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Buying a Company, Part 2

In the previous post on buying a company, I discussed what I have learned about finding and valuing a small company. In this post, I will discuss a second technique I used to find a seller, and then show how we conducted due diligence and selected the form of the deal (e.g. C vs. S Corporation, Asset vs. Equity purchase). In the next installment, we will get to the various legal documents and financing strategies.

A second way to find a target company

If you were reading the first post carefully, you will note that I am running a recreation services company but initially started to buy an industrial products distribution company. As it turned out, I got all the way through due diligence and within 24 hours of signing the agreements with company A when the owners (and founders) got cold feet about selling daddy's company and changed their mind. Bam, back to square 1. Four months work down the drain. I then found a second company, a marketing products company, and went three months down the road to buying them and - oops, they changed their mind about selling too. Eventually the third time was indeed a charm, and I ended up buying the recreation services company. Apparently, while my experience was extreme, it is not that uncommon for sellers to get cold feet.

Anyway, back to the point about finding companies to buy. When the first company backed out, I had already quit my job. I was left unemployed and without a company to run. Worse, though I did not yet know it, the SBA had stopped writing larger loans of the type I had obtained to buy the first company (we'll get to financing in a minute). Since I had no job, I could not sit around for months hoping for something interesting to come onto the market. My broker (Janice Staripoli referred me to a second broker name Walt Lipski who had a process for cold-calling on local businesses to see if they might be thinking about selling. (By the way, if you are in Arizona, I would recommend either of these folks to you - Janice handles smaller businesses while Walt handles larger ones).

Walt created a letter and sent it out to businesses in SIC codes that were of interest to me. From over 1000 letters, we ended up with 20 or 30 interested companies, many of which we went to visit. In retrospect, this was a very fun time - never had I imagined the diversity of businesses and interesting ideas right in our area. Anyway, through this process we identified company B, which fell through, and eventually company C which I bought.

Due Diligence

Due Diligence is a fancy legal word for kicking the tires. You need to gain confidence on a number of issues:

1. Are the historical financials trustworthy - do they really reflect how the business has been performing
2. Are there any hidden liabilities, like lawsuits, unpaid debts, aging equipment that needs to be replaced, pensions, etc.
3. Are there any looming business problems or opportunities that could radically change the company's performance in the future. For example, if you are buying a small hardware store, the fact that they are planning to build a Home Depot around the corner might make a difference. Or, if the business depends on low cost labor, a looming hike in the minimum wage may be significant
4. Can the business survive without the previous owners, or does it depend on their unique skills and/or relationships
5. Does the business make sense to you? Is the customer base strong and growing? Do they have a good plan for starying ahead of competitors?

Accountants are the perfect resource for answering question 1. There are many local accountants (your broker can recommend some) who have experience checking sellers' income statements. In my case, my accountant compared the sellers tax returns, bank statements, and income statements. Your main worry is that the seller is overstating income. Sellers who do this seldom also overstate income for taxes (because it would increase their tax bill). Even if they misstate taxes as well, it is very hard to explain why all that extra income is not appearing in the bank accounts. If these three match, the seller's statements are probably (but not definitely) OK. Also, you can learn a lot about the sellers by the quality and detail of their statements. If they are detailed and well-organized and meticulous, they probably expended the same care in the rest of the business. If they are cheating the IRS (which I found a LOT in looking at small companies) they may be cheating you too.

Questions 2-5 have to be answered by you. You need to question everything and everybody. You need to inspect all the facilities. Do not rely on others - its is your money. You need to have confidence that there are no surprises. When you and your attorney write the legal documents, you can protect yourself on some of this stuff but not all!

What are C and S Corps?

I won't go into lengthy details, but many of the older businesses you will encounter are organized as C Corporations. This structure tends to create some tax management problems due to the double taxation of dividends. You will find sellers who have C corporations to have made large loans to themselves over time- this is a normal alternative to dividends. These loans will be closed out in the sale. If you have any choice in the matter, you want your new company organized as an S corp - it avoids these double taxation problems. Of course, work with your attorney and accountant on this, don't just take my word for it. More on corporate structures here.

