I just recently bought my friend's iMac 10,1 21.5in with all of his documents in it He lost his installer disks and it has OS X Snow Leopard. How can I restore it to factory settings? Or can I buy OS X Lion online and restore it to factory settings?

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Sooner or later, you will need to have those install disks, so you or your friend need to call Apple, give them the serial number of the machine and ask for replacement disks which should be sent out for a nominal fee. Other than that, you could also buy Snow Leopard retail disk at various resellers or Apple store online for $29.
You will need that disk because: if you want to update to Lion and you purchase it at the app store, the license for it is not transferable, so if you ever sell that Mac, you are required to uninstall Lion and reinstall the original system (which you will need the disks for). The disks also include diagnostic/repair software.
So, it's best to have the disks; and, if you do purchase and install Lion, make sure you make a complete backup - bootable clone or Time Machine just in case.

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