Buying and Selling a Small Business - Chapter 5 - Sources of Legal Information

As in any sales, the basic legal problem in the purchase of a business involves the transfer of ownership or title to property. How serious the title problem is varies from one business to another, depending on the nature of the assets being purchased.

If the transaction involved only the transfer of good title to a single piece of real estate, it would be a simple matter. But buying and selling a business typically involves a conglomeration of assets--inventory, fixtures, vehicles, and equipment, all of which are movable, and assorted contract rights under leases, sales agreements, patent licenses, and so on, which are intangible.

Each asset has its own ownership aspects. It is important to ask this question about each asset: "Is the buyer getting the ownership rights he assumes he is getting?"

An even more careful investigation from a legal point of view is called for when the buyer either assumes liabilities or purchases the stock of a corporation. Even the risk of potential liabilities--liabilities that may occur in the future because of past events--may be reduced by proper investigation.

Both internal and external sources of legal information are usually available to the buyer and his attorney for examination. The buyer should not rely solely on the oral statements of the seller as to important aspects of the business. Any statements of the seller that have to be accepted without support from other sources should be incorporated into the buy-sell contract as warranties.

How much information should a buyer obtain about a business before legally committing himself to purchase? There is no easy answer to this question, but the buyer should realize that the legal risk he assumes is about inversely proportional to the amount of information he has obtained about the business.

Internal Sources of Legal Information

Contracts. The buyer and seller are both concerned with the rights and obligations created by outstanding contracts with suppliers, customers, creditors, employees, lessors, and so on. The seller is concerned with his liability for any breach of contract that may result from sale of the business. He should know that ordinarily only contract rights, and not contract obligations, may be transferred to a third party without the consent of the other party to the original contract. Sublease arrangements and mortgage assumptions are examples of this. The seller remains liable even though the buyer takes over the lease or mortgage as part of the buy-sell contract.

Here is an example involving a lease. A food merchant sold one of his smaller stores at what he considered a good profit. The sale price covered inventory, fixtures, and goodwill, for which the seller received $56,000. He had purchased the business 2 years before for $30,000.

The building was leased, and the seller was not able to assign the lease to the new owner of the business. He was, however, permitted to sublease the building for the remainder of the lease. The lease amounted to $1,300 a month. Recently, sales have been decreasing to the point where the present owner has threatened to give up the business and take his loss. If he should do so, the former owner will be liable for the remaining 2 years' lease. Unless he can find another tenant, he may lose all he gained from the sale and more.

Assignment of contracts. The buyer often wants any contractual rights of the seller that are needed in order to maintain the business as a going concern. In legal terminology, the transfer of contractual rights is called an assignment. Generally, a contractual right is assignable, but the original contract may expressly prohibit its assignment.

Such negative provisions are common in printed forms of leases. Loan agreements may prohibit the sale or other change in ownership of substantially all the business assets. Or they may call for speeding up payment of the principal if the assets do change hands. The buyer should get copies of important contracts and review them to determine whether they have nonassignment clauses.

A contract may be nonassignable, however, even without such a provision. This would be true if the contract rights are coupled with obligations of a personal character. For example, the seller's credit arrangements with a supplier are not assignable because they are based on the seller's reputation as a credit risk. A contract for the manufacture of certain goods may not be assignable because the customer, when he signed the contract, knew and was relying on the superior workmanship of the seller. Likewise, a supplier's agreement to supply the seller's manufacturing requirements of certain raw materials may not be assignable because the requirements of the new owner are uncertain.

Both buyer and seller should remember that third parties will, in all probability, have to be reckoned with in carrying out the buy-sell transaction. If the buyer must have a contract that is nonassignable and the seller is not a corporation, the only solution is to renegotiate the contract. In the case of a corporate seller, it may be possible to make the transaction a purchase of stock rather than assets.

Types of contracts. Following are some recommendations to the buyer about specific types of contracts:

• Copies of real-estate leases should be obtained from the seller and examined for provisions relating to amount of rent, terms of payment, expiration, renewal, subleasing, repair, improvement, insurance, and so on. The buyer should pay special attention to the duration of the lease. If the term remaining is too short, either the lease should be renegotiated before the purchase or an option should be obtained to renew for an additional period. Leases for a specific term are often misleading because of provisions granting to one or both of the parties the right to terminate the lease by giving a stated period of notice.
• Copies of patent, trademark, trade-name, and copyright registrations should be obtained in order to determine the legal status of the right and whether it can be transferred.

  The principle subject of the buy-sell transaction may be a contract right to be the exclusive agent, dealer or distributor of a product or line of products, or the right under license to use a patented process, trade name, or trademark. Copies of such contracts should be obtained to determine the precise nature of the right, its limitations, and the seller's power to transfer. Particular attention should be given to the exclusiveness of the right.

