BUSINESS SALES & MERGERS STRATEGIES
ASSET SALES

As you decide to move and then do move forward with a business purchase,  you will want to get a lot of information and review documents.

  1. Research the Business’s History and Finances

Before you seriously consider buying a particular business, find out as much as you can about it. Thoroughly review copies of the

  • business’s certified financial records, including cash flow statements, balance sheets, accounts payable and receivable,
  • employee files including benefits and any employee contracts, and
  • major contracts and leases,
  • as well as any past lawsuits and other relevant information.

This review (lawyers call it “due diligence”) will not only help you understand how the company ticks, but will alert you to potential problems. For instance, if a major contract like a lease prohibits you from taking it over without the landlord or other party’s permission, you won’t want to finalize the deal without getting that permission.

Don’t be shy about asking for information about the business, and if the seller refuses to supply it, or if you find any misinformation, this may be a sign that you should look elsewhere.

3. Due Diligence (Investigate the business in depth)

Some call it “due diligence.” We call it “common sense.” It’s the idea that before you buy a business, you need to know what you’re getting into.

As this proves moves along, we will be using my form of Due Diligence checklist.

You should investigate a business to detect any hidden problems, by asking for the right information and paperwork. 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.

4.Confidentiality Agreement

Be ready to sign a confidentiality agreement. This assures the owner that you’ll use the information only to check out the business. Just make sure the agreement lets you share the information with your lawyer and accountant.

5.Learn About the Business Finances

Step one in your due diligence is learning all you can about the financial condition of the business. Check out documents like the current balance sheet, profit and loss statements (past 5 years’), tax returns (for income, unemployment, and sales tax, for the past 5 years), audited financial statements, accounts payable and receivable, and more.

You also need a list of business debts — and information on whether the creditors have a security interest (lien) on any business assets. You or your lawyer can double check on liens at the public office where liens are filed. If you find that banks, suppliers, or other creditors filed what’s called a UCC-1 form when they extended credit to the business, realize that if their debts weren’t paid, they can seize and sell the secured assets, even if you’re now the owner.

6.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. If some equipment is being leased, look at the terms of the lease and make sure you have the right to take it over.

As for inventory, see that it’s up to date and marketable. You don’t want to pay good money for obsolete goods.

7.Read 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? Are the terms and restrictions acceptable?

Make sure it’s okay for the business to continue to occupy the space under the same lease if you’re the owners. The lease may require the landlord’s consent for this. Or, you may want to try negotiating a new lease — one with a longer term or lower rent, perhaps.

While you’re at it, have the landlord confirm that the current business owner is up to date on rent payments, so you won’t be the one facing eviction.

8.Check the Business’s Legal Status

If the business is owned by a corporation or LLC, there are two scenarios. One is that you’re buying the assets of the business. The other is that you’re 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 its legal structure) to tell you of any pending or threatened lawsuits or governmental proceedings.

9.Get the Owner’s Guarantee

Even after you’ve carefully investigated the business, other surprises may be lurking. 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.”

10.Possibly Hold Back Some of the Purchase Price

Don’t 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. In the alternative, provide in the promissory note that payments you owe to the seller can be offset by any amounts you pay for damages to third parties caused by seller or other debts that were due by seller and paid by you after closing.

Buying a business is a big decision — Nevertheless,  when you move forward on buying an existing business, you get the opportunity to become an entrepreneur all without starting a small business from the ground up, with the corresponding costs, worries and gamble. Buying an existing business means buying an operation with a history, workforce in place, and track record of success.

Every year, more than 500,000 businesses change hands. Based on existing economics, that number is expected to increase in the next several years as more people decide to work for themselves.

Buying an existing business is a popular alternative because it lets you skip past some of the learning curve, challenges and costs of starting a new business. But the journey from finding a business for sale to closing the deal can be long and complicated.

Before you begin the journey of buying a business of your own, find out everything you need to know to avoid unnecessary major costs, possible disaster and disappointment that can drain your financial and emotional resources.

I use my YAHNIAN LAW CORPORATION form of checklist when buying an existing business.

Below, I discuss and  also cover the pros and cons of buying a business when you’re still just thinking about the idea. I finish with how to buy a business when you’re ready to close the deal and take over the executive office.

1.Buying an existing business checklist

If you committed to buying or at least considering the purchase of an existing business (or Franchise), it’s critical to make sure you pick the right business for you. This route for success is buying a business that you’re passionate about. Further, you should have in mind improving and taking to that business to higher levels of success. However, everbody starts off with high expectations and emotional. In reality, passion alone isn’t enough — experience and knowing which questions to ask when buying a business are also important when making your choice.

Following is the  buying an existing business checklist:

2.Determine what type of business to buy

This is one of the most crucial steps. You just don’t go out and buy the any car or the first car you see. Instead, you study the different types of vehicles and look for one that suits you and your bank account. Narrow down your passions, interests, skills and experience. Tip: You’ll be happier if you buy a small business that dovetails with what you already like and have some experience in.

For example, if you’ve been an executive in a tech business for several years, maybe you’ve decided you’d like to own your own tech company. Or maybe you’ve been an employee for a long time at a company that’s now on the market. In that case, who better to buy the business than someone who knows it as well as you do?

