Although we have covered in some detail the necessary steps and issues encountered when creating a new business, we have not discussed what you need to consider when buying “into” a business, i.e. buying a partial interest in an existing business entity. Specifically, we have several inquiries posted to our Law 4 Small Business website asking for tips for buying into an existing partnership. Many of these suggestions or concerns will apply to buying stock in corporations or membership units in limited liability companies.
Remember firstly that there are big differences between general partnerships and limited partnerships. For example, when you buy a partial interest in a general partnership. you can be held personally liable for any liabilities of the partnership to the extent the partnership is unable to satisfy them. A general partner is considered as a manager of the business and personal liability is unlimited. This creates a great financial risk to be considered and demands a very rigorous “due diligence” process to access this risk.
A limited partnership allows you to buy into the business as a “limited” partner who is prohibited by law from participating in the management of the business and who is liable for partnership obligations only to the extent of his or her investment amount. Because of the “passive” nature of the investment (not managing), you stand to lose only the amount you contributed. This very much lowers the risk inherent in the investment.
Let’s assume for this article that you are buying into an existing general partnership. You will be required to sign the existing or perhaps a revised general partnership agreement indicating your acceptance of all various terms. The money you contributed, or may contribute later, will establish your percentage ownership in the business and will be used to create a “capital account” in your name. The agreement will specify all of the details as to the treatment of and account for your capital account and how you share profits and losses, among many other, important things. Each year you will receive a Schedule K-1 (Form 1065) from the partnership reporting to you and the IRS your share of the profits or losses of the business and the state of your capital account.
This brings us to the first very important step you should take before buying a general partnership interest. Be sure to carefully read and understand the entire partnership agreement. These agreements govern your relationship with the company and your partners. These agreements can be very lengthy, complicated, and often replete with “legalese”. If you do not have substantial training or experience in such business dealings, you should retain a legal advisor to assist you to that your decision will be a “fully informed” one.
The lawyers at Law 4 Small Business have many years of experience and education in these areas and can perhaps save you from making a big mistake.
Because of the great potential risk mentioned earlier and in order to assure that you are receiving fair value for your investment, it is important that you perform “due diligence” in investigating the company operations and financial position. In a general partnership it is important that you fully examine how capital accounting is performed and what increases or withdrawals can or will occur as to your capital account, including mandatory “capital calls,” if permitted. In most general partnerships, your percentage of ownership will relate to the relationship between the value of your contribution and the other capital accounts, meaning that the share you acquire may be somewhat mathematical. This may be less true when purchasing limited partnership interests, LLC units or stock. These types of interests may require additional due diligence related to value of the business and the appropriateness of your percentage share.
Another important aspect of your due diligence should include a thorough review of multi-year financial statements of the company reflecting its financial performance and position over a representative period and as of a relatively recent date. When analyzed by a financial professional, financial statements can help determine whether there may be intangible value in the company not reflected in the financials or even whether there may be liabilities or risks not reflected. For these tasks, you would most likely be well advised to also seek out the services of a certified public accountant or financial expert.
Other areas of due diligence or to be examined that you may want to consider depending upon the company and its attributes are:
• Tax returns and tax payments of the company.
• Claims against or disputes with the company by vendors, suppliers, customers or employees.
• Environmental conditions and Reports.
• Condition of the premises including equipment, raw materials or inventory.
• Intellectual Property assets (may or may not be reflected in the financials).
• Duration and rental provisions of leases.
• Reliance upon and longevity of employees.
• Major contract provisions.
• Existence and amounts of insurance.
• Government regulation and filings.
As you can see, there are a multitude of complicated relationships and activities which should be completely understood before making any final commitment to investing in any business. Since the company has a “history” and ongoing operations, a complete investigation and understanding is arguably even more critical with an existing business than when creating a new one. The lawyers at Law 4 Small Business are happy to discuss this with you in much more detail and to provide expert assistance.