Equity Purchase vs. Asset Purchase

While this issue may strike you as arcane, it is critically important to you as a buyer. The answer to which is better depends on the situation, and you definitely need to have a long talk with your lawyer, your broker, and your accountant about this issue. Here is how they differ:

In an equity purchase, you are buying the stock of the company. In doing so, you are buying everything - their assets, their debts, their corporate shell, their tax ID numbers, their pending lawsuits, everything. You are also buying the whole company history. You can get sued for past actions of the company even before you bought it. If the company has taxes or debts it owed, even if you did not know about it, they are your debts and liens now. You never, ever want to buy the equity of the company without first:

1. Having the previous owners indemnify you and the company for all debts, taxes, lawsuits, etc. prior to the acquisition date, and
2. Setting some money aside to assure that the previous owners have the resources to satisfy #1. For example, it is very normal in an equity purchase that 20-50% of the purchase price be deferred payment for several years. The purchase agreement will specify a process where the buyer can net out costs to satisfy the indemnity from the deferred money owed.

Despite these problems, equity purchases happen a lot, for at least 3 reasons:
1. The company is a C corp, and the seller refuses to tolerate double taxation of the proceeds of an asset sale
2. The seller has a really high equity basis and low asset basis, such that an equity sale results in a lower capital gain
3. The corporate shell has value. This is sometimes the case for multi-state businesses, where there are a lot of tax and business registrations necessary, or businesses where there are contracts that are not transferable to another company.

In an asset purchase, you the buyer are going to form a new company, with all new registrations, and then that company is going to buy the assets, contracts, trademarks, name, and intellectual property of the selling company. Unless agreed to in the purchase agreement, you therefore inherit none of the debts or liability or history. (there are some exceptions to this - for example, most states require that you inherit the selling company's unemployment reserve account and history whether you want it or not.)

Asset purchases are generally more work for the buyer. You have to form a new company, and get all the necessary pieces of government paper for that company (Federal tax ID, state sales tax number, state unemployment number, state withholding number, foreign corporation registrations, trademark registrations, local occupancy licenses and health inspections, etc.) and you will have to amend many contracts and vendor files.

I guess the obvious question was, what did I do? The seller had an S-corp with a very low equity basis. While they initially asked for an equity deal, they accepted an asset deal. After seeking lots of advice, I formed an S-corp to act as the purcahse vehicle. In the case of the company I bought, the paperwork to get things set up in this new company was ridiculously difficult, since the assets I bought were in 11 states. I spent months and months learning what every state needed, and I guarantee that in the fine federalist form of government we have, every state does things differently. Trying to get this all in place was probably the most stressful period of my whole life.

One other note - it is absolutely critical that in the purchase agreement for an asset purchase, you and the seller agree as to what value you are going to be putting on the assets for your taxes - its has to be the same. Lets say you did a $200,000 asset purchase. While there are other factors, basically you will allocate this price either to the purchase price of the assets themselves or to goodwill. Goodwill is the accounting way of saying "purchase price in excess of the asset values". It is basically the amount you spent for the intangibles of the business - their place in the market, their customer relations, their good name, etc. It is generally in the buyers interest to allocate as much as possible to the asset values, and as little as possible to goodwill, since you can depreciate tangible assets much faster than you can goodwill. The seller, due to a little known tax concept called depreciation recapture, often want the opposite.

In our case, the assets were relatively new and still on the books for a high value so there was not a lot of debate about their value. In addition, since a lot of the value of the company was in the contracts I was purchasing, we were able to assign some of the purchase price to these contracts and depreciate these values over the life of the contracts. As a result of the asset purchase approach, for the first few years of operation, we are getting a tax break as these assets and contracts are creating a lot of depreciation, which reduces taxes without affecting cash flow. Like most tax breaks, this is really just a deferal, with the taxes getting paid whenever I resell the assets. So the trade-off in the selection of the asset purchase has been a huge amount of work vs. some tax benefits.

To be continued

OK, things are getting long-winded again, so I will continue with the various legal agreements involved as well as financing the deal in the next post. See part 3.

Posted on September 30, 2004 at 11:33 AM | Permalink

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Easy to follow step-by-step guide to financial freedom by buying real estate

Posted by: John Beck | Sep 20, 2006 11:14:55 AM

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