Need a couple of backhoes for your swimming pool construction company? A complete restaurant operation as a second location for your delicatessen? A warehouse building in which to store that mountain of supplies for your plumbing service?

If you are a business owner, making such investments can be enormously expensive. There is, however, a frequently overlooked source for a range of business assets, often at bargain-basement prices: bankruptcy court auctions.

Purchases made through bankruptcy auctions can include anything from small fixtures and fittings the hard assets of a restaurant is an example to entire companies and large pieces of real estate. Bargains are not limited to hard assets. One recent bankruptcy auction included the sale of rights to a patent with significant potential value. The buyer got the patent at a fraction of fair value.

Although bankruptcy courts aim to realize the highest possible price for the assets being sold, in reality they usually go for prices considerably lower than going concern value. Adding to price pressure is the involvement of court-appointed trustees.

The vast majority of bankruptcies are Chapter 7 liquidation cases in which a trustee is always appointed. Trustees have a statutory duty to liquidate the assets under their charge. Trustees often do not have the opportunity to delve deeply into each debtor's business and industry environment, and therefore cannot know the worth of the assets in each industry.

In addition, because a Chapter 7 is a liquidation, the prices of the assets sold by a trustee are often much lower than if those assets were valued as part of a going concern. Even in cases in which the debtor has an ongoing operation, sales are more often than not a result of pressure to generate cash.

Another benefit of purchasing assets in bankruptcy is that the sale can be structured so that it's free and clear of all liens, claims and security interests. (You get lien-free assets, while the lien holders squabble in court over the division of proceeds.) When it comes to buying business locations in bankruptcy, for example, the landlord can often be compelled to assign the lease agreement to the buyer, notwithstanding restrictions in the lease.

So what is the process? The purchase process can take place in one of two ways. You can become what is known as a "stalking horse" by negotiating an advance agreement with the bankrupt seller to purchase assets for a specified price, subject to approval by the bankruptcy court. Alternatively, you can come in unannounced and make your bid.

Because nearly all sales in bankruptcy court are subject to overbidding someone can appear and put in a higher bid "stalking horse" buyers typically demand various protections, including a "breakup fee" if the agreed-upon deal falls through because the "stalking horse" buyer is outbid. This can happen because the stalker's early bid sets the floor for the auction and thereby adds value to the bankruptcy estate.

If you win, the amount of cash you have to pay will depend on the deal negotiated with the seller, or as determined by the competitive bids. The greater the cash you pay, the more likely your bid will be accepted.

Surprisingly, the winning bid isn't necessarily the highest bid. You may win because you are most able to meet stipulations for closing the deal, including being able to offer security for payment of the non-cash portion of the purchase price. Such assurance usually comes in the form of a financial statement or letter of reference from a bank.

Although the potential for reaping significant financial rewards from bankruptcy auctions is great, they are not for the faint of heart. This is definitely a case of caveat emptor: let the buyer beware. For starters, bankruptcy auctions do not usually provide the security of warranties or return policies. Sales at bankruptcy auctions are usually final.

How can you learn about bankruptcy auctions in your area? Keep your ear to the ground. In particular, pay attention to what is going on with competing companies in your line of business. Ask your professional advisors to let you know if they hear about any interesting bankruptcies.

In addition, you can subscribe to publications that list major filings including Turnarounds and Workouts. Business and industry publications often list bankruptcies as well.

If you do hear about a bankruptcy that seems promising, what should you do? If the bankruptcy court has appointed a trustee to the case, contact that person. (You can obtain information about the trustee from the courthouse.) If there is no trustee, talk with the bankrupt business owner directly. Also, review the bankruptcy papers on file at the courthouse to get a sense of the financial condition of the business and to review related disclosures.

Finally, if you want to bid on something with a hefty price tag, you would do well to consult with an expert, such as a bankruptcy attorney who knows how to structure the offer, where and when to conduct a specialized due diligence, and how to deal with the various constituencies in the bankruptcy arena.

Brian Davidoff is a lawyer with the Century City law firm of Rutter, Hobbs & Davidoff Inc. He is a certified business bankruptcy specialist whose practice focuses on corporate reorganization and emerging growth companies. He can be reached via e-mail at bld@rhdlaw.com.

Entrepreneur's Notebook is a regular column contributed by EC2, The Annenberg Incubator Project, a center for multimedia and electronic communications at the University of Southern California. Contact James Klein at (213) 743-1941 with feedback and topic suggestions.

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