By Attorney Amanda N. Follett, Schloemer Law Firm, S.C.
In selling your business, there are certain steps you should take to protect yourself. Our team of business law attorneys can help guide you through the process to help you protect yourself financially and limit your liability. This article addresses some of the most common questions we see in this area and provides an outline of some of the most important considerations in selling your business.
Marketing of a Business can be straight forward or complex. In a straightforward payout, the Seller and Buyer are aware of each other and agree to proceed to completion of a transaction for their mutual benefit.
However, it is not always that simple, and many times a Seller will have concerns with marketing the business as they do not want competitors, employees, etc. to be aware that the business may be changing hands. A competitor could be one of your best potential Buyers, but they could also use the knowledge to try to gain an advantage.
At the outset, the Seller is unaware of the potential Buyers. The Seller will many times create a marketing summary which basically identifies the business, its geographical location, and its operations without disclosing the name of the Seller. This more complex marketing approach is generally developed by the Seller’s team of professionals including the Seller’s attorney, accountant, and a qualified business broker. At a price, the business broker brings value to the transaction by identifying those potential buyers with synergy with the Seller, or equity buyers, thereby maximizing the sale value of the Seller. Based upon the responses from potential buyers, the Seller will enter into a Confidentiality Agreement, so as to elicit from the potential buyers a Letter of Intent (“LOIs”). Upon receipt of the LOIs, from one or more perspective buyers, the Seller will select one of the LOI, and move forward with that Buyer.
Recently, this process has become even more complex with Indications of Interest (“IOIs”) being solicited prior to Letters of Intent. While they basically serve the same purpose, an IOI may be served earlier in the process before much due diligence is complete. An LOI is more formal than an IOI.
What is a Letter of Intent?
A “Letter of Intent” (“LOI”) is a non-binding letter outlining the economics of the transaction. Certain terms of an LOI, however, are binding, including provisions regarding “no shop” clauses and confidentiality.
A “no shop” clause provides for exclusive dealings between the parties for a set period of time. In other words, a “no shop” clause takes the business off the market to other buyers during that time.
To analyze the purchase, a potential Buyer will want to obtain information about the target business. Before confidential information is provided, an LOI, Confidentiality Agreement, or Non Disclosure Agreement (also known as an NDA) should be signed. If an LOI is not going to be signed, or confidential information needs to be provided before the LOI is signed, a separate Confidentiality Agreement should be signed. Having a confidentiality agreement in place is important to allow a Seller to provide a potential Buyer with information. A confidentiality agreement helps prevent proprietary and other confidential information being made public during the pending sale, or if the pending sale falls through.
What is Due Diligence?
Due diligence is the time period during which the Buyer investigates and obtains information about the target business to analyze the potential investment and potential risk. Due diligence is conducted after the LOI is signed up until Closing.
Due diligence is important to the Seller, because disclosures during due diligence help protect a Seller from future litigation from a disgruntled Buyer.
During due diligence, various information, records, and documents will need to be provided, including information regarding the selling company’s organizational and governing documents, material contracts, customers, suppliers, operations, accounts payable and accounts receivable, real estate, assets, financials, tax returns, litigation and audits, employees, management, etc.
Due diligence requests are often comprehensive, and it is time consuming to prepare the information. In preparation for a sale, our office can provide you with a list of commonly requested documents. It is helpful to begin compiling the information before putting your business on the market so it is ready when the Buyer requests the information.
What are Representations and Warranties?
The purchase agreement will contain a section regarding the Representations and Warranties. A party making a Representation and Warranty is representing and warranting to the other party that a statement they are making is true, and the other party can rely on the information. For example, a common Representations and Warranty is that there are no environmental issues affecting the property, with a list of exceptions.
The scope of the Representations and Warranties is one of the most heavily negotiated points in a transaction, since this is a main source of seller liability after closing.
To protect a Seller, the Representations and Warranties often have “Knowledge Qualifiers”. Depending on the specific type of Representations and Warranties, it can be limited to whether a Seller has “Notice”, whether a Seller had “Actual Knowledge”, or whether it is to “the best of Seller’s Knowledge”.
- For example, “Knowledge is defined as only the actual present knowledge of Seller”.
Additionally, liability can be further limited by defining whose “Knowledge” we are talking about. Without careful definition, issues can arise if a prior owner has knowledge, an employee had reason to know about the issue, etc. We recommend narrowly drafting so that “Knowledge” is very narrowly defined.
