San Diego Business Lawyer Blog

November 8, 2010

Due Diligence When Purchasing a Business – Part One

The process of investigating a business for sale is commonly referred to as “due diligence”. In layman’s terms, “due diligence” is essentially the exercise of common sense, and it is the difference between the beginning of a successful venture and a complete disaster. Proper due diligence requires a thorough evaluation of the company’s business, its history and its finances, and it is best conducted with the assistance of a team of professionals including a lender (or lenders), an appraiser, an accountant (preferably a CPA) and a lawyer.

“Due diligence” starts with an understanding of the industry. It’s important to learn as much as possible about the industry’s fundamentals including operations, manufacturing processes, suppliers, current and historical markets, customer preferences, local and national competitors, marketing methods and anything else relevant to the industry. Wise purchasers look for businesses where they have an aligned interest or expertise. Once you have a clear picture of the industry you can better evaluate the specifics of the prospective purchase.

The next step is to examine the business for sale, starting with its financials. This is best done with the assistance of an accountant. The review should include an in depth analysis of the company’s records including but not limited to its current balance sheets, profit and loss statements, financial audits, accounts payable and receivable, debts (secured and unsecured) and information pertaining to any liens on debt, and the company’s tax returns for the past five years. Check, or have your attorney check, with the County Recorder’s office for undisclosed liens and UCC-1 filings (filings made by creditors with loans secured by the company’s assets). Ask the following important questions: What does the revenue stream look like? How has it changed over time? How about expenses?

November 2, 2010

Why Oral Partnerships Are a Bad Idea

by Donald Oder

In this writer’s experience, the most common cause of business failure is the lack of a written agreement between partners. No one ever enters into business with a friend or trusted associate thinking that the deal will collapse around them. Yet, business relationships routinely run into difficulties, and without a written contract defining the contours of the relationship, the difficulties are often destructive. Even minor disputes result in financial ruin for unwary partners who had vastly different expectations regarding the minutia of the business relationship. Moreover, partners expose themselves to substantial liability for the debts incurred by their partners on behalf of the partnership and for the conduct of their partners.

Partnerships are complex and demand serious commitment much like any business relationship, whether a corporation, limited liability company or other formal business entity. Along with the financial resources necessary to start up the partnership, partners invest their time and energy. In most cases, they make a personal and emotional commitment to the venture hoping for significant financial reward. This personal investment makes it all the more difficult to deal with the inevitable conflicts. The key to success is planning and this starts with a well drafted partnership agreement.

People often start out in business together with nothing more than a hand shake, but they rarely anticipate the number and variety of decisions they will have to make moving forward. It is common for young partners to exhibit flexibility in the beginning but as businesses grow or struggle, the decisions become more complex and more important and partner flexibility starts to wane. If the partners cannot agree on key decisions, the partnership falls apart. See “Ending Bad Partnerships“. Without a well drafted written agreement, the partners have no mechanism for operational continuity or for winding up the company’s affairs. Will one partner be bought out? If so, for how much? How should the business be valued? If both partners wish to continue, who will retain the company’s assets, including the company’s name, website, location and customer lists? If both partners have personally guaranteed a lease, how will the exiting partner be relieved of his obligations? What other continuing debt obligations will the exiting partner retain? If the partners decide to dissolve the partnership, how will the company’s debt be paid? How will the remaining assets be divided? Who will be responsible for winding up the company’s affairs? What if one partner abandons a failing business entirely and disappears? What recourse does the remaining partner have to recover losses? A well drafted partnership agreement will set forth mechanisms to deal with such contingencies.

October 25, 2010

Purchasing Existing Businesses In San Diego, Part Two

by Donald Oder

Continued from Considerations When Purchasing a San Diego Business, Part One.

