Acquiring an Existing Business: Considerations for Buyers

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Starting a business from scratch can be a daunting and expensive endeavor that carries a lot of risk to the entrepreneur. Below is a broad overview of certain items that potential buyers should consider and discuss with their advisors prior to and during the acquisition of a business.

Legal Structure of the Transaction: Asset Acquisition Versus Stock Acquisition

One of the initial decisions that buyers will have to make is how to structure the transaction. Some of the more common transaction structures are asset acquisitions and stock acquisitions[1]. An asset acquisition occurs when the buyer purchases all or a certain portion of the selling company’s operating assets (usually through a newly formed entity that the buyer creates). At the completion of an asset acquisition, the ownership of the selling company remains the same and the buyer takes ownership of the operating assets that it acquires. In a stock acquisition, the buyer acquires all of the stock in the selling company from the shareholders and becomes the owner of the selling company.

The structure of a buyer’s transaction will depend on the industry the target company is in and the goals of the buyer. For example, if a seller has a specific industry assignable license or a long-term contract that may be difficult to obtain, then a buyer may want to explore a stock acquisition. Through ownership of the stock in the target company, the buyer may inherit the license or the contract that is difficult to obtain. Alternatively, if the buyer desires to minimize the risk of inheriting any liabilities of the selling company, the buyer may want to explore an asset acquisition. In an asset acquisition the buyer is only purchasing specific assets of the selling company and usually receives indemnification for any liability of the selling company. Moreover, if a selling company has been in existence for some time, and has not made any major capital expenditures, it may have fully depreciated all of its major operating equipment. An advantage of structuring a transaction as an asset acquisition is that the buyer may be able to receive a step-up in its tax basis.

When determining the transaction structure and negotiating either an Asset Purchase Agreement or Stock Purchase Agreement, it is crucial that the buyer communicates its desires with its legal and tax professionals.

Due Diligence Considerations: What to Look For?

The due diligence phase is another crucial phase of the acquisition process. Depending on the transaction, this will often occur once a buyer and seller have executed an Asset Purchase Agreement or Stock Purchase Agreement. In this phase of the transaction, a buyer will gather and review information about the target company to determine whether a transaction makes sense to the buyer. Below are just a few items that a buyer will want to review during the due diligence period.

Organizational Documents

A buyer or its counsel must review and examine the organizational entity documents of the selling company. A review of the organizational documents will disclose the owners of the company, if any specific consents are required to approve the transaction, or if there are any restrictions on the sale of the stock or assets of the selling company. This review will include the selling company’s certificate of incorporation or articles of organization, by-laws or operating agreement, minutes and resolutions of the selling company, or any shareholder’s agreement, and any other key organizational documents.

Key Contracts

A buyer will want to examine all of the contracts and agreements that the selling company is a party to. These will generally include vendor agreements, supply agreements, customer contracts, leases, or any licenses a target company may have. When examining these contracts, a buyer should decide whether they want to assume such contracts, whether they are assignable to the buyer, when each contract terminates, and whether there are any unique terms in the contracts that impact the buyer.

Finance Documents

Especially in a stock acquisition, a buyer will want to review all loan documents, debt agreements, promissory notes, guaranties, and other financing documents that the target company is a party to. This review will disclose outstanding debt, the interest rates of such debt, whether the transaction will trigger an event of default with any lenders, whether any lender’s consent is required in connection with the transaction, any liens lenders may have on the target company’s assets, and whether the target company has guaranteed any other debt.

Litigation

A buyer must determine whether there is any active or pending litigation against the target company. If any exists, a buyer should understand the types of claims outstanding, the current status of each claim, whether the target company is able to successfully defend such claim, the potential amount of damages, and whether the buyer could assume any responsibility of the claim. If a target company has been the subject of a lawsuit or has existing debt that the buyer does not wish to assume, then the buyer may need to confirm the satisfaction of such obligation or alter the structure of the transaction.

The due diligence period is the buyer’s opportunity to assess the viability of its new venture and assess the risks involved to confirm whether a transaction will meet the buyer’s goal.

[1] Throughout this article, the term “stock acquisition” refers to both the acquisition of equity in a corporation and a limited liability company. The ownership units in a corporation are usually referred to as stock, while the ownership units of a limited liability company are commonly referred to as “membership interests” or “membership units”.

This article is intended for general informational purposes only and should not be considered legal advice or counsel, nor does it create an attorney-client relationship.