- For example, “Knowledge is further defined as actual present knowledge of solely the current Owner, John Doe”.
Furthermore, a Seller can seek to add a timeframe to a Representation and Warranty.
- For example, “From 2009 through 2019, Seller has not….”
Another way to limit liability is to include a “materiality” qualifier.
- For example, “There has been no material breach of contracts that would have a material adverse effect on Seller’s business…”
If there are any exceptions that need to be disclosed, the exceptions should be listed in the final agreement, or on schedules attached to the final agreement.
- For example, “There has been no……………, except………………..”
If the transaction is structured as a stock sale, the representations and warranties will be more important and more detailed because of unknown and contingent liabilities.
What is “Indemnification”?
Indemnifications provisions require one party to indemnify and hold the other party harmless in certain circumstances. Generally, an indemnification clause is a promise by one party to cover the other party’s losses if they do something that causes that party harm or that causes a third party lawsuit.
The most common indemnification provisions relate to breaches of the Representations and Warranties that damage the other party. Indemnification provisions can also serve as a way to enforce failure to perform terms of the purchase agreement.
One way for Sellers to protect themselves is to place a time limit on the indemnification provisions.
Another way for Sellers to protect themselves is to include a “cap” and “basket”.
What is a “Cap” and “Basket,” and why are they important?
A “cap” is a cap on the amount of damages the indemnifying party is required to pay under the indemnification provisions.
A “basket” is a threshold amount of damages that must be reached before the indemnifying party is required to pay under the indemnification provisions.
A “tipping basket” is a basket where the Seller is required to pay for all damages once the “basket” amount is reached. A Seller does not want a tipping basket; rather, a Seller wants to only pay for damages in excess of the basket amount.
For example, in a deal with a cap of $10 Million Dollars and a basket of $500,000, if an indemnification claim arises, the Seller would not have to pay unless the claim was in excess of $500,000, and would not have to pay more than $10 Million Dollars. If the claim is for $600,000, the Seller would have to pay $100,000. If the basket had been drafted as a “tipping basket”, the Seller would have to pay the entire $600,000.
What is an “Offset”?
Often, a Buyer will want the Seller to finance part of the purchase price on the sale. An “offset” gives the Buyer the right to offset against the amount that remains owing if an indemnification claim arises—for example, if the Representations and Warranties are not true, correct, and accurate.
What is “Sandbagging” and “Anti-Sandbagging”?
A Seller will prefer an “anti-sandbagging” provision, so that the Buyer cannot “sandbag” the Seller.
A “sandbagging” provision states that a Buyer’s remedies against the Seller will not be impacted by a Buyer’s knowledge of facts or circumstances giving rise to the claim prior to closing.
An “anti-sandbagging” provision states the opposite, that a Buyer cannot recover against the Seller if the Buyer had knowledge of the facts or circumstances giving rise to the claim prior to closing.
Without a properly drafted anti-sandbagging provision, a Seller runs the risk that the Buyer will conduct due diligence, find out about potential problems, proceed to closing anyways, and then sue after closing to receive a reduction in the purchase price via a lawsuit.
How Should the Purchase Price Be Paid?
Depending how the Purchase Price is paid has very important implications for the Seller.
Cash at closing. Cash at closing for the entire purchase price is obviously the best payment for the Seller. Even with cash at closing, there may be an escrow for a short period of time after the closing to substantiate closing statement figures such as final target working capital. Hence, the final target working capital is determined after closing, and then there would be a dollar for dollar adjustment up or down depending upon the finalized number in comparison with the estimated figure on the closing statement.
Promissory Note. If all of the purchase price is not paid at the closing, then a Promissory Note will be provided for the unpaid purchase price. This Promissory Note generally does not exceed five years and is subject to seller’s desires that it be personally guaranteed and collateralized. The Promissory Note is a form of Seller financing, and additional steps should be taken to protect the Seller, as discussed below.
Earnout. Many times, there will be cash at closing, a Promissory Note, and then a further carve out of the purchase price for an earnout. An Earnout Note provides payments to the Seller, provided the Buyer achieves certain financial results, as discuss below. This is often problematic for a Seller, since the Seller no longer has control over the operations of the Buyer and its stewardship of the Seller’s business. This becomes further complicated by the fact that the method of accounting may be different for purposes of determining the Seller’s performance and the Buyer’s performance of the Seller’s business, and this is additionally complicated by the fact that a synergistic buyer has the ability to allocate income and expenses between its existing business and the acquired business, which may taint the computation of the earnout payment.
