licenses for every computer.
• Contracts or leases for or on any equipment.
• Contract for any services provided to the old company.
• Any long- or short-term arrangements or understandings with any customers.

Added issues for the buyer

• State tax compliance rules need to be followed. This includes bulk sale reporting, tax compliance certificates, and possibly filing a final return and a liquidation of the selling corporation.
• Final payroll reporting of the seller’s business and a transferring over of wage limitations and caps to the buyer’s new entity.
• Withholding tax if there is a purchase from a non-U.S. person or entity.

The above is a pretty thorough list of things the buyer would need to do or should consider. However, since every deal is different, there are always new issues that arise and need to be dealt with. These transactions take considerable time, involve many professionals and advisors, need special care, and usually do not have much margin for error. Lots of times, it is the details that sink a deal, not the big picture of deciding on a price and transferring ownership. Spending the time, being deliberate, and avoiding short cuts can lead to a successful closing. Use this as a guide when advising buyers of what they should be made aware of and the intricacies of the transactions before commencing, so they will understand what they can expect and what they are getting into.

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Edward Mendlowitz, CPA, PFS, ABV, CFF, is emeritus partner with WithumSmith+Brown, PC, in East Brunswick, New Jersey. He has over 40 years of public accounting experience, is a licensed Certified Public Accountant in the states of New Jersey and New York and is one of Accounting Today’s 100 Most Influential People. The author of 28 books, Mr. Mendlowitz has written hundreds of articles for business and professional journals and newsletters and presented over 350 CPE programs. He writes a twice a week blog at www.withum.com/partners-network-blog.

Mr. Mendlowitz can be contacted at (732) 743-4582 or by e-mail to emendlowitz@withum.com.

Louis Young, CVA with WithumSmith+Brown, PC, in East Brunswick, New Jersey. He has been engaged to perform valuations primarily of closely held companies and family limited partnerships. These valuations have been performed for estate and gift tax purposes as well as purchasing and selling businesses. Mr. Young has extensive experience in finance, with emphasis on the automotive industry. He has performed corporate financial planning, automotive factory financial statement analysis and departmental internal control analysis, been involved with mergers and consolidations and cash flow planning.

Mr. Young can be contacted at (732) 379-5218 or by e-mail to lyoung@withum.com.