Although you might just want to buy a business for the financials alone — by its expected return on investment — it’s also important to align yourself with the business’s immaterial goals. After all, the more knowledgeable and familiar you are with the business’s model, products or services, customers, industry and trends, the more innovative and successful your new ideas will be.

How Much Do You Need?

2. Search for businesses that are for sale

There are plenty of ways to find the right business for sale that fits the criteria you’ve decided on. These include:

Online business marketplaces such as bizbuysell.com, the largest site of its kind with more than 45,000 active listings.

Craigslist ads.

Classified newspaper ads under the “Businesses for Sale” category.

Asking people in your network of small-business owners.

Going to meetups or industry conferences to ask other business professionals.

Working with a business broker.

Business brokers legally represent the seller, so you should be careful about conveying certain information to them (such as how far you’re willing to go in negotiations). However, a broker can help you understand what kind of business you want, prescreen businesses to cut out all the failing companies, keep negotiations civil and smart and help you with all the necessary paperwork. Brokers do earn a commission when a sale goes through, but it’s typically paid by the seller.
3. Understand why an existing business is up for sale

There are plenty of reasons a business owner might put their business up for sale, including something as simple as an innocuous lifestyle choice like retirement. Or, there might be a more worrisome reason, like a fundamental problem with the business. If you’re about to buy a business, you’ll want to know exactly why the businesses you’re considering are no longer working for their current owners.

You should ask the current owners what challenges they’ve encountered, what they’ve done to try solving those problems and how those attempts fared. During every conversation with the current owner, you should ask yourself, “Do I have what it takes to meet these challenges with different or better solutions?”

Be on the lookout for:

A poorly conceptualized business plan (there’s just not a market for the product or service).

Competitors that are far ahead.

Existing business debts.

Location problems.

A brand issue.

Inventory difficulties (the cost of production is too high, low quality is losing the business customers, storage is difficult, there’s no supply and demand balance, etc.).

Bad equipment (it’s outdated and too expensive to upgrade).

Make sure you know as much as you can about the existing business’s successes, failures, challenges and future opportunities. In addition to speaking with the owner about these concerns, also talk to existing customers, existing employees, locals in the area, neighboring businesses and so on. They’ll give you an honest view of how the business is doing, without the bias of the seller trying to convince you to buy.
4. Narrow in on a business that aligns with your budget, goals and resources

Until now, you might have been considering several different businesses, but now it’s time to hone in on the best option. The best option is the business that aligns with your budget, goals and resources.

Calculating the ideal size, location, sales, staff and so on of your prospective business is an important step in your plan of buying a business, since it will give you a scale to keep in mind when you’re shopping around. Figure out how much you’d ideally want to change a business, and assess how much that will cost you.

Money isn’t the only thing you’ll be spending. Look at the time and energy commitments you’re planning to invest to make the business your own. Some managers prefer to be “on” at all times, in the weeds with their employees, while others prefer to delegate and, one day, own multiple businesses.

The amount of resources you’ll have to invest depends in large part on the people and processes already in place and on the experience you have in the industry. For example, if you’re buying a tech company but lack technical expertise, you’ll need to invest time learning the ropes or hiring people who have the experience.
5. Do your due diligence

Due diligence is the process of gathering as much information and intel as you can before buying a business, and it is a critical step in your journey to becoming a business owner. During this period, you should work with an accountant and lawyer to make sure you have all the information you need to move forward.

As the buyer, you’ll want to have a good accountant on your side to review the business’s financials. It’s also beneficial to have a good business attorney to represent you in negotiations and to help you understand how the transaction will be structured.

Before you can begin your due diligence, the seller will most likely ask for a signed confidentiality agreement or nondisclosure agreement. By signing, you agree not to disclose any confidential information about the business that’s uncovered during the due diligence process. This protects the seller in case you decide buying the business is not for you after reviewing all the documents.

There are many business documents, files, agreements and statements that you’ll want to collect and analyze, ideally with the help of a lawyer and accountant. Here are some of the must-have documents when doing due diligence in the process of considering whether to buy a business:
Business licenses and permits

First up is to make sure that the business you’re looking at has all the business licenses and permits it needs. If you’re buying a business, you want to make sure that the current owner hasn’t run afoul of any local business licensing laws. Businesses in certain industries, particularly highly regulated ones like food services and childcare, need a valid permit to stay open.
Organizational paperwork and certificate of good standing

If the business you’re buying is a sole proprietorship or partnership, there may not be official “founding” paperwork. However, a registered business entity, such as an LLC or corporation, will have organizational documents on file with the state. For an LLC, this is the articles of organization. For a corporation, this is the articles of incorporation.

