by CHRIS KANG
For anyone starting a new business, it’s an exciting time. There are grand visions of endless customers and clients, emails and calls demanding your services and social media sites labeling you a success. All of this is definitely achievable: I see my clients taking that chance and running profitable businesses on a regular basis. But one thing that I always stress to them is this: You have to do your due diligence.
Generally, due diligence means taking the necessary steps to investigate whether entering into a business deal is a wise choice. The concept seems obvious, but you would be surprised at how often people overlook this step. I hear of many people—including first- or second-generation Korean Americans—entering into risky business deals, only to seek an attorney after the fact.
Take this recent real-life example (names and certain facts have been changed for the purposes of this illustration):
Mike, who is in his early 30s, is a mixed martial arts master who saved up more than $150,000 to one day open up his own school. After many months, he found the perfect location: a stable, middle-to-upper-class suburb filled with children interested in martial arts. He next located the owner of an existing karate school interested in selling his business.
The owner of the karate school gave Mike a purchase and sale agreement to sign, or a PSA, which is a contract between the buyer and seller of a business. Mike had never seen a PSA, so he consulted with our mutual friend, who set up a lunch meeting with me.
At lunch, Mike told me his story and showed me the PSA. The agreement was two pages long and clearly drafted by a non-attorney. It was missing several key pieces of information, including the list of inventory being sold, representations and warranties, indemnification provisions and information regarding the existing lease.
I told Mike he needed the missing information, especially the terms of the current lease for the karate school, since the building’s landlord may have no intention of renewing the lease, leaving his business stranded out on the street. Mike said he understood and that he would contact me after obtaining a copy of the lease.
A week went by with no word from Mike. Then, I received a brief text stating that he went ahead and signed the PSA. While Mike said he still had two years left on the lease, I learned that all of the renewal rights in the lease were used up and there was no guarantee he would receive a new extension or lease after two years. He essentially signed a document that could expose him to undisclosed liabilities as the new owner of the karate school business.
I’ve encountered many other excited entrepreneurs like Mike, who get so caught up in the pursuit of their dream that they skip the necessary steps that could protect them in the long run. If I were advising Mike from the beginning, I would have told him, first, to research the karate studio he was about to buy. Sit in on some classes, watch the customers who come in and out, speak with neighbors and neutral third parties.
Only when someone decides to move forward should he start negotiations with the owner or owner’s representative, discussing such details as price; whether the owner is selling just the assets of the business or ownership of the business that owns the assets; financial information, including operating and profit-and-loss statements; vendor information and a copy of the existing lease.
The general rule of thumb is to obtain as much information upfront as the seller is willing to provide. Based on these terms, you can then enter into formal negotiations with a Letter of Intent (LOI), followed by the PSA, which incorporates the business terms agreed upon by the parties in the LOI and contains other business and legal provisions related to the sale. The PSA must be reviewed in great detail; obtaining an attorney by this point is highly recommended.
By entering into a poorly drafted purchase and sale agreement and failing to secure a long-term lease, Mike exposed himself to more liability and headache than necessary. Currently, he is attempting to negotiate a new lease with the landlord while he operates his new mixed martial arts school. The whole point of exercising due diligence is to reduce potential risks as much as possible. Although it can be a slow and painstaking process, it is well worth the time in the long run.
Chris M. Kang is a business, real estate and intellectual property attorney with Inslee, Best, Doezie & Ryder P.S. in Bellevue, Wash.
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This article was published in the April/May 2015 issue of KoreAm. Subscribe today! To purchase a single issue copy of the April/May issue, click the “Buy Now” button below. (U.S. customers only. Expect delivery in 5-7 business days).
