Buying a Business in Distress can be a lucrative opportunity, but it also comes with unique risks and complexities. These businesses are often facing financial difficulties, legal issues, or operational challenges, making it essential for potential buyers to carefully consider the legal implications before proceeding. Failing to address these legal considerations can result in acquiring significant liabilities or other unforeseen problems.

This blog will cover the key legal factors to consider when purchasing a distressed business and how to mitigate the associated risks.

Navigating the legal complexities of buying a distressed business can be challenging. Contact Avatar Group today to get expert guidance on legal considerations and ensure a smooth acquisition process!

What Is a Distressed Business?

A distressed business is one that is experiencing financial instability or operational problems, which may result from excessive debt, poor management, declining revenues, or market shifts. These businesses are often sold at a lower price due to their weakened condition, but they may also come with significant legal and financial liabilities. As a buyer, it’s crucial to understand the scope of these liabilities and the legal frameworks governing the purchase of such businesses.

Key Legal Considerations When Buying a Business in Distress

1. Due Diligence: Financial and Legal

The due diligence process is vital when acquiring a distressed business. While financial due diligence focuses on assessing the company’s financial health, legal due diligence involves investigating any potential legal liabilities the business may have, such as:

• Outstanding debts and liabilities: What is the company’s debt load, and are there any secured creditors with claims on the assets? Secured debts can complicate the sale and affect the buyer’s ownership of certain assets.
• Pending lawsuits: Are there any legal disputes, lawsuits, or regulatory violations that could result in financial penalties?
• Contractual obligations: Review the company’s contracts with suppliers, customers, and employees. Some of these agreements may include clauses that could trigger penalties if the business changes ownership.
• Employment liabilities: Are there outstanding wage or benefit claims from employees? Are there any ongoing labor disputes or issues related to employment law?

Thorough due diligence will help you uncover potential legal risks and determine whether the distressed business is worth pursuing.

2. Structure of the Purchase: Asset vs. Stock Sale

When buying a distressed business, you’ll generally choose between two types of sales: an asset sale or a stock sale.

• Asset sale: In an asset sale, the buyer acquires specific assets of the business, such as equipment, inventory, intellectual property, and customer lists. The buyer can choose which assets to take and can generally avoid assuming the business’s liabilities. This is often the preferred method for purchasing a distressed business because it minimizes the risk of acquiring unwanted liabilities.
• Stock sale: In a stock sale, the buyer purchases the company’s shares, acquiring the business as a whole, including its assets and liabilities. While this type of sale may be simpler in terms of transferring ownership, it exposes the buyer to all the company’s existing liabilities, including debts, legal claims, and contractual obligations.

Most buyers of distressed businesses opt for asset sales to avoid assuming the full scope of liabilities that often accompany stock sales.

3. Bankruptcy Proceedings

If the distressed business is in bankruptcy, the sale process will be subject to specific rules under bankruptcy law. There are two primary types of bankruptcy proceedings that impact the sale of a distressed business:

• Chapter 7 bankruptcy: This is a liquidation process in which the company’s assets are sold to pay off creditors. Buyers can often acquire assets at a discounted price, but there is typically no option to purchase the entire business as a going concern.
• Chapter 11 bankruptcy: This is a reorganization process that allows the business to continue operating while it restructures its debts. In this scenario, the buyer may be able to purchase the business as a going concern, subject to court approval. One of the benefits of buying a business in Chapter 11 is that the sale can proceed “free and clear” of many of the company’s existing liabilities, such as debts or legal claims.

When a business is in bankruptcy, the court plays a significant role in approving the sale and determining how the proceeds are distributed to creditors. The buyer must work closely with legal counsel to navigate the complexities of purchasing a business through bankruptcy proceedings.

4. Asset Liens and Secured Creditors

When purchasing a distressed business, it’s important to identify whether any of the company’s assets are encumbered by liens. Secured creditors often have claims on specific assets, such as real estate, equipment, or inventory, which means the buyer may not have a clear title to those assets unless the lien is resolved.