The Valuation: Add your own critical assessment to the appraiser’s valuation by personally reviewing the company’s records. For small businesses, the valuation can be done without the assistance of an appraiser if necessary. The process of conducting a thorough valuation will be discussed in a follow up article. Either way, think about the intangibles. Will there be a future market for the goods or services provided? Will the company maintain the same goodwill with existing customers that the current ownership enjoys? Is there a likelihood that competitors will open up in the same geographic area? Is there a potential for a shock to costs such as a shortage of a key ingredient or an anticipated new law that will increase licensing fees and/or taxes? The fact that a business enjoys a positive revenue stream today doesn’t guarantee a future revenue stream.

Compare Other Options: It is common for prospective purchasers to fall in love with a particular business (much like first time home buyers). Recognize that the temptation is there, and look for other options, or if you are working with a broker ask that they provide several options. You may ultimately decide to go with the first business, but at least you have done so after comparing its value with other companies. Where possible, try and perform your own valuation before paying a professional appraiser. Narrow the field first, and then pay a professional to be sure you have chosen wisely. In addition, there’s no reason not to consider starting a brand new business if you have the expertise in a particular area. Put a lot of time and thought into your initial decision before committing your time and resources to a new venture.

October 19, 2010

Considerations When Purchasing a San Diego Business, Part One

by Donald Oder

As with any new venture, the purchase of an existing business is fraught with risk. Is the business viable? Does it have growth potential? What are its hidden weaknesses? Is the purchaser experienced enough in the company’s business? Is current goodwill and reputation dependent on existing ownership? Is the revenue stream consistent? The list of questions is endless. Ultimately, the decision rests on the purchaser’s due diligent efforts at valuing the business. This article briefly addresses some important considerations:

The Seller is the Seller: Whatever the business and whoever you deal with, whether directly with the seller or a broker, the seller is determined to get the most value for their business. Aside from their financial investment, most sellers have poured their hearts and souls into the business. Either way, you can be sure that the product is going to be pitched in the light most favorable to the seller. Avoid being lured in by “pie in the sky” stories of marketing genius, unlimited revenue and unreported incomes. Take everything at face value and let the professionals (an appraiser and/or a CPA) give you a frank assessment of the stream of earnings you will be purchasing. Even then, it’s wise to assume there are skeletons in the closet. Look for clues. If you have uncovered a minor misrepresentation, it might be a clue that they are hiding bigger secrets. Rely on your common sense and gut feeling about the seller and his or her representatives.

Funding: Marshaling the resources needed to purchase a business is not as prohibitive as many imagine. In fact, it is possible for some, especially those with good credit, to purchase an existing business entirely through seller financing. While the chances of obtaining 100% seller financing might be slim, seller financing of a portion of the sales price is common. Sources of funding include personal savings, asset backed loans, business loans and seller financing. Prospective buyers can expect to pay a 20% to 30% down payment on a business loan and sometimes a higher percentage for seller financing. However, a large cash layout isn’t always necessary. The Small Business Administration (SBA) can assist with loans of all sizes with as little as 10% down, and sellers are often more flexible than expected. Diligently investigate options and shop around for the right deal for you. You might be surprised at how low the sales price is for many businesses. The key is to think creatively about funding the purchase. Explore all options and combine the most attractive and practical sources.

October 11, 2010

Purchasing an Existing Business Offers Benefits Often Overlooked

by Donald Oder

San Diego has seen a steady stream of young entrepreneurs starting up their own businesses over the last few years. This is in large part attributed to the collapse of the financial markets and the ensuing recession. Professionals in transition and the recently unemployed see starting their own business as an alternative to the continued disappointment they face in a tight job market. An often overlooked alternative is to purchase an already proven business. The idea perhaps gets little consideration. In reality, purchasing an existing business is not that far out of the reach. The option should at least be on the table for anyone thinking about starting a new business. With numerous financing options available, many businesses can be purchased with the same up front capital typically necessary to start a new one.

