Succeeding in Your Business: Avoiding a ‘straw man’ when buying a small business

Cliff Ennico 

“My wife and I are looking to buy a business together. We heard about a great local business that’s for sale, but when we inquired with the business broker handling the sale, we learned that it was already under contract to be sold. However, the broker told us the buyer was getting ‘cold feet’ and probably wouldn’t want to go through with the sale. Since the buyer was getting a terrific price for this business, what this broker suggested is that we contact the buyer and offer to buy the limited liability company (LLC) he formed to acquire this business. That way we could become the buyer under the contract of sale and close on this business without the seller changing the deal. The buyer would stay on board as the president of the LLC and sign all of the documents at closing as if he were still the party in charge, so the seller wouldn’t suspect anything. After the closing, the buyer would resign as president, and we would own the business.

“I’m frankly a little nervous about this — it all sounds a little bit shady to me. Am I right or am I worried about nothing?”

Clearly, what this broker wants more than anything else is to preserve his commission on the sale. The seller may have a backup buyer or two, so if this buyer walks away from the deal, the broker will lose his commission.

Though, interestingly enough, what the broker is suggesting may be legal.

First, before doing anything else, you should get a copy of the contract of sale from the broker and review it carefully with a local business attorney. There will almost certainly be a clause in the agreement prohibiting the buyer from “assigning” his rights under the contract to anyone else before the closing. If the clause is well-drafted, the clause may contain language saying that a change in the ownership of buyer prior to the closing is a prohibited “assignment” of the contract. If that language is there, then you should not cut a deal with the buyer, as you will be inducing him to breach his contract with the seller and will almost certainly be named in the lawsuit when the seller sues the buyer for breaching the sale contract.

Next, check to see how the purchase price is being paid. If the buyer is going to pay part of the price in installments over time, the seller will no doubt insist on a personal guaranty from the buyer and will not accept that from anyone other than the person with whom he originally contracted.

If a change in ownership is not prohibited by the contract, and if payment at the closing is all cash, then it would technically be legal for you to buy the membership interests in the buyer’s LLC. It still may not be a good idea, however.

When you buy membership interests in an LLC, you are buying the company’s balance sheet — all of its assets and liabilities. You should do some diligence on the buyer’s LLC and make sure it hasn’t incurred any debts or obligations other than the contract of sale for the business. If the LLC doesn’t have any financial statements or tax returns (which is highly likely if it was formed recently for the sole purpose of buying this business), then you should make sure the buyer indemnifies you for any hidden liabilities that may crop up after you buy his LLC.

I’m not wild about the buyer agreeing to stay on board as a “straw man” to deal with the seller after you buy the LLC. If the seller finds out, it will look as if you and the buyer have been conspiring to do something weird, and that may give the seller the right to walk from the deal. The right thing to do would be to notify the seller of the change in his buyer’s ownership. If your attorney feels that a change in ownership of the buyer would not constitute a breach of the contract of sale, that’s what you should do.

If you absolutely must use the buyer as a straw man to avoid alerting the seller to the change in ownership, make sure your attorney attends the closing (as the buyer’s counsel) so the buyer doesn’t agree to any last-minute monkey business you will be bound by. Also, the buyer should sign a letter now resigning as president of the LLC, dated the closing date, so there’s no risk he will change his mind after the closing and ask you for compensation.

One last thing: Don’t forget to ask the buyer why he got cold feet and decided not to buy the business. You don’t want to buy his LLC and then find out you also don’t want to go through with the contract.

Cliff Ennico (crennico@gmail.com) is a syndicated columnist, author and former host of the PBS television series “Money Hunt.”

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