The secretary of state in your state should also be able to produce a certificate of good standing for the business you’re interested in buying. This certifies that the business is approved to operate in the state.
Zoning laws

Check with your area’s local zoning laws to make sure that you’re buying a business that isn’t violating any restrictions. While some localities allow mixed-use commercial and residential zoning, others have tight restrictions on where businesses can be located. This especially goes for businesses like bars and nightclubs that may not be desirable in a residential area.
Environmental regulations

Has this business been secretly dumping chemicals into the nearby reservoir or violating other environmental laws? Make sure the answer is a firm no before moving forward with buying the business. Double-check that this business abides by all of the area’s small business environmental regulations.
Letter of intent

As you move forward with buying a business, the seller issues a letter of intent, or LOI, to the buyer when both sides have agreed on a price point and about which business assets and liabilities will be included in the transaction. The price proposal, along with the terms and conditions of the business sale, should all be included in the seller’s LOI.

The LOI is an indication from the seller that they are serious about seeing the deal through to the end. Once you have it in hand, you can feel more comfortable forging ahead with the remainder of due diligence.
Contracts and leases

Half the fun of the decision to buy a business is all the stuff it comes with. Whether that means a lease for the location, equipment or something else, you’ll want to make sure the landlord is alright with transferring over these legal documents to your name. Otherwise, you’ll need to negotiate a new lease, which can significantly add to your expenses.

You’ll also want to review any outstanding agreements that the owner has with vendors or customers. This can be very revealing. For example, if your review indicates that 90% of the business’s revenue comes from a single client, you’ll want to think twice before buying. If that client parts ways with the business, it could put a serious dent in the business’s potential.
Business financials

Before buying a business, make sure to examine its past few years of financials, including:

Tax returns.

Balance sheets.

Cash flow statements.

Sales records and accounts receivable.

Accounts payable.

Debt disclosures.

Advertising costs.

Double-check that the tax returns and financial statements have passed an audit by a certified public accountant; don’t accept those financials from the sellers themselves.

Use the business’s financials as an opportunity to analyze its income stream. The business you purchase doesn’t necessarily have to be profitable yet (particularly if it’s a young business), but there should be a clear path to profitability.

Be in the know on whether the business’s debts and liabilities will be included in the transaction or not, and be wary of taking these on. For example, if some of the outstanding receivables the ex-owner was dealing with are too old — 90 days or more, for example — then they’ll be pretty tough for you to collect on. You might be better off asking the seller to insure them or contact the customers themselves.
Organizational chart

If you buy a business with employees, make sure you understand how they rank and relate to one another by asking for a business organizational chart. This should also include compensation data, management practices and processes, benefit plans, insurance and vacation policies.
Status of inventory, equipment, furniture and building

Make sure to critically analyze these aspects of the businesses, since their values will directly impact the cost of the business. You’ll want to check:

What’s on hand.

Its quality.

How sellable it is, both in terms of market viability and its condition.

How fast and for how much each type of inventory has sold in the past.

The present condition of equipment and furniture versus its original selling price.

Whether it was maintained well or needs repairs.

Whether the furniture will be useful to you or if you’ll need to replace it to be operational or for aesthetic reasons.

If you’ll need to make larger modifications to the building.

And other similar questions.

Sites like whayne.com can be used to look up equipment and obtain price estimates.
Other important documents

This list of documents will tell you a lot of information about the business, but there’s probably more you’ll want to examine. Your attorney or accountant should be able to identify additional documents specific to the business you’re interested in.

For example, ask the seller for property documents, equipment/asset listing, brand assets for advertising materials, an account of intellectual property assets, insurance coverage, employee policies and contracts, incorporation information and customer lists.

Once due diligence comes to a close, you’ll need to make your final decision about whether buying the business is right for you. If you decide to go ahead, the sales agreement is what ties it all together.

The agreement will enumerate the final purchase price and everything you’re purchasing, including:

Tangible assets (inventory, equipment, furniture, building).

Intangible assets (goodwill, brand value, etc.).

Intellectual property (patents, copyrights, etc.).

Customer lists.

Have a lawyer help you put this document together or, at the very least, review it carefully before you sign.
6. Evaluate the price of the business with the earnings, assets or market approach

This is where many deals fall apart because buyers and sellers often place very different values on the same business, and several factors affect a business’s value.

Buyers and sellers usually use some kind of pricing model to get a ballpark number and frame negotiations. During this process, it can be very helpful to call in an independent business valuation professional to make an objective determination of value. Valuation services, which can be found online or through word of mouth, cost around $3,000 to $5,000, but they can save you thousands more in the long run by coming up with a good estimate.

Whether you do this yourself or hire someone, it’s helpful to have some knowledge of different business valuation methods. To get some insight, we spoke with Mike Bilby, CPA and certified valuation analyst, at Concannon Miller.

Bilby said small businesses should understand three main approaches to valuing an existing company when they’re considering how to buy a business:
Earnings approach

Best used for: buying existing businesses that are already turning a profit or have a positive forecast of earnings.

The earnings approach values a business based on its historical, current, and projected profits. Specific methods you may come across that fall into this approach include the capitalized earnings method and discounted cash flow method.

For businesses with a history of fairly stable profits, that history can be used to anticipate future earnings and value the business. Even if a business hasn’t generated a profit yet, earnings models can be used to predict how much the business might earn in the future. The disadvantage of the earnings approach is that it relies on a prediction of future earnings, which may not be accurate.
Assets approach

Best used for: buying capital-intensive businesses, such as manufacturing and transportation businesses, and businesses that aren’t profitable yet.

