Buying or Selling a Struggling Business (aka the “Distressed” Business) – Part 3

In Part 1 of this series of posts, we discussed how business owners must think beyond the near term and that certain Buyers may view this as an opportune time to acquire a company while certain Sellers may be thinking that the best path forward is to sell their companies. In Part 2, we discussed some initial steps for Buyers and Sellers in preparing to buy or sell the struggling business. In this post, we will go over due diligence and structuring the deal.

Due Diligence

Due diligence is the process by which a Seller provides extensive information regarding its business to the potential Buyer, and the Buyer reviews that information and identifies issues or risks (that could affect how the transaction is structured or the amount of the purchase price). The due diligence process usually begins with Buyer providing a comprehensive written information request list to Seller, and Seller uploads all the requested information to an electronic data room.

For a struggling business, it is important that Seller prepare in advance to provide all the information that may be requested. While we always encourage a Seller to assemble information in advance, this becomes particularly important for the struggling business.

Timing

By having information organized and ready, a Seller can provide the information quickly and efficiently particularly if there is more than one potential Buyer. For a struggling business with dwindling cash or prospects, moving quickly is imperative.

Risk Management

As mentioned in our first post, in acquiring a struggling business, a Buyer may encounter more risk than in a normal course transaction. If Seller can identify and explain risks and propose solutions immediately, it may facilitate negotiations with the Buyer.

Tip to Sellers

Be sure to clarify with Buyer all the due diligence that will be needed. Often a Buyer will request preliminary financial and business information and Sellers think they are done! In fact, Buyer may engage internal and/or external resources who will be requesting in-depth information on every aspect of a Seller’s business: financial; legal; people/benefits; sales; real estate; intellectual property; and so on.

Deal Structuring

There are a few ways to structure a purchase and sale of the company, and the choice of the structure depends on the type of entity of each of Buyer and Seller (LLCs or corporations, for example), tax advantages or disadvantages to each, contract provisions, and payment terms. However, for a transaction involving a struggling business, an asset sale is the usual choice.

Asset Sale

As the name suggests, in an asset sale, the Buyer identifies those assets of Seller that it wants to acquire, and Buyer can specifically choose not to assume any liabilities of Seller. Buyer can, in essence, pick and choose the Seller assets it wants while avoiding the debts and obligations that Seller has (with some risk and limitations, which we will address in our next post). In addition, Buyer receives a step up in the basis of the assets acquired, to the extent the asset’s value has increased, which is beneficial for Buyer.

An asset sale is generally less favorable to the Seller: Seller is stuck with its debts and obligations; the receipt of the purchase price is generally not taxed at a more beneficial capital gains rate (as it would be in the sale of stock by Seller’s stockholders, for example); and it may be left with unsaleable assets.

If the Seller has valuable contractual relationships that can’t be assigned to a Buyer without the consent of the contract party, Seller may have the ability to negotiate for a sale of its stock or a merger transaction. In view of the risks around a struggling business, however, a Buyer may choose not to proceed with any transaction if an asset transaction is not possible.

Up Next in the Series

In part 4, we will discuss risks and risk mitigation in the purchase and sale of a struggling business.