Fundamentals of Buying a Business

Buying a business requires due diligence. Due diligence is a term regularly tossed around, but what does it mean? Merriam-Webster defines due diligence as: business: research and analysis of a company or organization done in preparation for a business transaction (such as a corporate merger or purchase of securities)

There are several fundamental points to review prior to finalizing the purchase of any business. A person buying a business in Sacramento should consider several provisions for their purchase agreement and thoroughly review financial documents. Considerations and due diligence include, for example, a fluctuating purchase price, a non-compete provision, performing a lien search, incorporating seller guarantees, negotiating the commercial lease, and a thorough review of the company's financial history.

Accounting for Inventory in the Purchase Price

A person selling a swimming pool cleaning route should continue to service the swimming pools pending the sale of the business. The amount of chemicals and chlorine in stock will fluctuate as the seller continues to operate. A person buying a sandwich shop will want to account for napkins, toiletries, ingredients, and 'useable' inventory.In essence, a person buying a business should only be purchasing the inventory that is available on the day of closing.

A person buying a business will need to account for on-hand inventory at the close-of-escrow. This is accomplished by conducting a physical count of the inventory, which is typically sold separately from the purchase price with a maximum capped value.

Non-Compete Provision

An individual buying a business should always consider the option of including a non-compete provision. Its important to prevent a selling small business owner from opening the exact same business down the street. The public is generally told that non-compete provisions are invalid in California; however, this is not always the result. The general rule in Business and Professions Code section 16600 prohibits covenants not to compete providing that every contract by which anyone is restrained from engaging in a lawful profession, trade, or business of any kind is to that extent void. Fillpoint, LLC v. Maas (2012) 208 Cal.App.4th 1170, 1182. There are exceptions to this general rule. For example, compare an employment non-solicitation agreement with a non-compete provision attached to a business sale. Business and Professions Code section 16601 protects covenants not to compete entered into in connection with the sale of the goodwill of a business. Covenants not to compete are permitted with the sale of a business, but there are limitations and they cannot be overly broad.
Any person who sells the goodwill of a business, or any owner of a business entity selling or otherwise disposing of all of his or her ownership interest in the business entity, or any owner of a business entity that sells (a) all or substantially all of its operating assets together with the goodwill of the business entity, (b) all or substantially all of the operating assets of a division or a subsidiary of the business entity together with the goodwill of that division or subsidiary, or (c) all of the ownership interest of any subsidiary, may agree with the buyer to refrain from carrying on a similar business within a specified geographic area in which the business so sold, or that of the business entity, division, or subsidiary has been carried on, so long as the buyer, or any person deriving title to the goodwill or ownership interest from the buyer, carries on a like business therein.

Business and Professions Code §16601.

Lien Search and Marketable Title

The California Secretary of State provides services for Uniform Commercial Code ("UCC")  inquiries. A UCC filing gives the public notice that a creditor has an interest in personal property of a debtor. A creditor accomplishes the notice by filing Form UCC-1. A person buying a business in Sacramento should consider performing a UCC search for any filings involving the seller or the seller's business. Meeting a surprise creditor shortly after purchasing a business would be terrible. Hence, its also good practice to search UCC Connect for UCC inquiries and filings.

A buyer can help protect themselves further by including a provision in the agreement that all tangible property is valid with marketable title free of liens and encumbrances. 

Seller Guarantee

Buying a business that consists of multiple customer accounts can be disastrous. For example a swimming pool cleaning route or financial services firm are based on multiple accounts. These accounts can be lost during the transition. Individual accounts may choose to go with another business because their relationship was with the seller. A buyer can better protect their financial investment in buying the business by including a seller guarantee. For example, the parties agree to a particular value for each account and fifteen percent of the purchase price remains in escrow pending the full transition in ninety days. Any accounts lost during the transition period will be reimbursed to the buyer at the value agreed upon. A seller guarantee is a great option for the buyer to help finalize a potentially troublesome deal.

No Discounts or Promotions

A person selling a business in Sacramento might have offered promotional discount programs shortly before listing the business. An example of a promotional discount is a Groupon or Living Social deal where the third-party buys a $50 gift certificate for only $30. This can cause tremendous issues for the person buying the business because they will be obligated to honor the deals. Its a good idea to include a provision in the purchase agreement where the seller covenants that no discounts or promotional deals were offered in the last six months.

Commercial Lease

The lease agreement is one of the most important facets of buying a business. Buying a business that is currently on a month-to-month lease is a terrible idea because the buyer could be evicted at any time.

Questions to ask about the commercial lease before buying a business:
  • How many years are left on the lease?

  • Are there options to extend the lease?

  • Are there additional costs, such as common area maintenance ("CAM")?

  • Does the landlord pay for janitorial services?

  • Does the landlord pay for exterior problems, such as roof, foundation, exterior walls, graffiti, etc.?

  • Does the landlord pay for interior cosmetic problems?

  • Does the lease incorporate annual rent increases?

  • Did the seller take advantage of free rent that may need to be repaid in the event the lease is terminated?

Financial History

The financial history of the business will provide insight into the operating costs and revenues of the business. Checking itemized bank statements can help the buyer to discovery any additional costs in the commercial lease, such as common area maintenance ("CAM"). Bank statements will also reveal more information than profit and loss statements, which can be tampered or altered.

Generally, a person buying a business in Sacramento should review all financial documents of the business including, but not limited to:
  • Bank Statements

  • Statements from Merchant Services

  • End-of-Day Receipts

  • Profit Loss Statements

  • Balance Sheets

  • Income Statements

  • Tax Returns

Sacramento Attorneys on Buying A Business

There are several of provisions that should be considered when buying a business. These fundamentals are a starting point for conducting due diligence and protecting the buyer's interests in the purchase.

Please feel free to contact Sacramento's business attorney if you would like assistance with buying a business. Our attorneys have assisted countless companies in purchasing small to medium sized businesses. Learn more about the business law services.

Call Us: (916) 669-8400

Buying a Business
*The information provided in this post does not constitute legal advice or opinion. The information is for guidance purposes only. Individual situations vary and you should contact an attorney for legal advice. Rooted Legal PC includes attorneys who are well-versed in business law matters and are located in Sacramento California. There is not intended to be a full list of items to include or exclude in a business purchase agreement.