In general, purchasing an existing business is less risky. It doesn’t matter whether one is purchasing a contracting business or a law firm. An existing business has a proven track record. It has developed a strong customer base and good will in the community; has invaluable systems in place for operations, accounting and employee management; and has reliable and trusted vendors, suppliers and professional advisors. The purchaser takes over an operation that is already generating profits. Of course, the quality of the existing business can vary widely. Ensuring that the business is viable requires an in depth analysis of the company’s history and finances, or what attorneys call “due diligence“. The importance of a “due diligent” examination of a prospective business cannot be overstated, and will be discussed in more detail in a follow up article.

The point of this article is to highlight the benefits of purchasing an existing business and to inform prospective entrepreneurs that the alternative is feasible. It seems that the biggest barrier to entry is an erroneous belief that purchasing a business is too costly. People tend to see the buying and selling of businesses as a game played by large investors. It is not. Individuals motivated to go into business for themselves can and do buy existing companies. They do so by marshalling personal resources, securing investment, securing seller financing, taking out business loans, and/or resorting to other creative financing. In some cases, the purchase of an existing business is entirely financed by the seller.

September 17, 2010

Geographic Considerations in Choosing a Franchise

by Donald Oder

The decision whether to purchase a franchise requires thoughtful consideration of numerous factors. It is common for prospective purchasers to be blinded by the success of the franchise’s national reputation. A national reputation with hundreds of profitable locations, however, does not guarantee that every potential location will be profitable. Before making the decision to buy a franchise, prospective franchisees should carefully examine the demographics of the proposed location.

Take for example, a successful franchised sandwich shop located in Chula Vista‘s Terra Nova Plaza at the intersection of East H Street and the 805 freeway. This is a high traffic location that some commercial tenants have classified as an “A” center. While this is a hypothetical example, there can be little doubt that a national franchised sandwich shop in this mall will be profitable, perhaps extremely profitable. Put that same franchise in one of Chula Vista’s Eastlake or Otay Ranch shopping areas and you will almost certainly show a different result. While these communities are rich, diverse and beautiful, they have suffered greatly from the current struggling real estate market. This writer is convinced that Eastlake and Otay Ranch will recover and thrive, but for now business owners in the area have accepted their reality. This is not to say that the national franchised sandwich shop cannot be successful there. It merely is to suggest that a prospective franchisee would be unwise to move forward without seriously considering this economic reality.

Of course, this example is dependent on recessionary factors. Other demographics may prove important to the sandwich shop’s success. There may be less demand for a sandwich product in minority communities like San Ysidro and more upscale communities like La Jolla. It will also likely be more successful in high traffic business centers such as downtown San Diego. The point is to evaluate the demographics before assuming the franchise will be successful.

September 8, 2010

To Franchise or Not To Franchise

by Donald Oder

As with the purchase of any business, purchasing a franchise in San Diego requires careful consideration of the company, its operations and profitability and the economic climate. Franchise opportunities abound and they offer purchasers the unique ability to operate a business using an existing and successful business model. With proven systems already in place, it is generally easier to operate a franchise than to start a new business. However, the franchise model does not guarantee success. Different markets, unfamiliarity with the business type, economic swings, geographic differences and other factors can combine to ensure failure in one locality where another thrives. This article briefly addresses some of the more important considerations prospective purchasers should look at before making the decision to buy a franchise.

Most importantly, the prospective purchaser should learn as much about the franchise as possible. It is important to analyze the franchise disclosure carefully, to contact existing franchise owners and to visit the franchise headquarters. Ask the following questions: How many individual franchises are there? What type of training is offered? What is the company’s reputation? What are the typical profit margins? What are the company’s plans for growth? The answers to these questions help to inform the ultimate decision. In addition, the prospective purchaser should perform its own a market analysis. An independent evaluation will look at the uniqueness of the product or service, the vulnerability of the business to market fluctuations and the franchise’s historical profitability. If a thorough independent evaluation isn’t practical, at least take a look at the differences and similarities between the proposed location and other successful locations. If the demographics are completely different, it could be a red flag requiring heightened scrutiny.

