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It’s a unique time for small businesses. The economic ups and downs are creating both winners and losers. If you find yourself on the fortunate side, should you seize the opportunity to expand by buying a distressed business (perhaps even a competitor)? Here are some questions to ask before you act:

Why is the business distressed?

Businesses become distressed for various reasons—many of those reasons may not even be readily understood by their own leadership. It’s critical, however, to uncover the factors that led to the distressed state of the business. Can those circumstances be turned around? Over-spending, disorganization, or outdated technology and processes may be factors you can tackle, especially if the customer base is strong. But if the business is saddled with debt, shows signs of being affected by fraud, or has a dwindling customer base or failing product line, it may be too costly to turn the tide.

How will you conduct your due diligence?

Uncovering why a business is distressed is just one step in the due diligence process. To get a more complete picture, you’ll need a team on your side that can include an attorney, banker, valuation expert, and accountant. It can be easy to misread financial statements, especially if the numbers are inflated, or issues like outstanding payroll, tax liens, legal actions, and other liabilities are hidden from you. Sometimes it takes a forensic accountant to examine the valuation of the distressed business with an eye for “following the money” and determining the truth behind the numbers presented.

Is bankruptcy a factor?

Many distressed businesses are at or near bankruptcy, which is a vital factor in determining your purchase strategy. Sometimes buying a distressed business already in bankruptcy can eliminate tax and legal liabilities. However, an attorney can best address the pros and cons of purchasing a bankrupt company as well as the danger signs that bankruptcy complications could come into play before, during, or after the purchase.

What’s your purchase strategy?

Entrepreneurs will often purchase assets over equity to receive a stepped-up tax basis and minimize liabilities (although that strategy may not pan out if the business is severely distressed). You might also decide to hold back a large portion of the purchase price in escrow to reduce risk. Your attorney and accountant can work through these factors with you, and your attorney can also help you with any indemnity, non-compete, and other legal documents you should have in place.

What part will taxes play?

Don’t forget how taxes affect the purchase price. When treating an acquisition as an asset purchase, not only can you receive a step up on the tax basis, but several other tax opportunities may present themselves post-sale. These opportunities can vary depending on your business structure (corporation versus a pass-through entity, for instance). How you allocate the cost is also critical. For example, you might allocate more of your purchase on inventory, equipment, and intangible assets like software, intellectual property, and goodwillthan you would on the business’s building(s) and land (which either slowly depreciate or don’t depreciate at all).

Is it a smart move in the long run?

Throughout the process, it’s important to listen to your team of experts but also to follow your gut. Is it an opportunity that feels right? Has your team given you a clear representation of the benefits and risks involved? Do you think you’ll be able to turn things around to the benefit of the employees and customers of both the distressed business and your own? Buying a distressed business can be a great move forward, but it takes planning and strategy to make it work in your favor. Feel free to contact us with questions.

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