Before finalizing the purchase, conduct a thorough search for any liens on the company’s assets, and work with legal counsel to negotiate with creditors if necessary. In some cases, creditors may be willing to release their claims in exchange for partial payment or other concessions.

5. Successor Liability

Successor liability refers to the legal concept that a buyer of a business may be held responsible for certain liabilities of the seller, even if those liabilities were not explicitly assumed in the purchase agreement. While this risk is generally lower in asset sales, there are certain circumstances in which a buyer may still face successor liability, such as:

• Employment-related claims: Buyers may be liable for unpaid wages, employee benefits, or workers’ compensation claims, even if they did not assume these obligations.
• Environmental liabilities: If the business has violated environmental laws, the buyer may be held responsible for cleanup costs or regulatory penalties, regardless of the structure of the sale.

To minimize the risk of successor liability, ensure that the purchase agreement clearly specifies which liabilities are being assumed and which are excluded. Additionally, consider purchasing insurance to protect against unexpected claims.

6. Regulatory Approvals

In some industries, purchasing a business may require regulatory approvals from government agencies. This is especially true in highly regulated sectors such as healthcare, finance, and utilities. Before proceeding with the purchase, ensure that you understand the regulatory requirements and obtain any necessary approvals to avoid legal complications post-sale.

7. Purchase Agreement Terms

The purchase agreement is the key legal document governing the terms of the transaction. It should include:

• Representations and warranties: These are statements made by the seller regarding the condition of the business. For a distressed business, the buyer may seek additional representations to ensure that they have accurate information about the company’s financial and legal status.
• Indemnification provisions: These clauses outline the seller’s obligation to compensate the buyer for any losses resulting from undisclosed liabilities or breaches of the purchase agreement.
• Contingencies: Buyers should include contingencies in the purchase agreement that allow them to back out of the deal if certain conditions are not met, such as the discovery of significant liabilities during due diligence or failure to obtain regulatory approvals.

Working with an experienced attorney to draft and review the purchase agreement is critical to ensuring that your interests are protected.

Conclusion

Buying a distressed business offers potential for significant gains, but it comes with considerable legal risks. Conducting thorough due diligence, understanding the structure of the sale, addressing bankruptcy issues, and crafting a solid purchase agreement are essential steps to mitigate these risks. By working closely with legal professionals and understanding the legal landscape, you can increase your chances of making a successful acquisition.

FAQs

1. What is the difference between an asset sale and a stock sale?
An asset sale allows the buyer to purchase specific assets of a business, often avoiding liabilities, while a stock sale involves buying the entire company, including its assets and liabilities.

2. What is due diligence in the context of buying a distressed business?
Due diligence involves thoroughly investigating the financial, legal, and operational aspects of the business to uncover potential risks, such as debts, lawsuits, or contractual obligations.

3. Can I avoid liabilities when purchasing a distressed business?
In an asset sale, the buyer typically avoids assuming most of the seller’s liabilities. However, certain liabilities, such as employment or environmental claims, may still be transferred to the buyer under specific circumstances.

4. What happens if the distressed business is in bankruptcy?
If the business is in bankruptcy, the sale may be subject to court approval. In a Chapter 7 bankruptcy, the business is liquidated, while in Chapter 11, the buyer may purchase the business as a going concern, often free and clear of many liabilities.

5. What is successor liability?
Successor liability is the legal concept that a buyer may inherit certain liabilities of the seller, even if those liabilities were not explicitly assumed in the purchase agreement.

6. How do secured creditors impact the purchase of a distressed business?
Secured creditors have claims on specific assets of the business. The buyer must resolve these claims, usually through negotiation, to obtain clear title to the assets.

7. What legal protections should I include in the purchase agreement?
The purchase agreement should include representations and warranties, indemnification provisions, and contingencies to protect the buyer from undisclosed liabilities and other risks.

8. Do I need regulatory approvals to buy a distressed business?
Depending on the industry, you may need regulatory approvals before completing the purchase, especially in highly regulated sectors such as healthcare or finance.