Armed with an in-depth understanding of the business model, the prospective purchases can next consider whether the purchase of the particular proposed franchise makes sense for them individually. What level of expertise do they have in the particular business? What kind of start-up capital is required and how might they raise it? What are the franchise fees and will the profit margins be high enough to cover them? How long will it take to recoup the initial franchise fees? What is the term of the franchise agreement? What are the franchise’s operational requirements? What about leasing obligations? It isn’t wise to take short cuts when answering these questions. Where possible, enlist the services of an accountant, business attorney and/or financial advisor with experience in assisting clients with franchise businesses.

September 3, 2010

Trade Secrets – Protecting Customer Lists

by Donald Oder

San Diego businesses typically invest significant resources in the development of customer lists, but often fail to adequately protect them. Companies may believe that such lists are automatically protected “trade secrets”. However, without affirmative steps designed to ensure that confidential lists fit within the definition of a trade secret, customer lists are at risk. In California, customer lists are considered trade secrets if the lists are valuable because they are kept secret (information that “derives independent economic value, actual or potential, from not being generally known to the public or to other persons who can obtain economic value from its disclosure or use”), and if the business takes reasonable steps to protect the lists. The greatest risk comes from the company’s employees. In order to maximize protections, companies should take the following affirmative steps:

Maintain physical security: Customer lists should be isolated from other company information and clearly labeled “Confidential”. Computer files containing customer lists should be password protected and each file marked “Confidential”. When computer lists are accessed, the computer should flash the user a confidentiality reminder. Hard copies should be kept under lock and key with the cabinet and individual files clearly labeled “Confidential”. In addition, employee access should be limited to those employees that actually need it. These physical security measures serve as a constant reminder to employees and others that the company’s customer lists are indeed confidential.

Require non-disclosure (confidentiality), non-compete and non-solicitation agreements: Require employees to sign non-disclosure, non-compete and non-solicitation agreements. Requiring employees to sign non-disclosure agreements puts them on further notice that the company’s customer lists are confidential. It’s important that the non-disclosure language specify the company materials intended to be confidential. Courts are inclined to strike contract language that is too broadly worded. Non-compete clauses limit an ex-employee’s ability to hire on with competitors. Such clauses are generally unenforceable in California. This is because courts are reluctant to place restrictions on an individual’s ability to seek new employment. However, their inclusion in employment agreements can affect how departing employees behave. Where enforceable, non-compete clauses are typically limited in time and geographic scope. Non-solicitation agreements are less burdensome than non-compete agreements and therefore are more readily accepted by courts. In non-solicitation agreements, employees agree not to solicit a company’s existing customers or prospective customers. Whichever state your company resides, it is important to have your attorney carefully draft non-disclosure, non-compete and non-solicitation language to ensure enforceability.

August 31, 2010

Understanding Your Lease – Common Area Expenses

by Donald Oder

Common Area Expenses (or CAM expenses) are nothing new in the commercial leasing business. However, new business owners are often caught off guard by the thought of the additional expense that sometimes is as high as the base rent itself, especially where there is so little control over how the expenses are managed. Leases that require tenants to pay common area expenses (including property taxes and insurance) are called triple net leases. It is common these days for landlords to pass on every imaginable expense to its tenants. So long as the landlord is passing on legitimate expenses that are necessary for the operation and maintenance of the common areas, there is nothing inherently wrong with the practice. However, prospective tenants should work closely with their attorney to carefully review the proposed lease terms to ensure they have a complete picture of the potential liability and that the landlord isn’t using the CAM charges as an additional source of revenue. Ideally, tenants will negotiate for a gross lease that is inclusive of all landlord expenses. However, in most cases negotiating for a gross lease is difficult (if not impossible). Where a net lease is your only option, the following is a list of important considerations:

Leasing Opportunities2.jpg

Pro Rata Share: A tenant’s pro rata share of common area expenses should be determined based on the tenant’s leased square footage compared to the commercial property’s gross leasable space, not “leased” space. In other words, the pro rata share is determined based on 100% occupancy. Landlords often seek to defer costs associated with empty space and will try and include lease language that calls for CAM charges to be calculated based on the square footage of “leased” space rather than “leasable” space. Tenants should seek to amend such language so that the landlord absorbs the expenses associated with empty space.

