What to Investigate Before You Buy a Business

Take these steps to make sure the business is a good investment.

Some call it "due diligence." I call it "common sense." Itís the idea that before you buy a business, you need to know what youíre getting into.

Buying a business can be a fantastic opportunity -- or a disaster waiting to happen. You should x-ray a business to detect any hidden problems, which you can do by knowing the questions to ask and the papers you should look at. Some information, such as the extent of equipment liens, will be available from public sources. For other information, your main source will be the owner of the business.

Before a business owner shares sensitive information with you, you may be asked to sign a confidentiality agreement. Thatís a reasonable request. It assures the owner that youíll use the information only to check out the business, and not for any other reason. Make sure the confidentiality agreement lets you share the information with your lawyer and accountant.

Thereís no hard-and-fast rule about when youíll get your hands on the information you need. It can be early on -- for example, before youíve signed anything but a confidentiality agreement. Or it can be after youíve signed a non-binding letter of intent. It can even be after youíve signed a purchase agreement. But if thatís the case, be sure you can walk away from the deal if youíre unhappy with what your investigation discloses.

All right. Now letís get down to the specifics.

Learn About the Business Finances
Learn all you can about the financial condition of the business. Even if you think you can make a decent profit, you need to see how the current owner has done. Some of the documents worth looking at include:
  • the current balance sheet
  • profit and loss statement (for past 5 years)
  • tax returns (for past 5 years)
  • audited financial statements
  • unemployment tax returns
  • sales tax returns
  • accounts payable, and
  • accounts receivable (With accounts receivable, a list may not be good enough. You need to know more about the individual accounts, as some of them may not be collectable.)
You also need a list of business debts -- and information on whether the creditors have a security interest (lien) on any business assets. To double check on liens, you or your lawyer can do a lien check at the public office where liens are filed. This is often called a UCC-1 search. UCC stands for Uniform Commercial Code -- the basic business law thatís in effect in virtually every state.

Banks, suppliers, and other creditors typically file a UCC-1 form to protect their interests when they extend credit to a business. If a secured debt isnít paid, the creditor can seize and sell the secured assets.

Inspect the Physical Assets
Your purchase may include physical assets such as equipment and inventory. Make sure the equipment is in good working order. Consider hiring an expert to check it for you. Also, find out if the business owns the equipment or is just leasing it. If the equipment is being leased, look at the terms of the equipment lease and make sure you have the right to take over the lease.

As for inventory, see that itís up to date and marketable. You donít want to pay good money for obsolete goods that youíll have to sell at distress prices or cart to the dump.

Get Consent to Take Over the Lease
Most businesses occupy leased space. You need to get a copy of the lease and review it carefully. How long will the lease last? Will you have an option to renew it? Are the rent terms acceptable? Can you live with the lease's restrictions?

Make sure itís okay for the business to continue to occupy the space under your ownership. The lease may require the landlordís consent for you to take over the lease -- especially if the current business is owned by a sole proprietorship or partnership. Talk to the landlord directly about this.

While youíre at it, have the landlord confirm that the current business owner is up to date on rent payments. Youíd hate to take over the business, only to learn that the lease is in default and that youíre facing eviction.

In talking to the landlord, you may want to negotiate a new lease -- one with a longer term or lower rent, perhaps. Give it a try. Be prepared to show why itís in the landlordís best interest to cut a deal with you.

Check the Business's Legal Status
If the business is owned by a corporation or LLC, there are two scenarios. One is that youíre buying the assets of the business. The other is that youíre buying the business entity itself (which owns the assets). Buying the assets is usually the better option for the buyer.

But if your plan is to buy the business entity -- the stock of the corporation or the membership interests of the LLC -- then you need to see the documents that created the entity and also any related documents such as bylaws, resolutions, and operating agreements.
Confirm that the business is in good standing with the state and that the owner has legal authority to sell it.

Finally, ask the owner of the business (no matter what its legal structure) to tell you of any pending or threatened lawsuits or governmental proceedings. You and your lawyer can then evaluate your own exposure if you decide to buy the business.

Get the Owner's Guarantee
Even after youíve carefully investigated the business, other surprises may be lurking in the background. Have the current owner personally guarantee that the information you have is complete and accurate. You can put this in the purchase agreement under the heading, "Representations and Warranties."

Hold Back Some of the Purchase Price
If you decide to buy the business, donít pay the full purchase price at closing. Arrange for at least part of it to be paid six months or a year down the road. That way, if you suffer a loss because the owner failed to disclose crucial information (a debt, for example, or a tax liability), you can deduct the money from what you owe.

You can either withhold a set amount of money for a period of time or have the seller place some of your purchase money in escrow. (Place money with a third party, called an escrow agent or escrow holder.) If you and the seller agree to place money in escrow, write up a short escrow agreement (the escrow holder may have one for you).

Record the Terms of the Deal in a Contract
Be sure to record all the terms of the purchase in a written contract, including a list of all assets being purchased and their value. Your contract should also mention your promissory note and security agreement, if you will sign these additional documents.

About the Author
About the Author
Attorney Fred S. Steingold practices law in Ann Arbor, Michigan. An expert on small business law, he represents and advises many small businesses. He is the author of The Complete Guide to Buying a Business, The Complete Guide to Selling a Business and Negotiate the Best Lease for Your Business.