Five Steps to Buying a Small Business in New York – Part 3: Due Diligence

(See Part 1 here; Part 2 here; Part 3 here; Part 4 here; Part 5 here😉
Due diligence is the process of investigating the business you are planning to buy inside and out;  lots of files to look at, numbers to crunch and agreements to review.  You want to know that the price you are paying for the business is fair, and that there are no hidden secrets about the business that could haunt you after you become its owner.
Here is a list of the most common issues for investigation when doing due diligence for a small business purchase:

Due Diligence Checklist
1.  Tax Returns
Federal, state and local tax returns for anywhere from 2 to 5 years
past; if the business is subject to sales and use tax, sales and use
tax returns for several years past.  Know this:  In New York, if you
are buying substantially all of the assets of a business, you can be
made liable for any sales tax outstanding from the seller.
 
2.  Financial Statements
Detailed financial statements (income statements, balance sheets) for 3 to 5 years past;
Don’t expect to be presented with “audited” financial statements. “Audited” financial statements are a company’s financial statements that have been prepared and certified by a certified public accountant.  Smaller businesses rarely have audited financial statements, since they are expensive and are not legally required.
Get your accountant to help you with interpreting the tax returns and financial statements.  He or she should check whether there are any questionable accounting practices. You may want to ask the seller for approval to request the tax returns directly from the IRS, state and local tax authorities.  That alone will prevent the seller from cheating you.
The seller may ask you to enter into a confidentiality agreement with respect to the disclosures in due diligence.
3.  Agreements
Lease;  Typical issued to be investigated: Can the lease be transferred?  Do you need the consent of the landlord?  Are the terms of the lease (remaining term, rent) favorable to the buyer?
Supplier contracts, licenses, sales agreements, distributor agreements, non-compete agreements;
Insurance contracts;
Equipment leases;
4. Corporate Documents (or LLC Documents)
Corporation:  Certificate of Incorporation, by-laws, minutes of shareholder and director meetings;
LLC: Articles of Organization, operating agreement, minutes of membership meetings;
If you are buying the entity rather than the assets of the business, you need to check whether the entity is in good standing, i.e. has filed all necessary reports and paid applicable taxes.  In New York, you can order a good standing certificate from the Department of State, Division of Corporations.
5. Licenses and Permits
What licenses and permits does the business require?  If you are buying the assets of the business, rather than the entity, check whether licenses and permits that are being transferred, are assignable.  For example, liquor licenses are not transferable per se, the new operator of the restaurant has to fulfill all requirements for a licquor license and apply for a new license.
6. Asset List
When you are buying the assets of the business, you want to be sure what is included in the asset transfer.  In an entity sale, you similarly want to know what assets there are and what potential liabilities are transferred with them.
Assets may include:
Equipment
Inventory
Intellectual Property
Accounts Receivables
Real Property
7. UCC Liens
Check with the Department of State whether there are liens on any of the seller’s assets that are being transferred.  Liens are preferential rights of creditors in the assets.
8. Tax Liens
If the seller hasn’t paid taxes, the IRS may have put tax liens on the seller’s property.  Check if there are any tax liens in the business’ name.
9. Pending or threatened law suits
Look for any past or pending law suits.  Also, the seller should let you know if anybody has threatened to bring a law suit and make a corresponding representation in the sales agreement.
10. Dun & Bradstreet Report for the business
Check the business’ credit report at Dun & Bradstreet.
11. Violations, Customer Problems
You should find out about violations or customer complaints that have been brought against the business.
12. Employees
List of employees with salary, benefits, other relevant information;
Closing Remarks:
Remember that due diligence varies according to the type of the business you are buying and the structure you choose for the deal. If you are buying the entity in a stock or membership interest sale, you will step into the shoes of the business.  This requires a lot of investigation into the business and its obligations.  If you are only buying the assets of the business, due diligence is somewhat more limited.  For example, if you are only buying the rights to the lease from the seller, there is no need to look at the other agreements of the business.  Similarly, in an asset sale, you are less concerned about the legal status of the entity.
Your attorney’s role in due diligence:
Your attorney is there to help you overcome roadblocks to the transactions that surface in the course of due diligence. For example, if you find that there are liens on the assets of the business, your attorney could incorporate a provision into the sales agreement that requires the seller to pay off such liens on or before closing of the transaction.  Similarly, if one or more of the agreements to be transferred require a consent from a third party, your attorney should make the transaction conditioned upon receipt of such consent.
Stay tuned for Part 4 of this series: Documenting the Deal
If you need help with buying or selling a small business in New York, contact a licensed small business attorney in your area.
Picture courtesy of Juan23for.