Audit Rights: Tenants should try and negotiate for the right, upon reasonable notice, to audit the landlord’s accounting records. Such clauses are common in commercial leases and allow tenants to ensure that the common area expenses are calculated correctly. Look closely at the lease language as these clauses typically set forth specific procedures for examination of records and for resolution of disputes. Sometimes leases limit the frequency of tenant audits. The more often you are allowed to audit, the better. At the very least, tenants should have the right to audit accounting records once a year within six months of reconciliation (the time landlords reconcile actual expenses with estimated expenses).

Management Fees: Management fees are common, especially in the retail setting. The practice is prevalent and prospective tenants should ensure that the lease clearly defines what the management fees are and how they will be calculated. Management fees should not exceed three percent of the property’s gross receipts, and shouldn’t include expenses for off-site personnel and overhead. In some cases, landlords seek both administrative and management fees. While this may be appropriate in some circumstances (i.e. landlord hires a separate management company to manage the property), it’s important to clearly understand exactly how these fees are delineated and to make sure that the landlord isn’t double dipping. Try and negotiate for limits on management fees.

Clearly Defined Expenses: Ensure that the common area expenses are clearly defined in the lease. Vague and ambiguous language that doesn’t spell out precisely what expenses will be included in CAMs leave tenants open to excess costs.

August 20, 2010

Piercing the Corporate Veil

by Donald Oder

“Piercing the Corporate Veil” is a well-known phrase. To the average American, it conjures up visions of corporate giants being slain by David. This pejorative understanding has little practical value in today’s business world. In fact, “piercing the corporate veil” (holding the principals of a corporation or limited liability company liable for the debts of the company) is an all too real legal principle for entrepreneurs concerned with protecting their personal assets from the liabilities of their business. Incorporation law has developed to encourage business development and risk taking. Limiting owner liability (whether of individual owners or of parent companies) furthers this goal. However, there are limitations to the protections provided. First, it’s important that companies fully comply with the legal formalities required to maintain their business entity to ensure personal insulation. Second, the corporate veil may be pierced where one forms a corporation or LLC for the purpose of insulating personal assets, insulating the assets of another business or for some other unjust purpose.

The Deal.jpg In California, courts will pierce the corporate veil when two requirements are met: 1) the Court finds unity of interests (the shareholders, or owners in the case of an LLC, treat the corporation as an alter ego) – this happens when shareholders treat the assets of the corporation or LLC as their own and/or use corporate funds to pay their private debts; and 2) the Court finds that allowing shareholders to dodge personal liability would sanction fraud or promote injustice.

To answer these questions, courts look at numerous factors including: whether the shareholders/owners acted in bad faith; whether individual contracts were entered into with the intent of avoiding performance and hiding behind a corporate shield; whether assets have been diverted to the detriment of creditors; whether there is ownership and control of the entity by a few key individuals; whether the shareholders/owners and the corporation share the same office or business location; whether the shareholders/owners and the corporation share the same attorney; whether the shareholders/owners used the entity to procure labor, services and merchandise for others; whether the entity was adequately capitalized; whether corporate formalities were followed; and whether the result would be unjust should the court fail to pierce the corporate veil.

While California courts are generally reluctant to pierce the corporate veil, they are not afraid to apply the theory where the above factors evidence injustice. Entity shareholders and owners unsure about their personal protections should consult a business attorney.