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A Brief Legal Guide to Buying a Distressed Business

Business MovingEarlier in the pandemic, our team identified the economic crisis caused by COVID-19 as a growth opportunity for businesses with the vision and the resources to take advantage. One such opportunity is the chance to diversify or grow by acquiring distressed competitors, suppliers, or customers.

States across America are beginning to re-open and restart their economies. Unfortunately, not all businesses will have survived COVID-19 and its impact on the economy. Some businesses have been unable to generate their pre-pandemic revenue for nearly a year and may be struggling to meet their fixed cost obligations. At the same time, federal lending programs, such as the Main Street Lending Program and the Paycheck Protection Program, have made available large amounts of low-interest financing. This creates an opportunity for businesses that have or have access to liquidity to purchase distressed businesses at bargain prices.

There are a number of legal issues to consider when purchasing a distressed business, but two stand out. First and foremost, the buyer must conduct thorough due diligence. Second, the buyer must decide whether to purchase the business’s assets before it is insolvent or wait to purchase the business in Chapter 11 bankruptcy.

Due Diligence

Due diligence is the cornerstone of any deal, but it takes on a heightened importance when purchasing a distressed or bankrupt business. Potential buyers should search public records for any UCC financing statements, tax or judgment liens, or lawsuits. Financing statements reveal any liens or debts tied to the seller’s specific property and shine a light on hidden liabilities. Reviewing these documents will paint a more complete picture of the seller’s business and will help the buyer in assessing the risks and value of the assets. It also helps identify potential creditors who may seek recourse post-closing.

Theoretically, purchasing assets out of bankruptcy should reduce the due diligence burden. Uncertainty is reduced as creditors have been identified and claims have been made. However, due diligence remains paramount as assets are sold “as is,” which can leave the buyer with little recourse for damaged or subpar assets. Furthermore, the timeframe for due diligence may be reduced by the nature of the auction process.

Regardless of the type of sale, any buyer should have an experienced due diligence team on stand-by to help uncover any traps for the unwary.

Buying the Assets of a Distressed Business

A distressed business is a business that cannot or is struggling to pay its financial obligations. Rather than purchasing the equity of a distressed business, it is advisable to structure the deal as an asset purchase. This allows the buyer to limit its exposure to risks related to both known and unknown liabilities, while assuming only the desired assets.

The main concern when purchasing the performing assets of a distressed business is that the seller may then declare bankruptcy and creditors will attempt to avoid the sale as a fraudulent transfer. The trustee can avoid any transfer occurring within two years of the seller filing bankruptcy if there is (1) actual fraud or if (2) the transfer is for less than the assets are worth when the seller was insolvent or was made insolvent by the sale. Obtaining a fairness opinion from an investment bank that demonstrates the transaction was for fair consideration can help a buyer avoid this pitfall.

Another way to reduce the risk of buying a distressed business is to require a large portion of the purchase price to remain in escrow. This allows the buyer to more easily recoup costs stemming from a post-closing issue and to cover indemnification agreements. The indemnification agreement should cover any breaches of traditional representations and warranties, as well as any costs that stem from creditors seeking to void the conveyance. Without a significant holdback, it will be difficult to seek repayment because the entity holding the remaining assets may be worth only pennies on the dollar.

Buying in a Bankruptcy Sale

A bankruptcy sale has its own advantages and disadvantages. Like a distressed asset sale, buyers have the opportunity to pay bargain prices for underperforming assets primed for a turnaround.

The most common type of sale is the Internal Revenue Code Section 363 sale. The Section 363 sale usually involves an auction and the winning bidder receives assets free and clear from any and all liabilities, unless expressly assumed. The sale is subject to court approval.

There are generally two types of buyers in the context of a bankruptcy auction – bidders and the stalking horse. The stalking horse makes a baseline offer, which is subject to higher offers. If the stalking horse’s bid is the high bid, the deal proceeds from there. If there is a higher bid accepted, the stalking horse typically receives a break up fee of 1-3% of the purchase price. The stalking horse also enjoys the advantage of the longest due diligence period.

The bidders compete with the stalking horse and the other bidders for the bankrupt company’s assets. This creates two risks – first, the risk of overpaying to win the auction and second, the risk of underbidding and losing the auction. The bidder may have a shorter due-diligence period and should be prepared to move quickly to identify risks associated with the purchase.

Regardless of its role, buyers should be open to negotiations with the seller, any creditors, and the court. Each of these three constituencies has varying degrees of authority to accept or reject the deal, so it is important to take each one’s considerations into account.

Final Considerations

Purchasing any business comes with risks and rewards. Those same risks and rewards are magnified when purchasing a distressed business or purchasing a business out of Chapter 11 bankruptcy. You will want an experienced team on your side to help assess and minimize any risks associated with the transaction.

If you have any questions, please reach out to one of the authors or another member of our Deal Team:​​​​​​

Categories: Chapter 11, Contracts, Mergers & Acquisitions

Photo of Nicholas M. Oertel

focuses his practice in the areas of Michigan non-property tax disputes, business entity selection, corporate transactions, and information technology.

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