Buying a Business: Check for Liens!
If you’re buying a business – or if you’re a business broker representing a client in buying a business – one of the most important aspects of a buyer’s due diligence – and one that too often slips through the cracks – is determining if there are any liens against any of the business’ assets.
Most reasonably intelligent buyers – and, hopefully, ALL professional business brokers – understand the importance of due diligence when buying a business. Any reasonably well-drafted letter of intent, term sheet or purchase and sale agreement will contain a clause describing what the due diligence will consist of as well as the time period the parties agree the buyer will have to perform its due diligence and the seller will have to deliver documents and other data that enable the buyer to execute on that due diligence.
But it has been our experience that any consideration of liens is often an afterthought – if thought about at all – which redounds to the buyer’s detriment.
What is a Lien?
A lien is a legal claim or a right against property – and “property” is everything from real estate and vehicles to furniture, fixtures and equipment (“FF&E”). Liens provide security, allowing a person or organization to take property or take other legal action to satisfy debts and obligations. Liens are often part of the public record, informing potential creditors and others – in our case, buyers – about existing debts.
For a simple example, if you utilize a mortgage when you buy a house – that is, if you borrow to buy the house – you promise to repay your lender. But your lender might want more than just your signature because with only your signatures, the lender has very little leverage if you stop making payments. But by filing specific documents with local government offices, the lender becomes a lien holder (the person or organization that files the lien) on your property. The debt is now secured, and the lender has significantly increased the likelihood of getting repaid.
How does a creditor benefit from placing a claim on something you own? Liens may give creditors the legal right to take your property and sell it if you don’t repay your debt.
How Does This Pertain to Buying a Business?
If the business owner borrowed to purchase any of the FF&E used in the business’ operation – from the equipment in the production line or the fork lifts in the shipping area to the office furniture and potted plants – there is a good chance that the lender – or the vendor, the company that sold whatever was purchased – filed a lien against that purchased item.
A simple example is the purchase of a tractor by a landscaping contractor.
The contractor could go to his or her banker to borrow the money or they could be offered a very attractive purchase financing package by the seller of the tractor. Either way, there will almost always be a lien against that tractor until the landscape contractor pays off the debt.
If the business changes hands, the lien, if not paid at closing, stays against the tractor and, if the tractor is part of the deal, the lien transfers with the tractor to the new owner. If the buyer is unaware that a lien exists, unpleasant surprises are almost certainly in the buyer’s future.
How to Find a Lien
Because liens protect the seller of something from the buyer of that something defaulting on payments for that something, a lien reflects a debt. A business’ debt can generally be determined by analyzing the business’ balance sheet. As well, most such debt will require periodic payments, so you should be able to match debt payments on the operating statements to the debts listed on the balance sheet.
But that analysis will only tell you what the business owes and that it’s making periodic payments to pay down that debt. That analysis will not tell you if a lien was filed by the holder of that debt.
The buyer or the buyer’s broker, lawyer or other member of the acquisition team can check public records at sites such as publicrecordsreviews.com to see if any liens have been filed but not yet released against any asset of the business being considered. This site allows you to search for any business and gain access to any public records on file. If you find that a UCC-1 form was filed by a bank, creditor or supplier when they extended credit to the company, then it’s important to understand that if the debt is unpaid, the lender can still seize any secured assets, even after ownership passes to you.
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Are Liens a Problem?
Not in and of themselves they aren’t.
Growing businesses buy stuff all the time, much of it on credit so as to preserve cash. In the case of the landscaping contractor, the tractor was expected to pay for itself over time, an expectation that would logically suggest to the business owner that the tractor should be paid for over time, as well.
That said, liens that the buyer of a business is not aware of can become a BIG problem – and one that may not become apparent until well after the closing of the deal.
Generally, as long as debts are repaid on time, and you do not need to borrow additional capital, a UCC lien will not have a huge effect on your business. However, there are some risks of UCC liens that will need to be considered if you are thinking about buying a business that has one filed against it.
- Difficulty borrowing: A UCC lien can make it difficult for the business or the new owner to borrow money in the future. Prior to repaying the debt, a UCC lien may stand in your way of obtaining additional financing, even if any previous financing was borrowed by the last owners.
- The business’s credit report: Any UCC liens from the past five years will show up on your business’s credit report, even after you take over as the new owner. Although a UCC lien itself will not have a negative impact on your credit score, it will likely be taken into consideration in any future lending decisions when lenders review the report, even if the debt in question has been repaid in full and the lien has been released.
- Loss of assets: When assets are used as collateral for borrowing money, the business will always run the risk of losing these assets if they fail to make repayments. Therefore, if you are considering buying a business that has a UCC lien filed against certain assets by a lender, it’s important to be certain that you will be able to continue repaying the debt or you risk losing valuable assets. Any assets used to secure a loan should be considered at-risk until the debt is fully repaid.
A public records search will significantly reduce the risks that liens present. When the buyer is aware of existing liens, the purchase agreement might be able to be structured so that the liens are paid off at closing; the seller’s proceeds reduced by the amount of debt secured by such liens.
But a lien represents existing financing and a buyer might see the benefit in maintaining that financing in which case our buyer might approach the lien holder and assume the responsibility for the debt. (There are a million ways to skin the financing cat!)
A properly drafted purchase agreement will go a long way toward reducing the buyer’s risk in this regard. For example, it would be wise to include a clause by which the seller indemnifies and holds the buyer harmless if some undisclosed liability such as a lien pops up down the road. But even including such language in the purchase documents will not eliminate the hassle that is sure to develop if the buyer receives a demand for payment from a lawyer representing someone or company he or she has never heard of.
The Bottom Line
For business buyers, liens can often pose a significant risk. It’s important for buyers to conduct due diligence and such due diligence should include a UCC, judgment, and tax lien search and the transaction documentation should be structured in a way that affords the greatest protection against such risk.
If you have any questions, comments or feedback on this topic – or any topic related to business – I want to hear from you. Put them in the Comments box below. Start the conversation and I’ll get back to you with answers or my own comments. If I get enough on one topic, I’ll address them in a future post or podcast.
I’ll be back with you again next Monday. In the meantime, I hope you have a profitable week!