The Top 5 Traps to Avoid When Buying a Business

The American dream of one day owning your own business and being your own boss is often considered.  After years of hard work and savings, you finally purchase your own business. Within 6 months of purchase, however, your business is closed, and to make matters worse, you have signed a personal guaranty on a long term lease and are considering filing for personal bankruptcy protection. Unfortunately, the attorneys at Goldman & Pease LLC have seen this happens all too often. We have, however, seen a recurring reasons for these business failures that we would like to share with you so that you can seriously consider these factors before the business purchase.

I.     KNOW THE “VALUE” OF THE BUSINESS YOU ARE BUYING

Know the “value” of the business you are buying. This seems quite obvious, but in our experience, overinflated asset values are the biggest reason for failure of a recently acquired business. For example, consider the acquisition of a real estate franchise. Certified financials, based upon the last twelve months of operations, show that the real estate franchise is generating average monthly gross revenue of $50,000.00 per month. Your accountant’s review of the financials reinforces the legitimacy of the financials. Based upon these financials, you agree to purchase the business. If you agree to purchase the business based solely upon past financials, you are falling into a trap that can lead to disaster.

The value in a real estate franchise is the “good will” and the reputation the franchise has developed in the community. Most importantly, the top notch real estate agents must remain a part of the acquired company. All too often, we see someone buy a business, such as a real estate franchise, and end up with the desks, the chairs, and the business cards, but the top sales producers leave the company. The value in any acquired business is the ability to make money in the future, based upon the future income stream, not the past income stream.

In our example, it is important to review who the top producers are that generate most of the revenues. What assurances do you have that those top sales producers are going to stay with the firm? Often times the “owner” is the top producer or the other top sales producers are planning to leave the company and start a business that is in competition with the acquired company.  Such a departure will remove valued clients from the acquired company.

Other businesses such as hair salons, accounting firms, or insurance agencies are also affected by flight of top producers after an acquisition.  In many such businesses, the top sales producers and their book of business is what has value, and the buyers do not adequately protect themselves from loss of such top producers.

II.     KNOW WHAT YOU ARE BUYING

Know what you are buying. This also seems quite evident, but in our experience the insufficient understanding and knowledge of the business being purchased is the second biggest reason for business failure. Business sellers obviously seek to maximize the purchase price. In doing so, sellers often report their financials in such a way that makes the business look desirable. For example, a business may show $1,000,000.00 worth of sales. When you look a little closer, however, you may find that a large percentage of those sales are uncollectable and/or are very old receivables which negatively impact future revenue production. Make sure you and/or your accountant really look at the financials and receivables to understand their impact of the company.  .

Make sure you know what is included in the purchase. Are you buying just the assets or are you also assuming the liabilities?  Are you going to owe existing employees long term accrued leave and, if so, is the purchase price adjusted to reflect this leave? How are contingent liabilities treated, such as potential lawsuits, product recalls or warranty claims?

Do not simply rely upon oral representations made by the seller. Obtain all material representations in writing as warranties in the purchase agreement can be enforced through the Seller’s written indemnity. Conduct extensive and thorough due diligence to confirm that the seller’s representations are accurate and complete.  Obtain appropriate professional advice about the representations made by the seller.

III.     UNDERSTAND THAT OPERATING A BUSINESS AND PRODUCING A PRODUCT AND/OR SERVICE ARE TWO VERY DISTINCT SKILLS

Know how to run a business. Often times, we see very skilled people in a craft and/or trade who provide a phenomenal product or service, but they do not know how to operate a business. You may be the best builder and/or pizza maker in town, but if you do not know how to operate a business and/or you do not hire someone who does, you are doomed to failure.  Running a business requires dealing with managing cash flow and finances, inventory, marketing, payroll, developing new business, retaining existing accounts, working with creditors and suppliers, and managing personnel.

The skills required to operate a business are very different than the skills required to produce a product or service.  Seek advice from those who have the necessary skills to operate the business.

IV.      KNOW THE REAL REASON WHY THE SELLER IS SELLING HIS BUSINESS

Know the real reason why the seller is selling the business. Is the  seller  selling his business because it is not profitable and/or there is some event which will happen in the near future which will drastically affect the business (i.e. the lease is due to terminate, the franchisor will not renew the franchise agreement, the product and/or service provided is about to become obsolete, etc.)?  Do not be fooled into believing the seller is telling you the true reason he is selling the business.

Family sickness, seller desiring to slow down or wanting to retire is frequently stated as the reason for the business sale. Make sure you find out the real reason the business is being sold. Talk to people in the industry, review all vital contracts, and obtain written warranties on all matters that are material.

V.     INSIST ON A COVENANT NOT TO COMPETE AND NON-SOLICITATION AGREEMENT

Insist on a covenant not to compete and non-solicitation agreement. A covenant not to compete prevents the seller from setting up a competing business for a set period of time, within a certain geographic radius. A non-solicitation agreement prevents the seller from soliciting employees away to a competing business for a set period of time, within a geographic radius.

While many people insist on non-competition and/or non-solicitation agreements, we have seen recurring traps that buyers have fallen into even when they obtain these agreements. For example, in a recent transaction in which our firm was involved in a post-closing litigation dispute, the seller signed a non-competition agreement agreeing not to solicit the existing employees who helped generate sales for the business. At first blush, this seemed appropriate. What the seller did not tell the buyer, and the buyer did not discover until after the closing, was that at the time of closing the seller had already taken away the top producers from the business to the seller’s competing business and left the buyer with relatively “green” employees with just a small book of business. This could have been avoided by listing out the employees by name and making sure that these were the employees who had, in fact, generated the revenues upon which the purchase price was based.

Another disturbing occurrence is a seller violating his covenant not to compete when the seller begins working as a so-called “employee,” and not as an owner at a competing business. This problem can be avoided with appropriate language in the non-competition agreement that contains a right of setoff for breach of a seller’s representation or warranty where seller financing exists, states that there is no direct or indirect competition, and inclusion of an attorney’s fees provision to pursue the remedy for a seller breach.  A provision that injunctive relief is appropriate when seller breaches the non-competition agreement is also helpful to stop the offending conduct.

VI.     CONCLUSION

Owning and operating your own business is extremely hard work, but it can also be very rewarding and profitable. This article is not meant to deter the reader from buying his own business and attempting to live the American dream. Instead it is meant to empower the reader and to assist in avoiding living through the nightmare of a business failure.  Through the implementation of thorough and active due diligence, well thought out non-competition and non-solicitation agreements, and appropriate indemnity for misrepresentation, a business acquisition will have the best chance at succeeding.

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Contact the Massachusetts business attorneys at Goldman & Pease for a free initial and confidential consultation regarding your business law legal matter.

The Massachusetts business lawyers at Goldman & Pease specialize in Massachusetts condo law and serve the greater Boston metro region including Alston, Arlington, Belmont, Brighton, Brookline, Cambridge, Canton, Dedham, Dover, Milton, Natick, Needham, Newton, Norwood, Waltham, Watertown, Wayland, Wellesley, Weston, West Roxbury, Westwood, and all of Massachusetts.