• Copies of employment contracts and union agreements should be studied for terms relating to compensation, working conditions, duration of employment, termination, pension and profit-sharing plans, stock option, insurance programs, and so on. The buyer should find out whether key employees will remain with the company if the ownership changes hands. If the employees have not been organized, he should inquire about possible activities of union organizers among them.

The buyer should also get from the seller copies of financing agreements between the seller and commercial banks, finance companies, and other third-party lenders. Attention should be given to the term of the loan, repayment provisions, interest rate, finance charges, insurance requirements, acceleration provisions, security requirements, and recourse rights. The buyer will generally have to make his own financing agreements, but the seller's experience in financing the business will often suggest what the buyer can expect if he purchases the business. A buyer's willingness to purchase accounts receivable, apart from his financial ability to do so, should depend on their apparent collectibility. The buyer should require the seller to submit a complete list according to the age of the accounts. Inquiry may disclose factors other than the statute of limitations that would prevent collection.

A study of the seller's insurance policies may give the buyer some insight into the availability, adequacy, and cost of coverage of such risks as liability arising from manufacture or sale of defective products, liability to customers for injuries sustained on the premises, liability for property damage and bodily injury arising from negligent operation of company vehicles, liability to employees for injury under workmen's compensation laws, and property hazards such as fire, windstorm, and theft. The buyer should be aware, however, that premium rates based on the seller's experience may not be available to him.

Evidences of Ownership. The buyer should get from the seller a certified abstract of title for each parcel of real estate involved in the transaction. The abstract should be examined by the buyer's attorney. In addition to disclosing any defects in the title, examination of the abstract and the abstractor's certificate will usually show whether there are any unreleased ortgages, judgment liens, mechanics' liens, tax liens, or unpaid real-estate taxes and special assessments.

The seller should be asked to show evidence of his ownership of principal items of personal property in the form of bills of sales, receipts, assignments, motor-vehicle title certificates, and so on. Such evidence will not prove that there are no recorded liens against the property, but lack of it should alert the buyer to the possibility that personal property in the physical possession of the seller is rented, leased, borrowed, or delivered on consignment.

Organizational documents. If the seller is a partnership, the buyer should get a copy of the partnership agreement. If there is no written agreement, he should find out who the partners are and whether authority exists to sell the business assets.

If the seller is a corporation, the buyer should get a certified copy of the resolution of the shareholders authorizing the sale of the corporate assets. In a corporation stock transaction, he should get a copy of all organizational documents. These documents include the articles of incorporation and amendments to it, the corporate bylaws, stock-transfer books, and minutes of shareholders' and directors' meetings.

Observation and inquiry. Certain types of legal problems can be uncovered only by observation and inquiry. This is true of mechanics' liens. The basis for mechanics' liens against real estate may exist even though no lien is on file. If the buyer learns that there has been repair or construction within the allowable period for filing mechanics' liens, he should check with the contractors and suppliers to find out whether they have been paid.

The real estate should be examined to make sure that it complies with building codes and other ordinances. It is advisable also to have the real estate surveyed to determine whether buildings are located within boundaries in compliance with setback lines, whether adjoining buildings or driveways are encroaching upon the property, and so on.

External Sources of Legal Information

A record search will not disclose what items of personal property in possession of the seller have been rented, leased, borrowed, or delivered on consignment. Also, lien notations on motor-vehicle title certificates may take precedence over recording--it depends on State statutes.

Tax authorities. Investigation is especially important where the buyer is purchasing the stock of the seller or assuming liability for the payment status of Federal, State, and local income taxes, Social Security and income withholding taxes, Federal excise taxes, State and local taxes, license taxes, and real- and personal-property taxes. Have tax returns been reviewed and approved by the taxing authority?

Zoning ordinances, planning agencies, building codes. The buyer should check zoning ordinances and building codes to determine the existence of nonconforming land uses or violations of building codes. Comprehensive zoning plans may provide for steps to be taken toward elimination of nonconforming uses. This can be done by prohibiting alteration or enlarging of buildings or by requiring liquidation of nonconforming use within a prescribed period of time.

City, county, or metropolitan planning agencies and engineering departments should be consulted about the existence of master plans for future rezoning, redevelopment, and street or highway changes. Highway relocation, limited street or highway access, elimination of on-street parking, or changes in the composition of the immediate market area may be enough to destroy the business as a going concern. City annexation policies may be important to businesses located in the suburbs. The cost of planned improvements may affect the buyer's decision.

Court records. The buyer should find out from court records whether judgment liens exist against real estate involved in the buy-sell transaction and whether lawsuits are pending that may retroactively result in the attachment of liens. This is of particular concern to the buyer who either assumes business liabilities or purchases the stock of a corporation. Not only litigation costs and liability must be considered but also the impact of the publicity on the goodwill of the business.

Even if a court record search is negative, future litigation may arise out of events of the past several years, such as motor-vehicle accidents, manufacture or sale of defective products, accidents on the premises involving customers or employees, breach of contract, violations of wage-and-hour laws, and so on. The best protection is to inquire of the seller and of employees who have been intimately concerned with the business.