In the Middle Ages, food could be scarce, and meat was almost impossible to find. There was no problem, however, in finding plenty of dogs. Thus, came the phrase, “A Pig in a Poke.” A con-artist would find a dog, put it in a bag (“poke”), and tie off the top. The con-man then took the bag to market and told the buyer that he had a pig in the “poke.” The buyer paid for the bag without opening it for fear the pig would escape. He brought the bag home, only to find a hungry dog looking for supper.

The message is clear: inspect the merchandise before you buy it. When it comes to buying a business, due diligence is a critical component of an acquisition.

First, when buying a business, don’t buy the stock or membership units of an existing privately-owned company unless you work for it and know its cobwebs. Unless you work for the company as an insider, it is far preferable to buy the assets of it (including the name for purposes of good will) and only assume certain identified liabilities that are clearly spelled out in the Purchase Agreement. Otherwise, you may end up with a poke full of unknown liabilities and undisclosed debt.

Even when you buy the assets, due diligence is the operative word in every acquisition. Follow these basic steps as a starting point in exercising due diligence.

Organization Documents: The buyer needs to see the certificates of organization filed with and the certificate of good standing issued by the government. The buyer should review the minute book, the organizational chart, the list of owners, and any agreements made by and between buyers. This will help buyers know things like whether the acquired company had preferred stockholders with a “right of first refusal.”

Financial: The buyer should order a credit report and request the financial statements for the previous three years. The balance sheet should include a list of all debts and liabilities, a schedule of inventory, a schedule of other assets, a schedule of accounts payable and accounts receivable, and any depreciation allocation. The income statement should include a comparison of results for the most recent three years and be juxtaposed next to the tax returns for purposes of reconciliation. Any fluctuation in the profit margin should be explained. The sales tax returns must be reviewed, and any audits undertaken by the government or regulatory agencies should be produced. A UCC search for filings is important. Major capital assets should be identified as to dates of purchase and depreciation. In one case, a purchaser of a bankrupt company recouped the entire investment just by selling the artwork in the office building that the trustee didn’t bother to appraise.

Employees: The buyer should request a schedule of employees that identifies start dates, salaries, employee benefits, and duties. Resumes should be reviewed. Employment agreements, non-disclosure agreements, and restrictive covenants should be reviewed, and a determination made as to whether retention agreements should be considered for key employees. Claims filed with regard to workers’ compensation, harassment, discrimination, unemployment, or other employment- related matters should be reviewed. Benefit plans should be viewed. Buyers may want to consider restrictive covenants for sellers and key employees.

Contractual Obligations: Copies of agreements or leases with suppliers, customers, distributors, lenders, officers and competitors should be reviewed. Loan agreements can produce surprises, and security agreements need to be reviewed. A sample of invoices issued to customers and received by vendors should be reviewed to determine the concentration of business. Determine if the contracts are transferable. In one case, an investor in a staffing agency didn’t check that the investment capital was going to a vendor that in fact was a subcontractor of the seller which operated a competing employment agency.

Customer and Vendor Relationships: If possible, confirm the existence of relationships with the largest customers and their interest in continuing the relationship. Make sure the inventory is current. Look hard at the accounts receivable and the company credit policy. Take a survey of competitors and determine what the reorganization will do to customer relations. Long-term and profitable supplier contracts can inadvertently be terminated in an asset transaction.

Litigation: Get a schedule of any pending or threatened litigation. Find out if insurance policies are “claims made” or “occurrence” policies. A “claims made” policy covers claims made when the insurance policy is in effect vs when the conduct occurred. Review the claim’s history – both with insurance companies as well as the courts. Ask for copies of any regulatory orders, settlements, or judgments filed against the company.

Intellectual Property: Request a schedule of the copyrights, patents, or copyrights issued to the company as well as any licenses that are being utilized by the company.

Location: Real estate requires title insurance, a review of the encumbrances and perhaps an appraisal. The leases need to be reviewed. Zoning rules may be important. A service station located by a highway exit loses value if the exit is closed and a cloverleaf is built two miles down the road.

Taxes: Work with an accountant to determine the most efficient manner to conduct the transaction for tax purposes.

Some of the above due diligence considerations can be avoided with an asset purchase as opposed to a stock purchase. On the other hand, there may be key agreements with vendors or customers that will result in a loss of benefit if the company is not continued in the same organizational structure.

In any event, the more information you get, the more you will know about future operations. “Buyer Beware” grew out of the “Pig in the Poke” con-game. It is always better to avoid problems during the acquisition process than having to hire lawyers to straighten them out after the purchase.

For more information, please contact former Minnesota Attorney General Lori Swanson or former Minnesota Attorney General and Commissioner of Commerce Mike Hatch at Swanson|Hatch, P.A. as follows:

Lori Swanson: lswanson@swansonhatch.com
Mike Hatch: mhatch@swansonhatch.com