The assets approach measures the value of a business’s tangible and intangible assets minus debts and liabilities. Tangible assets include things like equipment and real estate, and intangible assets include things like patents, trademarks and software. The assets approach considers the current fair-market value of the business’s assets but also the future return on investment that the owner could get from those assets.
Market approach

Best used for: accounting for local factors or confirming a price that you arrived at based on one of the other two approaches.

The market approach measures the value of a business based on how much comparable businesses have sold for. It’s a good way to get a ballpark range for a business’s value and to account for local factors that the other approaches may miss, such as the business’s location in a particular neighborhood.

It might be confusing to get all these approaches straight in your head, but the point of all of them is to assess the current financial health of the business, as well as its growth potential. In reality, Bilby says, none of these methods exists in isolation. All three of these approaches can be used to arrive at a fair price for a business, and the final price will always be the one that both the buyer and the seller agree on.
7. Secure capital to make the purchase

Once you and seller agree on a number, the next step in buying a business is to get the money. There are a few different ways you can gather the capital you’ll need to purchase a business — some specific to buying an existing business, others pretty standard.

Here are some of the ways to finance a business acquisition:
Use personal or family money

If you’re able to cover the costs of buying an existing business, that’s always an option. This is more likely if you’re buying a small business rather than a chain. Of course, you’ll want to consult your accountant before ponying up a large lump sum of your own cash. Also, make sure that you’re not using all your money buying a business because running a business takes capital, too.

Many businesses are also funded with money borrowed from family. If you go this route, you should understand the tax implications for gifts and family loans. Make sure that you and your family member put the exchange of money in writing and follow IRS rules for family loans.
Seller financing

Some sellers will agree to holding a note, or accepting staggered payments — sort of like a lender. This way, they get guaranteed income for the coming months (or years, depending on your plan).

There are rules around seller financing, particularly if you plan to use another form of debt financing as well. For example, sellers have to be on “standby” if you’re also getting an SBA loan, meaning they have to agree that they won’t be paid back until you pay off the SBA loan.

Some sellers might also be willing to trade in some assets, like some furniture they really loved or the company car, for a lower price.
Partner up

By turning to a partnership instead of buying a business solo, you can divide the payments you’ll be making while still owning that company.

Taking on a partner when buying a business isn’t only useful to cut costs, though: You can also bring someone on board with more specific experience or a different skill set. Just don’t forget to draw up a partnership agreement, so co-ownership doesn’t cause any problems down the line.
Sell stock to employees

By selling company stock to your employees, you can get a big discount — making up 50% or even 90% of the business price by some measures. You’ll probably want to sell non-voting stock, if possible, to retain ownership over the business. In order to issue stock, you’ll have to organize the business (or re-organize it) as an S corporation or C corporation.
Start by leasing the business

It might be possible for you to lease the business instead of buying it outright — with the option to make the big purchase down the road once you’re able to afford it.

Understandably, not all sellers will be open to this option, since they more likely than not want to wash their hands and walk away from the sale. However, if leasing is something you’d be more comfortable with — even though it may cost more money in the long run — you might as well ask.
Debt financing

Buying a business will give you tons of documents to approach a bank or alternative lender with for financing: financial histories, tax returns, employee records, cash flow analyses, inventory and equipment valuations, and much more. This wealth of data makes business acquisitions a good candidate for loans because lenders aren’t working with a risky blank slate.

If you’re looking for a small-business loan, here are a few potential financing options that might help in buying a business:

Term loan.

SBA loan.

Asset-based financing.

Getting a business acquisition loan is typically easier because the lender has a history to assess. But just like with any business loan, lenders will scrutinize all of the following:

Borrower’s personal credit score.

Business credit score.

Annual revenue.

Time in operation.

Tax returns.

Balance sheet.

Cash flow.

Outstanding debts.

For term loans and SBA loans for when you buy a business, banks typically require buyers to put down a 20% to 25% down payment on acquisition loans. However, the SBA recently made some changes that make it easier for buyers to obtain SBA 7(a) loans for buying a business. Now, the SBA requires the buyer to put down just 10%, and only half of that (5%) has to come from the buyer’s own cash. The rest can come in the form of a seller’s note as long as the seller agrees to be on full standby — meaning that the seller won’t be paid back on their note until after the bank is paid.

When getting a business acquisition loan to help with buying a business, you’ll also have to provide a formal business valuation (like we discussed before), explain your relevant experience, offer an updated business plan, and show financial projections for the business under your command. In short, you’ll want to tell a story of how you’ll improve the business.
8. Close the deal with the appropriate documents

The last step in our buying an existing business checklist is to close the deal.

