Before You Buy a Business

In a previous post, we discussed the five items that a seller should consider before they sell their business. Today we look at five other items, but from the buyer’s perspective.

#1 – The Purchase Price

As lawyers, we typically do not comment on the purchase price. The purchase price is determined between the parties, and we presume that the purchase price is bona fide and at fair market value when the parties are at arm’s length. That said, the buyer should conduct their own due diligence in assessing where the value is in the business. For example, is the value in the business in the:

• the tangible assets, such as the equipment and the inventory?
• the trademark?
• the “know-how”?
• the goodwill?
• the location of the business from which it operates?
• the prospect of future contracts?

Consider if the departure of the seller would impact the value of the business. This is usually the case if the skillset and personal relationship between the seller and the customers are particularly strong. If the seller’s presence is tied directly to the value of the business, consider negotiating with the seller for a longer transition period during which the seller can help you build new relationships with the customers and pass on to you their skill and goodwill.

#2 – Funding for the Purchase Price

The purchase price is usually satisfied by the buyer as follows: (1) all cash, (2) payments made over time to the seller, or (3) loan from a third-party (such as a bank). If the source comes from the latter two, the buyer often will be asked to provide a personal guarantee on the loan. The buyer should always try to negotiate in capping their personal liability so that it is not unlimited. Liability can be limited either by duration or by monetary amount. The lender, of course, would push really hard to not have any cap, but our view is that you never know until you ask; the buyer has a lot more leverage if repayment is financed by the seller and the seller is desperate to sell the business.

#3 – How do you want to own the business?

There are various business structures through which you can own a business, such as a limited company, partnership, joint venture, or sole proprietorship. For everyday small businesses, limited company or sole proprietorship are the most common ownership structures. Partnerships and joint ventures are usually industry specific or project specific.

Owning a business through a limited company is common because of the “corporate veil” that shields owners from personal liability. Absent of fraud, your liability would be limited to your investment in the company (losing any money you paid for the shares or otherwise invested into the company). The other benefits of a limited company are tax related, of which there are many. We’ll look at two of the big advantages. Firstly, companies pay tax only on their net income, whereas sole proprietorships pay tax on their gross income. Companies also often pay a lower tax rate on money left in the company year-over-year, whereas all earnings of a sole proprietor are taxed and usually at a higher rate. Secondly, ownership of a company opens the possibility of using the lifetime capital gains tax exemption (“LCGE”) if you were ever to sell the business by way of selling the shares of the company. When selling ‘qualified small business corporation’ shares, the profit that you make can be tax-free if certain pre-conditions are met. The disadvantage with having a limited company is that it adds a layer of administrative complexity and is more expensive to upkeep than a sole proprietorship.

Another common way that you can own a business is through sole proprietorship. You don’t get the benefit of personal liability protection as you do through a company, but you save on the annual upkeep costs. This is attractive only for business owners who are just starting off and do not want to incur too much expenses at the outset, and for businesses where there is little liability risk and all of the revenue needs to be used as income for the owner.

#4 – Shareholder’s Agreement

If you own a business through a limited company, and the company has more than one shareholder, then you will want to consider having a shareholder’s agreement. Shareholder’s agreements should be customized based on the nature of the business and the relationship and expectation between the shareholders. But fundamentally, the shareholder’s agreement needs to have a road map for dispute resolution so the parties avoid going to court when the relationship breaks down. Our blog posts here and here talk more about shareholder agreements.

#5 – Tax Advice

No matter what you decide on your business structure, you should always speak with your accountant before entering into an agreement to buy a business so you understand the tax implications, and whether there are optimal structures for reducing taxes. For example, maybe your accountant would suggest advancing funds to your limited company by way of a shareholder’s loan instead of a subscription price, allowing you to withdraw the first profits as a loan repayment (tax-free) rather than as a dividend (which is usually taxable). Or your accountant might suggest that you structure the corporate ownership on a tiered basis, such that you own 100% of a holding company, and your holding company owns 100% of an operating company (and the operating company be used to make the business purchase) to plan for the future expansion of the business with multiple locations.

If you need legal help in buying a business, we are here to help!