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All business owners like a good bargain, especially when that bargain might allow for the expansion of a product line or the elimination of a competitor. A business experiencing financial difficulty (a “distressed” company) is often a great target for purchasers to acquire a business or its assets at a discounted price. While many are loath even to dip a toe into the murky waters of distressed deals for fear of unknown liabilities, others jump in because, if done right, acquiring the assets of a complementary or competing business that is experiencing financial difficulty can yield a significant return for only a modest price.  

A bargain-basement price, however, does not come without risk. Distressed companies typically face deteriorating assets, lender pressures and legacy liabilities. Those purchasers prepared to tolerate such risks can realize material returns on a distressed acquisition if risk is properly priced. Two important ways to price such risks are to (1) conduct due diligence and (2) utilize an acquisition structure that best accomplishes the goals of the purchaser given the distressed company’s financial circumstances.  

Due diligence: As with any acquisition, it is important to understand the legal and financial challenges affecting a distressed company. However, the ability to do thorough due diligence in these scenarios is often very limited. This may be due to poor record keeping, disorganized management or the fact that the financial pressure on the business compels a speedy transaction. Regardless of the situation, a purchaser should try to best understand the financial condition of the business and be comfortable enough with the purchase price given limited information. Thus, it becomes particularly important when there is limited due diligence for a purchaser to structure the transaction in a way that best mitigates risk associated with the distressed company.

Structuring the transaction: There are multiple transaction vehicles that a purchaser might use to structure a distressed acquisition: an asset sale, an Article 9 disposition or a formal judicial proceeding. Each has its pros and cons and corresponding level of risk depending on the condition of the distressed company and the tension between speed of closing and the prospect of potential successor liability for the purchaser.

It is generally accepted law that a buyer of assets will not be liable for the liabilities of the seller unless the buyer expressly or impliedly agrees to assume such liability; the transaction amounts to a de facto merger; the buyer is merely a continuation of the seller; or the transaction is entered into fraudulently for the purpose of escaping liability. It is, therefore, wise for purchasers to acquire only assets and address such exceptions when determining the best structure for a given acquisition.

Asset sale: A basic option is to conduct a simple acquisition of the distressed company’s assets. This option is the quickest, but it is also the riskiest. In a typical asset sale, a seller will often give representations and warranties that are supported by an obligation of the seller to indemnify the purchaser if those representations and warranties turn out not to be true. In a distressed situation, a seller is often not in the position to give full representations and warranties about the business. Furthermore, any representations and warranties that could be given would not be supported by a viable indemnification provision because the seller will likely either be out of business or not have the money, or the ability to hold back money, to reimburse the purchaser for any damages relating to the pre-closing distressed company.

Click here to read the full article from Crain's Cleveland.

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