When you’ve finally found the right business, done your due diligence, agreed on a fair price and gathered the capital you need, make sure you (or a broker) have all of these documents, notes and agreements in place before you officially buy a business:
Bill of sale

When buying an existing business, this document will prove the actual sale of the business, officially transferring ownership of the business’s assets from the seller to you.
Adjusted purchase price

This is the final count of the cost of your purchase, including all prorated expenses—like rent, utilities, and inventory.
Lease

If you’re taking over the business’s lease, make sure your future landlord is in the know. On the other hand, if you’re negotiating a new lease, double-check that everyone understands its terms.
Vehicle documentation

Does the business you’re buying come with any vehicles? If so, you might have to transfer ownership with the local DMV — make sure to get the right forms completed by the time of sale.
Patents, trademarks and copyrights

Similarly, when buying an existing business, all patents, trademarks, and copyrights might require certain forms to get transferred to you, the new owner.
Franchise paperwork

Check the SBA’s Consumer Guide to Buying a Franchise to see if you’ll need to file any franchise documents.
Non-compete agreement

It’s standard practice — and generally a good idea — to ask for a non-compete from the former owner. This way, the previous owner won’t set up a competing shop right across the street.
Consultation/employment agreement

This document should be drafted in the case that the seller is staying on as an employee. Make sure to file this agreement if so.
Asset acquisition statement

The IRS Form 8594 will list the assets you’ve acquired, and for how much. This document is pretty important in the “buying an existing business” checklist for your tax returns, so don’t forget it.
Bulk sale laws

Bulk sale laws have to do with the sale of business inventory and are designed to prevent business owners from evading creditors by transferring ownership of the business to someone else. To comply, prospective buyers usually have to notify the local tax or financial authority about the pending sale.

And that’s everything you need to know about how to buy a small business. But knowing how to do it is one thing, knowing why you’re doing it is another. So let’s talk about reasons for buying a business.
Reasons to buy a business

Buying a business is kind of like being in the market for a home. Although some people like the history and character that comes with an older home, others don’t want the baggage that can saddle an older home and prefer something turnkey. Similarly, there are plenty of advantages when you buy a business that’s already been around for a while, but there are drawbacks, as well.
Pros of buying a business
Proven business concept

When launching a brand-new business, the bulk of your time will be spent on the planning phase. You’ll have to write a business plan and figure out how to turn that plan into a reality.

But when you buy a business that’s already up and running, you’ll typically have all of this in place:

A building or office space.

Inventory and equipment.

An established brand and business brand identity (whether or not you want to change it, people know it).

Customer base.

Vendor and supplier base, plus manufacturing resources.

Existing employees who can share their knowledge and expertise.

Management processes and policies.

An understanding of your competition and market.

Granted, each of these things may not be in great condition, and the business might not be turning a profit yet. However, buying an existing business means it has some structure already in place, which will save you time upfront, letting you quickly see what you need to zero in on. Particularly if you’re testing a new market or entering an industry that you don’t have much experience in, zipping past the difficult startup phase can be a huge advantage.
Lower operating costs

One of the major benefits of buying a business is that the operating costs are lower. For example, startup costs for a brand-new restaurant can run upward of $450,000 for initial supplies, food and beverage, signage and a customized kitchen design. With an existing business, your initial operating costs are lower because — unless your acquisition is pretty atypical — many parts of the business are already in place and ready to go once you’re at the helm.

You don’t need to spend as much of your budget on hiring employees, developing marketing strategies or building a customer base because those come with the transaction. Instead, you can pour more cash into expanding the business and adapting it to your vision.
Easier to obtain financing

While the move to buy a business isn’t always a safe bet, lenders and investors see it as lower-risk than launching a new company. This is because there’s a history of financial performance that a lender or investor can use to gauge how the business has performed to date and to predict future performance. Plus, there’s also existing data around the company’s market position, competitors, brand recognition and customer base.

All this makes investors more likely to invest in the business and can make lenders more comfortable in giving you a business acquisition loan. The current owners can even participate in financing the transfer of ownership by giving you a loan.
Intellectual property is on the table

If your business-to-be has patented their products or has a copyrighted slogan or trademarked logo that wins over customers, then that intellectual property value will probably transfer over to you in the acquisition. That means when you buy a business, you sometimes buy more than what the eye can see.

This isn’t on the table with every business acquisition, but it could be critical if you’re dealing with something that you think could be expanded even more. What if you turned this small business into a national franchise? All of a sudden, that patent and copyright becomes a lot more valuable. Patents, copyrights and trademarks are often included in sales of software companies, tech businesses and creative businesses (e.g., music, design and art).
Cons of buying a business
Higher upfront purchasing costs

By buying an existing business, you’ll be able to save money on operating costs, such as inventory and equipment. However, you’ll probably face some pretty sizable purchasing costs. In fact, those purchasing costs might be greater than what it would take you to start a new business.

That’s because, in addition to the obvious assets, you’re also buying ownership over the following:

Customer base.

Built-out brand.

Design work, from logo to store interior.

Business concept and plan.

Time, effort, and money spent testing out products.

Refined processes, procedures and policies.

Income stream (if the business is already profitable).

Assets and equipment.

Intellectual property, such as copyrights, patents and trademarks.

