Ten Traps to Avoid When Buying a Business

Ten Traps to Avoid When Buying a Business

Ten Traps to Avoid When Buying a Business

If you are in the early stages of the process of buying a business, there are a few typical issues that always come up in negotiations. I have written previously about the use of a Letter of Intent, which will get the basics in place for the final actual purchase and sale documents. The Letter of Intent (or LOI) is a short document that spells out the important terms and conditions of the sale such as the price, how and when the price will be paid, the assets that will be sold to the buyer (and those the seller will keep), and other terms such as the seller’s noncompete agreement. The LOI allows that parties to put in place a signed document for the basics of the deal so the process can move forward.

Here are ten of the most common “traps for the unwary” for a client buying a small business


If the seller is a corporation or limited liability company (LLC), under no circumstances should you buy stock in the business. Instead, you should offer to buy the assets of the business, and form a separate company to act as the purchaser. Why? There are two reasons. First, you will get better tax treatment, since your “tax basis” in the assets will be the amount you paid for them, rather than the amount the seller paid for them long, long ago. Second, if the seller owes money to people, or is being sued by someone, you will not assume any of those liabilities ifs you buys the business’ assets.


In many states, even if you buy a business’ assets, the state tax authority can come after you if they find out the seller owed sales, use, payroll and other business taxes. If the seller has employees (other than herself), ask if she was using a payroll service, and make sure she is current in her employment tax payments. Then, ask the state tax authority to issue a “clearance letter” saying the seller is current in her sales and use taxes on the closing date. This may take a while, and you might have to postpone the closing a few days until the “clearance letter” issues, but having a “clearance letter” dated the closing date will save your client tons of heartache down the road.


Chances are, some of the customers of the business will owe the seller money on the closing date. Who will be responsible for collecting these overdue debts? There are only two ways to handle this: either you must purchase the accounts receivable at closing (for a discount, to reflect the fact that some of these folks won’t pay up), or you must let the seller collect them at her leisure. Unless there is a compelling business reason to do otherwise, you should buy the accounts receivable at closing.

Why? Because inevitably a customer who owes the seller money will approach you after the closing and ask for additional work. How is the payment for the new work to be allocated between the seller’s account receivable and your payment for the new work you’re is doing? By purchasing the seller’s accounts receivable, you are in a stronger bargaining position to insist that the customer’s “account balance” be cleaned up before any new work is done.


Is the seller leasing the premises where she conducts her business? If so, you should find out (1) how much time remains on the lease term, and (2) whether the landlord is willing to let you assume the seller’s lease “as is,” without an increase in rent. If the lease has only two years or less to run, you might want to spend the money now to negotiate a brand new lease with a five to 10 year term. Also, find out if the landlord is holding a security deposit (usually two month’s rent, but sometimes more)—the seller probably will want you to purchase her Security Deposit on top of the agreed-upon purchase price for the business assets. If the seller is including the Security Deposit in the purchase price, make sure that is spelled out in the Letter of Intent.


Take Yellow Page advertising, for example. When you buy a Yellow Pages ad, you normally pay for a whole year in advance. Chances are the closing of the business sale will take place sometime during the year, and the seller will want to be reimbursed for the portion of the year when your client is running the business and benefiting from the Yellow Pages ad. Prepaid expenses (like the seller’s Security Deposit) are usually not included in the agreed-upon purchase price, but are tacked on at the closing. Ask the seller’s attorney up front for a list of “closing adjustments”—amounts the seller has prepaid that will have to be “pro rated”—so they can be included in the Letter of Intent, you can budget for them accordingly, and there will be no nasty surprises at the closing.


Most states have done away with these, but many states still require the buyer of a business to notify the seller’s creditors that the transaction is going on. Failure to get a list of the seller’s creditors and send “notices of sale” to them may give the seller’s creditors a shot at undoing (or “rescinding”) the transaction in order to prevent the seller’s assets from being sold out from under them. Even if the seller has no creditors at all (a rare occurrence), the state tax authority generally wants a copy of the “bulk sales notice” so it can determine if the seller owes any sales, use or other business taxes on the business assets. If the seller does, she will have to pay them before the closing takes place (see “Ask About Sales Taxes and Payroll Taxes,” above).


Even if your client’s accountant has torn apart the seller’s books and records, sometimes things get overlooked, and you will find herself getting sued because of something the seller did (or failed to do) before she took over the business. Insist on an indemnity from the seller, promising to defend the lawsuit and pay all judgments and fees if that should happen. Likewise, you should be prepared to give the seller an indemnity if she gets sued because of something you do (or fail to do) after the closing takes place.


When you buy a business, you are going to need money to live on after paying the seller, providing for working capital expenses such as payroll, and dealing with the possibility that some customers may be lost once the business changes hands. Unfortunately, many business owners do not report their “discretionary income”—the amount of money they have been taking out of the business to live on after all expenses have been paid—in great detail when preparing their financial statements and tax returns.

When drafting the seller’s representations and warranties regarding financial matters, be sure to include a representation that the “Owner’s Discretionary Income” is at least as much as is reported in the seller’s financial statements and tax returns you reviewed prior to closing—that way any surprises you have will be pleasant ones. Be sure to include a definition of “owner’s discretionary income” in this clause, as this is not a standard accounting term and will have to be defined by reference to specific line items in the seller’s financial statements. For example, a typical definition would read as follows: “owner’s salary + owner’s benefits + owner’s portion of payroll taxes + management fees + personal automobile expense + operating profit/loss, as each of such items appears on the Seller’s income statement for the year ended December 31, 20__ in the form attached as Schedule ___ hereto.” That way there will be at least some assurance that you and the seller will be calculating “owner’s discretionary income” in the same manner, and not comparing “apples with oranges.”

If you are deferring a portion of the purchase price for the business by giving the seller a promissory note at closing, consider adding a clause permitting the buyer to reduce the outstanding principal balance on the note by a specified amount for each month that her “owner’s discretionary income” falls below the amount represented by the seller in the asset purchase and sale agreement.


In many retail and service businesses, the customers have a personal as well as business relationship with the owner. Make sure the seller sticks around for a couple of weeks after the closing to introduce you to customers, help you figure out the books, and “ensure a smooth and orderly transition of the business.” Consider paying the seller for her time so she has an incentive to stay off the golf course, at least until you are comfortable you knows what you are doing.


Likewise, you should take the time prior to closing to make sure the “key employees” are willing to stick around, since they’re often the ones who see the customers day to day, operate all the tricky machinery, and know “where the bodies are buried.” Many sellers will be reluctant to let their employees know the business is up for sale, for fear they will quit en masse the date of the closing and leave you with a business you don’t know how to run. Frankly, you will probably be just as concerned that that doesn’t happen.

In that case, you should put a provision in the sales contract as follows: “Seller and Buyer will announce the proposed sale to all employees of the Business within forty-eight hours before the Closing, and Buyer will be given a reasonable opportunity to meet with each employee individually before the closing date to determine, to Buyer’s reasonable satisfaction, the employee’s willingness to continue working for the Business.” Then add a provision allowing you to walk from the deal if you are not totally satisfied that the key employees will stay on board at least long enough for you to learn what they already know.