What Protections are needed if there is Seller Financing?
If a Buyer wants the Seller to finance part of the purchase price, additional Seller protections are needed.
A Seller should also do their due diligence on the Buyer. A well-capitalized Buyer with a proven record of success in operating similar operations is less likely to default on payments. If the Buyer wants the Seller to help finance the transaction, the Seller is essentially becoming a lender, and the Seller should not hesitate to ask questions of the Buyer, just like any other lender would. For example, depending on the circumstances, it may be appropriate to request credit checks, copies of business and personal taxes, personal financial statements, business financial statements, etc.
The financed amount should also be proportionate to the down payment at closing. The Seller should leave the parking lot of closing with an adequate cash down payment to feel secure. If a Buyer defaults or files for bankruptcy, there is no guaranty a Seller will ever see the remaining amounts due.
A Seller should also consider a premium purchase price or adequate interest for an installment sale due to the extra risk involved compared to a cash sale.
The Buyer will execute a Promissory Note in favor of the Seller to be paid over a certain number of years at a set interest rate. Payment is usually subordinate to any senior lender (i.e., the bank) that is helping the Buyer finance the transaction.
A few ways to help secure payment and protect the Seller include:
- Personal guaranties from the principals (i.e., owners) of the Buyer
- Stock pledges
- General Business Security Agreement providing a security interest in the specific assets that are pledged as collateral in case the Buyer defaults
- Mortgage on real estate
- Assignment of Leases and Rents
What is an “Earn Out”?
If there is Seller financing involved, a Buyer may seek to have an earn out provision included. An earn out consists of amounts to be paid to Buyer based on performance of the acquired company after closing. Earn outs are typically tied to measurements of performance, such as revenues, EBITDA, sales figures, etc.
An earn out depends on the performance of the Company after closing. Accordingly, a Seller should think very carefully before agreeing to an earn out, as an earn out depends on a Buyer’s ability to continue to run the business successfully after closing.
How should we allocate the Purchase Price in the Sale?
Allocation of Purchase Price will have important for tax ramifications for both the Seller and the Buyer. The Seller’s accountant should be consulted as early as possible in the process to ensure an advantageous allocation. The allocation can even be addressed in the LOI to ensure that both parties are aware of the allocation early in the process, reducing the need to further negotiate this point later.
The Purchase Price is often broken into four components:
- Assets – Real Property, Machinery & Equipment, Intangible Property.
A Buyer will prefer to have price allocated so that it all can be expensed, depreciated, or amortized, and to have price expensed, depreciated, or amortized over the shortest time possible.
The Seller will prefer to receive capital gain treatment, to avoid self-employment tax, to use up Net Operating Losses, and to offset capital gains with capital losses.
What is a Restrictive Covenant or Covenant Not To Compete?
A restrictive covenant is often included in the sale of a business to avoid the Seller entering into competition with the Buyer after closing for a certain period of time.
A Seller should consider its post-closing plans. If completely retiring, the restrictive covenants may not be as much of a concern.
If a Seller is going on to another venture, however, the restrictive covenants must be more closely scrutinized and the following should be considered and negotiated:
- What is the length of time of the restrictions?
- What is the geographic scope of the restrictions?
- What activities are prohibited?
- Should any exceptions be specifically listed based on the Seller’s post-closing plans?
Do I need an Employment or Consulting Agreement?
If the transaction contemplates that the Seller will stay on to help with the transition, an employment or consulting agreement should be specifically negotiated as part of the sale. Terms to address include:
- Guaranteed Salary or Minimum hours, if applicable – this is important if Seller is relying on post-closing income as part of the transaction.
- Maximum hours, if applicable – this is especially important if it is a true consulting agreement to help with the transition, and the Seller wants to limit the amount of time dedicated to the business after closing.
- Vacation time or ability to work remotely – once again, this is important if the Seller does not want to have to be at the business day to day.
If you decide to sell your business, it is important to consult with your attorney as early as possible in the process, especially regarding Confidentiality Agreements before proprietary information is shared with prospective buyers.
Originally published: August 15, 2019.
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Disclaimer: The information contained in this post is for general informational purposes only and is not legal advice. Due to the rapidly changing nature of law, Schloemer Law Firm makes no warranty or guarantee concerning the accuracy or completeness of this content. You should consult with an attorney to review the current status of the law and how it applies to your unique circumstances before deciding to take—or refrain from taking—any action. If you need legal guidance, please contact us at 262-334-3471 or [email protected].