All of these items will be the subject of negotiations between the buyer and seller and factor into the final purchase price when buying an existing business.
Unfamiliarity with the details

If you’re buying a business you didn’t start, you’ll understandably be a bit less familiar with its inner workings and the details of its products, processes, employees and financials than if you built the business yourself. This could be a bit of an obstacle, especially when you’re just starting out. This is especially true if you are entering an industry that you lack experience in. You’ll need to spend a lot of time learning the ropes, and prepare for the learning curve to be steep.
Risk of a hidden problem

As a prospective business buyer, you’ll go through a fairly intensive due diligence process, where you’ll gather information about the business and the current owner. But no matter how much information you uncover, you always run the risk of taking on an issue that you’re not aware of or that’s worse than it appeared. For example, equipment could be damaged, or the brand might have a bad reputation. Once you buy a business, you buy those issues, like it or not.

Evaluating Income Tax Consequences of Sale

[1] Identifying Basic Income Tax Issues

The two income tax issues for the seller arising under federal and California law from the sale of a business are (1) the amount of gain or loss realized and recognized [see [2], below], and (2) the character of the gain or loss as ordinary or capital income [see [3], below].

In the case of an asset acquisition, the sale of a business is not considered the sale of a single unit or interest. Instead, it is treated as the sale of the separate assets that, taken together, constitute the business [Williams v. McGowan (2d Cir. 1945) 152 F.2d 570, 572]. Therefore, the purchase price must be allocated to the separate assets being sold [Rev. Rul. 55-79, 1955-1 C.B. 370].

For further discussion of the income tax consequences of the sale of real property generally, see Ch. 23, Real Property Sales Agreements, § 23.26. For further coverage of the capital gain treatment of specific assets, see Rabkin & Johnson, Federal Income, Gift and Estate Taxation, Ch. 34, Capital Transactions (Matthew Bender).[2] Determining Amount of Gain or Loss

For purposes of federal and state income taxation, the amount of gain or loss recognized by a seller on the sale of any property is the difference between the amount realized from the purchase price (including the fair market value of any note received, or any mortgages or deeds of trust the buyer assumed) that is allocated to the asset, and the seller’s adjusted income tax basis for the asset [I.R.C. §§ 1001(a), (b) (computation of gain or loss), 1011 (determination of adjusted basis); Rev. & Tax. Code §§ 18031 (gain or loss determined in accordance with federal law), 24901(b) (amount realized includes fair market value of other property received)]. Often sellers prefer stock sales to asset sales and the seller can achieve capital gain treatment. Buyers tend to pursue assets sales as discussed below. On occasion a buyer may prefer a stock sale where the target corporation, for example, holds a favorable contractual, lease or property right that cannot be transferred or negotiated. In such cases, a stock sale may be the only alternative for a buyer to keep the contract.[3] Determining Character of Gain or Loss

Determining the character of gain or loss on the sale of a business should reflect the tax interests of the buyer and seller, even though those interests may conflict under certain circumstances. For example, the characterization of gain from the sale of a business as capital rather than ordinary is advantageous for high-income noncorporate taxpayers. For these taxpayers capital gains are taxed at lower rates than those applicable to ordinary income [compare I.R.C. § 1(j)(2)(A)–(E), (i)(2), (3) with I.R.C. § 1(h)]. No similar advantage, however, is available to corporate taxpayers selling a business. For corporate taxpayers, the tax rate for capital gains is the same as those for ordinary income [compare I.R.C. § 11(b) with I.R.C. § 1201]. That said, for federal income tax purposes, corporations are subject to a flat tax of 21 percent [I.R.C. § 11(b)]. Thus, this rate is nearly the same as the individual capital gain rate. Some advantage may be available to the corporate taxpayer if it has capital losses than may be offset only against capital gain [I.R.C. § 1211(a)].

To characterize gain from the sale of a business as capital gain, a seller would allocate as much of the purchase price as possible to goodwill or other intangibles such as trademarks or trade names, going concern value, or covenants not to compete, which are usually treated as capital assets [see I.R.C. § 1221; but see I.R.C. §§ 197(f)(7), 1221(a)(2) (goodwill and other intangibles eligible for amortization are depreciable business assets and not capital assets)].

A buyer, however, is likely to want to allocate the bulk of the purchase price to inventory or depreciable fixtures machinery, or equipment. This allocation provides higher immediate deductions (and more immediate capital cost recovery) either because of an increased cost of goods sold [see Treas. Reg. § 1.61-3(a)] or increased depreciation deductions [I.R.C. §§ 167, 168]. This type of allocation, however, increases the ordinary income to the seller [see I.R.C. § 1221(a)(1), (2) (stock in trade, inventory and depreciable business property are not capital assets)], and thus a natural friction between the buyer and seller. Even though a buyer who acquires goodwill in a business may be eligible to amortize the cost, the 15 year amortization period makes the amortization deduction less attractive than depreciation or cost of goods sold deductions [compare I.R.C. § 197 with I.R.C. §§ 167, 168].[4] Allocating Purchase Price to Each Asset[a] Burden on Parties to Purchase and Sale

Ordinarily, the parties in a purchase and sale have the burden of establishing the amount of the purchase price allocated to each of the assets being sold, including intangible assets such as goodwill. The amount that they allocate to each asset should bear a reasonable relation to the asset’s fair market value [see Rabkin & Johnson, Federal Income, Gift, and Estate Taxation, Ch. 34, Capital Transactions, § 34.03 (Matthew Bender)].[b] Applicable Asset Acquisition

