Mergers & Acquisitions

Guide to Buying a Business

Prepare for the Closing

The first step in preparing for the closing is completing Morgan & Westfield’s Preliminary Closing Questionnaire. The goal of this document is to ensure a smooth and uneventful closing. Closing the sale of a business can be stressful. Things may not go according to plan when last-minute issues arise (and they almost always do).

Most problems stem from a lack of clarity regarding key transaction terms between parties, such as: Is inventory included in the price? Was the seller’s spouse supposed to sign the non-compete? Is the buyer’s spouse supposed to personally guarantee the note? In this section, we explain how to help avoid last-minute snafus.

Closing Questionnaire

The Preliminary Closing Questionnaire is intentionally redundant. Many questions will not apply or we may already have the answers. Morgan & Westfield compiles all questions into one concise document at the beginning to ensure all terms are mutually agreed upon at the outset and prevent last-minute hiccups or negotiations before the closing.

The Preliminary Closing Questionnaire should be completed as soon as possible. We cannot prepare the closing documents until we receive this questionnaire. You should review this document several times, as consistency and clarity are critical.

Closing Checklist

Once an offer is accepted and due diligence begins, we prepare a “Closing Checklist” and send it to the parties so they can begin preparing for the closing. The Closing Checklist contains detailed instructions for dozens of events that must be successfully orchestrated to ensure a smooth closing.

We suggest tackling these items simultaneously while you conduct due diligence. Some items require waiting periods, such as forming an entity, and must be done regardless of which business you purchase. Starting early in the process will help ensure you close on time.

Contact the Landlord

The lease is one of the most critical elements of the sales process and needs to be carefully orchestrated. Issues around the transfer of a lease make this a common deal killer, so the process must be handled with care.

Landlord’s Cooperation

The transfer of the lease is not guaranteed to be easy, and delaying the landlord’s involvement can create issues that delay the closing or prevent it altogether. We recommend that the seller involve the landlord in the process as early as possible. It is important to gain the landlord’s cooperation and let them feel comfortable about the transfer of the business. They can stall or withhold the lease transfer if they feel the buyer is not qualified.

Ask the seller to ask the landlord what the most important qualifications are for a new tenant (such as experience, credit score, financial strength, etc.) and address these in your presentation to the landlord. Prepare a resume and financial statement, fix any blemishes on your credit report in advance, if necessary, and otherwise position yourself in the best light possible for the landlord.

Is the landlord’s consent required to assign the lease?

Yes, nearly every commercial lease requires the landlord’s consent to assign or sublet the lease. We recommend involving the landlord as early as possible in the process.

When should the seller contact the landlord about transferring the lease?

The earlier, the better. If sellers wait too long to inform the landlord, they run the risk that the landlord may refuse the transfer of the lease. Contacting the landlord upfront will reduce this concern and will help ensure the landlord is flexible and agrees with the terms of the transfer.

What is an “assignment” of the lease?

The assignment of a lease means the lease is transferred to the buyer while the seller remains on the lease as a guarantor. If the seller assigns the lease to you, there can be a fee of $500 to $5,000 or more. The fee varies by landlord.

How is the security deposit handled?

Landlords often keep the seller’s security deposit, and you reimburse the seller for the deposit.

What is a sublease?

In a sublease, there are two leases: One is for the landlord to the seller (master lease); the other is for the seller to you (sublease). Most leases do not allow a sublease.

The Role of a Landlord When Buying or Selling a Business

Transferring the Lease When Selling or Buying a Business

Purchase Agreement

Unlike a letter of intent, which is a non-binding, preliminary document, the purchase agreement is the final agreement to be signed before or at the closing. The purchase agreement replaces any previous agreements, such as a letter of intent or an offer to purchase.

Who Drafts the Purchase Agreement

The purchase agreement is commonly drafted by the buyer if the buyer is a private equity group or other company. We often draft the agreement on behalf of the buyer if the buyer is an individual or a smaller company. If so, we begin preparing the purchase agreement during due diligence and send it to the parties for review before the closing.

Signing the Purchase Agreement

The purchase agreement is sometimes signed before the closing occurs. However, change of possession of the business does not happen until closing occurs. If the purchase agreement is signed prior to closing, contingencies may remain. These contingencies could include denial of approval by key third parties such as the financier, lessor, franchisor, or licensor. If these contingencies are not satisfied, the sale is canceled.

M&A Purchase Agreement | A Complete Guide

Allocation of Purchase Price

Allocating the purchase price or total sale price of a business among the various assets of the business (asset “classes”) is necessary for tax purposes when a business is sold. This is the case regardless of whether the sale is structured as a stock sale or an asset sale.

IRS Form 8594

The IRS requires that both the buyer and seller allocate the purchase price among the various assets of the business being purchased. An agreement is required because both of your allocations must match and be entered on IRS Form 8594.

This form must be filed with the tax returns for the buyer and the seller at the end of the year. While there is no legal requirement that the buyer’s and seller’s allocations match, most tax advisors agree that a match will decrease the chances of an audit.

Classes/Categories on IRS Form 8594

IRS Form 8594 breaks down the assets of the business being purchased or sold into seven classes or categories. Each type of asset is treated differently for tax purposes.

Specific allocations are referenced on the IRS form and are broken down as follows:

  • Class I: Cash and Bank Deposits
  • Class II: Securities, including Actively Traded Personal Property & Certificates of Deposit
  • Class III: Accounts Receivables
  • Class IV: Stock in Trade (Inventory)
  • Class V: Other Tangible Property including Furniture, Fixtures, Vehicles, etc.
  • Class VI: Intangibles (including Covenant Not to Compete)
  • Class VII: Goodwill

Stock vs. Asset Sales: Where stock sales are concerned, the majority of the purchase price is normally allocated to the value of the stock, with the remainder allocated to the value of any non-competition agreements, consulting agreements, or any other assets that are personally owned by the seller and not the entity.

Common Allocations

Class I: Cash and Bank Deposits

  • Allocation: None.
  • These assets are not normally included in the purchase. If they are included, they are listed at face value.

Class II: Securities, including Actively Traded Personal Property and Certificates of Deposit

  • Allocation: None.
  • These assets are not normally included in the purchase. If they are included, they are listed at face value.

Class III: Accounts Receivables

  • Allocation: None.
  • These assets are not normally included in the purchase for smaller transactions. The seller normally retains ownership of the accounts receivables, and the buyer receives the outstanding payments and remits them to the seller post-closing. If they are included, they are listed at face value.

Class IV: Stock in Trade (Inventory)

  • Allocation: Normally valued at the seller’s original cost.
  • As a result, there is no gain for the seller and, therefore, no tax due on the amount allocated to this asset.

Class V: Other Tangible Property including Furniture, Fixtures, Vehicles, etc.

  • Allocation: Normally valued at current market value, often “replacement value.” Note that the buyer may have to pay sales tax on the amount allocated to this class of assets.
  • Any gain on the sale of tangible property is taxed based on ordinary income rates to the seller, and the buyer can begin to depreciate these assets based on their stepped-up value.

Class VI: Intangibles (Including Covenant Not to Compete)

  • Allocation: Normally less than a few percentage points of the purchase price.

Class VII: Goodwill of a Going Concern

  • Allocation: The balance of the purchase price is normally allocated to goodwill.
  • Goodwill is treated at capital gains tax rates for the seller, and the buyer can amortize goodwill over a 15-year period.

Once the parties agree to the allocation, the allocation is usually attached as a schedule to the purchase agreement and signed at closing. The parties then file IRS Form 8594 at year-end, ensuring that IRS Form 8594 matches the allocation provided in the purchase agreement.