Sooner or later, any entrepreneur thinks of buying or selling a business or expanding their business by purchasing another. The bread and butter of most transactional attorneys is assisting in the negotiation and drafting of documents cementing such transactions. It is critical to obtain experienced legal and tax advice in such transactions since the cost of the sale (and the risk of the purchase) can be radically altered by failure to get the requisite advice.
Nevertheless, the experienced lawyer and CPA is well aware of recurrent issues that must be addressed in almost every transaction and this article will give a “preview” of issues that the business owner or buyer can expect to consider once the deal progresses to the point of drafting the agreements. By pondering the appropriate answers to the questions below, the business person can perhaps facilitate the rapid culmination…or abandonment…of a particular deal. The reader should also read our articles on Contracts and on Due Diligence to supplement this article.
THE ROLE OF THE BUSINESS BROKER:
Many businesses are located using a business broker who normally charge a percentage of the sales price for assisting in the transaction. Business brokers have pre printed forms and hundreds of past transactions as experience but are seldom attorneys or CPAs. Their goal is to make the deal happen since most do not receive any compensation minus the successful completion of the transaction. This can be good and bad. It does lead to aggressive and proactive involvement by the broker. The downside is that a careful and objective review of the transaction is not achieved since the inherent conflict of interest must arise since the broker wants the deal to happen even if due diligence demonstrates it should not.
As a client once told the writer, “I like you because you tell me things I don’t want to hear about deals. All the brokers tell me is why I should go forward.”
The danger of attorneys and CPAs is that they become too cynical and suspicious and are prone to reject chance and risk taking. Since business inevitably involves risk taking, such advice must be evaluated carefully.
A good solution is the right mix of professionals. Legal, tax and business advice combined is of greater value than only a single category.
The Broker generated agreements are seldom complete enough and were often created by ancient attorneys twenty or even thirty years ago. The wise buyer or seller will take the time and expense of having an agreement carefully structured to the particular needs of the transaction and the innovations in business and technology that have arisen. For example, web site ownership and warranties are now an inherent part of a business transaction and did not even exist fifteen years ago.
Brokers may be useful. They are seldom enough.
KEY AREAS OF CONCERN TO BE CONSIDERED:
CONFIDENTIALITY
The Seller should be sure to have all potential purchasers sign a confidentiality agreement before providing proprietary information.
TYPE OF TRANSACTION
Purchasers generally want the deal structured as a purchase of assets in order to try to avoid picking up unknown liabilities. Purchasers also prefer a purchase of assets because they want to inherit the seller’s historic low tax basis of the assets (rather than a tax basis equal to the purchase price). Corporate sellers often want the deal to be a sale of stock, since a sale of assets results in two levels of income tax for the seller: a corporate tax on the transaction and a second tax, if the seller’s corporation is dissolved after the sale, imposed on the shareholders to the extent their portion exceeds their tax basis in the stock.
SALES TAXES
In asset sales (but not sales of stock), sales tax is often imposed unless the company being sold is a service business (where the “occasional sale” exemption may apply). In the absence of any provision in the purchase agreement, the seller is liable for the sales tax.
BULK SALES LAW
With sales of assets (though not sales of stock), the purchaser must be wary of the Bulk Sales Law. This law applies when, “The seller's principal business is the sale of inventory from stock, including those who manufacture what they sell, or that of a restaurant owner” …and…” the sale is not in the ordinary course of business” (more than half the seller’s inventory and equipment is sold.)
Essentially, the Bulk Sales Law makes the buyer liable to pay the debts of the selling company–although unless agreed otherwise, the buyer has the right to recover these amounts against the seller. For sales where the purchase price is $2 million or less, the creditors must be paid from the escrow. The buyer can limit its liability by requiring the seller to provide a list of creditors and agreeing to pay the creditors on the list (with an adjustment in the purchase price) or making sure the seller has paid these debts.
DUE DILIGENCE
In addition to all the other due diligence that the purchaser conducts, the purchaser should hire an accountant to examine the seller’s books and determine if any adjustments in the purchase price are needed.
ADJUSTMENTS IN PRICE BASED ON PERFORMANCE
In order to limit their risk, purchasers may want to include a performance clause in the purchase agreement. Such a clause states that if the business’s revenues drop, there is an adjustment in the promissory note used to pay the remainder of the purchase price. Faced with this, the seller may also want a provision where there is an increase in the amount of the promissory note if the business’s revenues increase.
ASSETS AND LIABILITIES
The assets being purchased obviously must be listed in a sale of assets. The agreement should also list any liabilities being assumed by the buyer and state that no other liabilities are being assumed. In a sale of stock, the buyer should not rely on the books of the seller. The agreement should list all the assets and liabilities that are being acquired. Remember, regardless of wording of the agreement, taxing authorities often have the right to seek recovery from a buyer, so get tax clearance certificates as a condition of any purchase.
HOLD BACK
Frequently the buyer wants a certain amount held back in escrow to cover any adjustments (due to changes in inventory or accounts receivable, or due to unpaid creditors) or pro-rations (such as taxes, utilities or rent) based on the closing date. The seller, of course, tries to minimize the amount of the hold-back.
ASSIGNMENT OF LEASES
If existing leases are important, provisions should be included in the purchase agreement stating that closing is contingent on the landlord’s approval of the leases using the current rents and lease provisions.
LICENSES & TRANSFER
The seller should represent that it has all licenses and permits needed to operate the business, and that these can all be transferred to the purchaser. The buyer should investigate if there will be any charges from the issuing authorities for these transfers.
PRE-CLOSING TRAINING & POST-CLOSING CONSULTING BY OWNER
For smaller transactions in particular, if the purchaser needs training to operate the business, the purchase agreement should state precisely how much (in hours or days) pre-closing training and post-closing consulting will be provided by the owner and what (if any) compensation will be paid to the owner for this.
NON-COMPETE AGREEMENT
The buyer will almost always want the seller to agree to not start or participate in a competing business. Generally the buyer will want to allocate a specific amount of the purchase price to the non-competition covenant so that this amount can be amortized for tax purposes. Often the buyer will want the non-competition provisions to be in a separate agreement, so if there is some argument over adjustments in the purchase agreement then the non-competition agreement will still stand.
Although sales of a business are one of the rare occasions California will uphold a covenant not to compete, it is good practice to limit the restriction to a specified number of years and geographic area if at all practicable.
SUCCESSOR LIABILITY
If the purchaser is continuing the seller’s business, the purchase may be liable under a “successor liability” theory for any product-liability suits brought by pre-closing customers. It Is a good reason to have an indemnification clause running from the seller in favor of the buyer.
ARBITRATION AND ATTORNEY’S FEES PROVISIONS
In the United States, the winning party in any dispute does not usually get attorneys fees awarded. This means that one can win a fight…but end up still “losing” because the cost of the attorneys was so great. By providing that the prevailing party gets attorneys fees in the agreement, it not only remedies this danger, but stifles all but sincere claims since few will risk the double cost of litigation unless they have good reason to believe they will win.
Further, by providing for arbitration and mediation rather than the court resolution of a dispute, the matter may be resolved in months rather than years in a private forum without the danger of jury emotionalism and at about half the cost. See our article on Arbitration and Mediation.
CONCLUSION
The above checklist is far from a complete list of the issues confronting the typical business sale or purchase but being aware as to approaches to the above questions is a prerequisite to moving to the typical additional unique problems and questions that each individual transaction often encounters.
But, as one client stated after signing a particularly complex deal, “Well, if it was easy, everyone would do it, right? This is like an entrance exam…if I can’t do this right, I shouldn’t be in business.”
He ended up quite successful…