A special method of allocating value among various assets in the sale of a business must be used if there is an applicable asset acquisition [I.R.C. § 1060]. An “applicable asset acquisition” is any direct or indirect transfer of assets in which (1) the assets constitute a trade or business, and (2) the buyer’s basis in the assets is determined wholly by reference to the consideration paid for the assets [I.R.C. § 1060(c); see Rev. & Tax. Code § 18031 (federal income tax law applies in California with respect to the gain or loss on disposition of property—IRC §§ 1001–1092, unless otherwise provided]. A group of assets constitutes a trade or business if use of the assets would constitute an active business for purposes of I.R.C. § 355 (regarding distribution of stock of a controlled corporation)], or if goodwill or going concern value could attach to those assets [Treas. Reg. § 1.1060-1(b)(2)(i)]. A transaction that is part purchase of assets and part like-kind exchange [see I.R.C. § 1031; see also Ch. 24, Exchanges of Real Property] is also subject to these restrictions [I.R.C. § 1060(c)].[c] Treatment of Applicable Asset Acquisition

In the case of an applicable asset acquisition, for purposes of determining the buyer’s basis in the assets and the seller’s gain or loss, the consideration received for the assets must be allocated among the assets in accordance with I.R.C. § 338(b)(5) (relating to stock purchases treated as asset acquisitions) [I.R.C. § 1060(a)]. Under I.R.C. § 338(b)(5), allocation is made by the “residual allocation method,” generally in accordance with regulations under I.R.C. § 338. The seller substitutes “consideration” for ADSP (aggregate deemed sale price) in making the allocation under the regulations, and the buyer substitutes “consideration” for AGUB (adjusted grossed-up basis) [Treas. Reg. §§ 1.338-6, 1.338-7, Treas. Reg. § 1.1060-1(c)].

Allocation—both to each of seven classes of assets, and among the assets within each class—is done according to the gross fair market value of the assets [Treas. Reg. § 1.338-6(a)(2), Treas. Reg. § 1.1060-1(c)(2) ]. To make the allocation, assets are first divided into the following seven classes [Treas. Reg. § 1.338-6(a)(2), Treas. Reg. § 1.1060-1(c)(2)]:

•Class I Assets. Cash and general deposit accounts, including savings and checking accounts [Treas. Reg. § 1.338-6(b)(1), Treas. Reg. § 1.1060-1(c)].
•Class II Assets. Actively traded personal property [see I.R.C. § 1092(d)(1); Treas. Reg. § 1.1092(d)-1, but without regard to I.R.C. § 1092(d)(3)] and certificates of deposit and foreign currency, even if they are not actively traded personal property. Assets in Class II include US government securities and publicly traded stock. Class II assets do not include stock of target affiliates, whether or not of a class that is actively traded, other than actively traded stock described in I.R.C. § 1504(a)(4) (certain preferred stock). This restriction excludes target affiliate stock from Class II when the target holds and 80 percent or greater interest in the target affiliate but a minority interest in target affiliate stock of the same class is actively traded [Treas. Reg. § 1.338-6(b)(2)(ii), Treas. Reg. § 1.1060-1(c)].
•Class III Assets. Assets that the taxpayer marks to market at least annually for federal income tax purposes and debt instruments. These assets include accounts receivable, mortgages, and credit card receivables from customers that arise in the ordinary course of business [Treas. Reg. §§ 1.338-6(b)(2)(iii), Treas. Reg. § 1.1060-1(c)]. Class III assets do not include debt instruments issued by persons related to the target at the beginning of the day following the acquisition date, certain contingent debt instruments [see Treas. Reg. §§ 1.1275-4, 1.483-4; I.R.C. § 988], but not those subject to the non-contingent bond method [see Treas. Reg. §§ 1.1275-4(b), 1.483-4 ] or which involve single nonfunctional currencies [see Treas. Reg. § 1.988-2(b)(2)(I)(B)(2)]), or debt instruments convertible into the stock of the issuer of other property [Treas. Reg. § 1.338-6(b)(2)(iii), Treas. Reg. § 1.1060-1(c)].
•Class IV Assets. Stock in trade of the taxpayer or other property of a kind that would properly be included in the inventory of the taxpayer if on hand at the close of the taxable year, or property held by the taxpayer primarily for sale to customers in the ordinary course of its trade or business [Treas. Reg. § 1.338-6(b)(2)(iv), 1.1060-1(c)].
•Class V Assets. All assets that do not fall in any of the other six classes [Treas. Reg. §§ 1.338-6(b)(2)(v), Treas. Reg. § 1.1060-1(c)].
•Class VI Assets. All Section 197 intangibles [see I.R.C. § 197] except goodwill and going concern value [Treas. Reg. § 1.338-6(b)(2)(vi), Treas. Reg. § 1.1060-1(c)].
•Class VII Assets. Goodwill and going concern value (whether or not the goodwill or going concern value qualifies as a Section 197 intangible) [Treas. Reg. § 1.338-6(b)(2)(vii), Treas. Reg. § 1.1060-1(c)].

