BUYING AN EXISTING RESTAURANT- Legal considerations
You decided to buy a restaurant. What next?
STRUCTURE OF THE TRANSACTION
There are two ways to purchase the business. You can purchase the assets, or the buyer can purchase the stock. The two methods have notable differences.
If the buyer purchases the stock, the buyer purchases everything that goes with the company. The buyer purchases debts, tax liabilities (employment and sales taxes), and potential claims which COULD exist but have not yet surfaced like a potential harassment claim or an unreported injury. On the other hand, the buyer gets inventory, liquor license, corporate name, recipes, and the benefit of any prepaid advertising or favorable lease. Sellers may prefer to sell the stock of their business because of tax advantages for the seller. Often the business may be purchased at a lower price by buying the stock and taking the risks.
An asset purchase includes only specified assets. An asset purchase avoids the former owner’s liabilities EXCEPT the buyer may be stuck with some payroll/unemployment taxes if the buyer hires the seller’s employees. Like any purchase, the buyer ends up with liens on assets which the seller doesn’t “clear”. When the buyer purchases assets (rather than stock) it is important to specify, in writing, any contracts the buyer wants to assume (like a lease of the premises or equipment) and to make sure the transaction is contingent on being able to make an acceptable arrangement for the assumption. It is necessary to expressly include “intellectual property” being purchased including: the name of the restaurant, the recipes, the phone number, the website, any prepaid advertising, etc. Buyers prefer to purchase assets because there is greater certainty as to what they are buying and because it has the best tax result for the buyer. Often a buyer will pay a higher price to simply purchase assets and to avoid many risks.
TERMS OF THE PURCHASE
The purchase price is normally the subject of a negotiation between the buyer and the seller. An ongoing business is generally worth a premium over the replacement cost of its assets. This is sometimes referred to as “blue sky” or “going concern” value. The value of the blue sky is like beauty – it is in the eye of the beholder. In some cases where buyer and seller disagree on the price to be paid, the purchase agreement contains an “earn out” which is a contingent additional payment to the seller, dependent on the operating results of the business.
Whether the transaction is a stock sale or asset sale, it is common for part of the purchase price to be paid in cash at closing and for the seller to take payments over time on the balance (a “Seller Note”). Seller Notes generally run from 25% to 50% of the purchase price, have monthly payments, and have a term of 3 to 5 years.
As part of the transaction, buyers often require that the seller, and/or seller’s key employees, sign an agreement that they will “not compete” with the buyer for a period of time. This is designed to protect the “blue sky” that the buyer is acquiring. Contrary to popular belief, these agreements are often enforceable, provided they are reasonable in length and scope. While each situation is different, the length of the non-compete could be equal to the length of the Seller Note.
Transactions often include agreements regarding the personal services of the seller and/or key employees of the restaurant. As an example, the transaction may require the head chef to agree to remain with the restaurant for a period of time (as well as agree to sign a non-compete agreement) or may require the seller to train the buyer for a period of time).
A properly drafted purchase agreement is essential. The purchase agreement sets out the terms of the transaction, and the terms of any additional agreements (described above), and contains certain statements/responsibilities of the seller on which the buyer is relying (commonly called “Representations and Warranties”). If “Representations and Warranties” are inaccurate/untrue, the buyer may recover “damages” from the seller. Representations and Warranties may include statements that seller has: complied with all tax laws; clear title to the assets/stock being transferred; and has no knowledge/notice of potential litigation or administrative action.
If the buyer’s obligation to “close” is subject to certain conditions, these must be in the purchase agreement. These “Buyer Contingencies” could include provisions that buyer is able to obtain: financing to close the transaction; an assignment of the lease; franchisor approval; or a liquor license.
As President Regan once said: “Trust, but verify.” Upon both parties signing the purchase agreement, the buyer should be granted, and should exercise broad rights to review the seller’s books, records, and operation. It is common for buyer’s lawyer and accountant, to be involved in this process. The crucial aspect of the due diligence process is gaining a clear understanding of what is being purchased, and how seller’s business operates.
At closing the buyer pays the remaining cash portion of the purchase price, and receives title to the assets or the stock of the restaurant. The buyer should receive signed copies of all “additional agreements”. The buyer should provide the seller with a signed promissory note for any unpaid purchase price.
The trickiest part of a restaurant sales transaction is when and how to notify employees of the transaction. In an “asset purchase” transaction, the seller is normally required to “terminate” all of the restaurant’s employees immediately before closing. This is done so that the buyer will not have liability for any pre-closing/pre-termination costs, including: accrued salary, accrued vacation, accrued sick leave. A “stock purchase” transaction often includes an adjustment to the purchase price for employment costs.
If employees are told of the transaction early, they may quit before closing, reducing the value of the restaurant to the buyer. Conversely, if they are told late, they may quit with hard feelings toward the buyer. A common practice is to gather non-key employees on the day of closing. At that time, the seller gives them termination notices and COBRA notices and the buyer immediately hires employees who “stay on”. Key employees are frequently closer to the business and are involved in the transaction earlier. Each restaurant must evaluate the potential impact of the “word getting out” about potential sale to determine who gets notice when.
Just like operating a successful restaurant requires a capable staff of people, a successful purchase of a restaurant requires a team of capable professionals including an attorney, an accountant and an insurance professional. For legal assistance please give us a call (515) 727-0900.