The consideration is first reduced by the amount of the Class I assets. Any amount remaining after the reduction is then allocated to the remaining assets [Treas. Reg. § 1.338-6(b)(1), (2), Treas. Reg. § 1.1060-1(c)]. The remaining consideration is allocated to Class II assets in proportion to the fair market value of each Class II asset, then among Class III assets in proportion to the fair market value of each Class III asset, then among Class IV assets in proportion to the fair market value of each Class IV asset, then among Class V assets in proportion to the fair market value of each Class V asset, then among Class VI assets in proportion to the fair market value of each Class VI asset, and finally to Class VII assets [Treas. Reg. § 1.338-6(b)(2)(i), Treas. Reg. § 1.1060-1(c)].

In making the above allocations, the seller and purchaser must each adjust the amount allocated to an individual asset to take into account specific identifiable costs incurred in transferring that asset in connection with the applicable asset acquisition (such as real estate transfer costs or security interest perfection costs). Those costs increase (or decrease, as appropriate) the total consideration that is allocated under the residual method. No adjustment is made to amounts allocated to an individual asset for general costs associated with the overall asset acquisition or with groups of assets (such as non-specific appraisal fees or accounting fees). These costs are taken into account only indirectly through their effect on the total consideration to be allocated [Treas. Reg. § 1.1060-1(c)(3); see Treas. Reg. § 1.1060-1(c)(3)].
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The allocation of consideration is based on the gross fair market value of the assets [Treas. Reg. § 1.338-6(a)(2), Treas. Reg. § 1.1060-1(c)(2)]. To substantiate proper valuation, and to reduce the chance of a successful challenge by the IRS upon a later audit, an independent, expert appraisal of the assets should be obtained near the time of the transaction. An appraisal is especially important when the parties do not have a binding allocation agreement.

Both the buyer and the seller must file IRS Form 8594, Asset Acquisition Statement, with the IRS with the following information about the asset acquisition [I.R.C. § 1060(b)]:

•The amount of consideration to be allocated to I.R.C. § 197 intangibles.
•Any modification of the amount to be allocated to I.R.C. § 197 intangibles.
•Any other information about any other assets transferred that the IRS deems necessary. Regulations require information concerning the amount of consideration in the transaction and its allocation among all assets transferred, and information concerning subsequent adjustments to consideration [Treas. Reg. § 1.1060-1(e)(1)(i)].

Form 8594 must be filed with income tax returns for the taxable year that included the first date assets are sold pursuant to the applicable asset acquisition [Treas. Reg. § 1.1060-1(e)(1)(ii)(A), effective for asset acquisitions occurring on or after March 15, 2001]. When an increase or decrease in consideration is taken into account in a later taxable year, the seller and the purchaser each must file a supplemental asset acquisition statement on Form 8594 with the income tax return for the taxable year in which the increase or decrease is properly taken into account [Treas. Reg. § 1.1060-1(e)(1)(ii)(B)]. An information return must also be filed in certain entity transfers, as discussed in [5], below.[d] Allocation Inconsistent With Allocation in Parties’ Written Agreement

Any agreement between the parties as to the allocation of any amount of consideration to, or as to the fair market value of, any of the assets generally is binding on them [I.R.C. § 1060(a)], unless they would be permitted under existing legal authority [see Commr. v. Danielson (3d Cir.) 378 F.2d 771, cert. denied, (1967) 389 U.S. 858 (the “Danielson Rule”)] to refute the valuation or allocation, as because of mistake, undue influence, fraud, duress, or similar reason. However, the Tax Court has rejected the Danielson Rule in cases appealable to the Ninth Circuit [see Grossman v. Commissioner, T.C. Memo 1988-278 (“petitioners are permitted to submit additional evidence as to the contracting parties’ true intent when entering the contract. However, in order to overcome the written language of the contract, petitioners must show ‘strong proof’ that the terms of the written instrument do not reflect the actual intentions of the parties to the contract” citing G C Services Corp. v. Commissioner, T.C. 406, 412 (1979))]. The IRS, however, may challenge any valuations or allocations if it determines them to be inappropriate [I.R.C. § 1060(a); Treas. Reg. § 1.1060-1(c)(4)].[5] Reporting Requirements for Additional Information

When a seller who is a 10-percent owner with respect to any business transfers an interest in that business and the seller (or a related person) enters into an employment contract, a covenant not to compete, a royalty or lease agreement, or other agreement with the buyer in connection with the transfer, the seller and the buyer must furnish any required information to the IRS [I.R.C. § 1060(e)(1); see I.R.C. § 1060(e)(3) (“related person” defined); see also I.R.C. §§ 267(b), 707(b)(1)]. A “10-percent owner” is any person who holds 10 or more percent, by value, of the interests in the business immediately before the transfer [I.R.C. § 1060(e)(2)(A); see I.R.C. § 1060(e)(2)(B) (constructive ownership rules); see also I.R.C. § 318]. This reporting requirement applies regardless of whether or not the transaction is an applicable asset acquisition that must be reported under I.R.C. § 1060 [see [4][c], [d], above], and, in the case of a stock purchase, whether or not an election is made under I.R.C. § 338 to treat the stock purchase as an asset purchase [House Conf. Rep., Pub. L. No. 101-508, § 11323].