Basic Things to Know When Buying or Selling a Business
I am often asked to explain what certain terms mean or to explain the process of buying or selling a Texas business. Usually I will find myself stating a term, and then realizing that the document title is also unknown to the client. I have developed a roadmap I use with my clients so they can follow the process. I provide this with our engagement agreement and it serves to clarify the process and work we will be doing to complete the transaction. If you are buying or selling a business and want to discuss the process in more detail, email Tim from the Contact Us page or call the office today.
The definitive purchase agreement is the final agreement for buying or selling a business. If the buyer and seller used a letter of intent, which is (usually) non-binding as a preliminary document, the terms will likely be the same or very similar provided there were no changes between the two documents. Usually, as I have written about before, the letter of intent sets forth the basics of the potential deal such as price, dates, and what is being bought and sold. In the instance the business is owned by a business entity (such as a corporation, limited liability company – LLC) then the entire entity may be purchased by the buyer. Another alternative is for the buyer to purchase the assets of the business and in this situation the buyer would not purchase the actual entity but instead purchase everything the entity owns. A buyer that purchases the assets would transfer the assets to a new entity set up by the buyer for this purpose. That said, the definitive purchase agreement transfers the ownership of a business either through purchase of the assets or entity.
- Stock/Membership Purchase Agreement – By purchasing the shares/membership of the entity, which owns the assets of the business, the buyer then owns the entire business.
- Asset Purchase Agreement – Rather than buy the entity, the buyer can buy the assets from the entity and in doing so can purchase some but not all of the assets. The seller would retain the entity, which likely would no longer have any assets. The buyer will have set up a new entity for this purpose.
THE USUAL CLAUSES
The definitive purchase agreement usually includes these clauses:
- Definitions – If there are words and phrases that have a special meaning used in the document, the agreement will define these for clarity to avoid any disputes on this basis.
- Price – Not only will there be the actual total price, but there may be earnest money deposit, down payment, and if there is a need for financing then there will be terms for financing.
- Non-Solicitation – This takes care of whether the seller is looking for buyers in case the deal falls through. At times the parties will negotiate exclusivity so neither is selling or buying during the time the agreement is being negotiated.
- Inventory – There will be a list and description of inventory included and excluded in the deal.
- Contingencies – Buyer contingencies can be a requirement that the buyer obtain a certain level of satisfactory financing, licensing, assignment or sublease of a commercial real estate lease, or franchise approval. There can be contingencies related to landlord approval or financial approval such as credit checks.
- Earnest Money Deposit – The term explains the person or entity that holds the earnest money deposit, whether it is refundable or non-refundable, and the conditions for refunding the deposit such as the timing for a refund and the factors that entitle the buyer to a refund of the funds. This is important to avoid disputes about whether and when the funds are to be returned to the buyer.
- Closing Costs and Pro-Rations– This explains who pays closing costs and third parties such as brokers or attorneys.
- Training / Transition Period – This outlines whether there will be training by the seller to the buyer of the business and the amount of time such as by hours, days, weeks, etc. Also, there will be an explanation of the type of training and typically I would include an option for more training at an agreed rate of compensation to the seller if the buyer requires more time to get a handle on the business to facilitate the smooth transition from seller to buyer.
- Representations and Warranties – Seller’s representations include: all assets are in good repair; all taxes will be paid at closing; seller has the legal capacity to sign the agreement; and seller has complied with all laws and paid employees.
- Confidentiality – This may be relevant when dealing with customers or third parties about the terms of the deal.
- Default and Remedies – This covers breaches of the agreement and what the penalty or remedy is to the non-breaching party.
- Miscellaneous Legal Provisions Common to All Legal Agreements – This states where to sue and the law that governs, whether it is in civil court or arbitration, mediation requirements, notice addresses and requirements, whether the parties will have an agreement for attorney fees, indemnification in the event suits arise due to the other parties actions, that the final agreement that is in writing is the entire agreement, severability.
Supporting documents are exhibits to the definitive purchase agreement, such as:
- Corporate Resolution – A corporate resolution is required in an asset sale, if the seller is an entity and is selling a majority of the assets of the company. Technically, the seller in an asset sale is the entity (corporation or LLC), and a corporate resolution is typically required in the Corporate Bylaws for taking major actions, such as selling all assets of the company. This resolution is not required if the buyer is selling the entity, such as in a stock sale.
- Bill of Sale (if selling the entity) – This document transfers the individual assets of the company, similar to when you sell a car and must sign a bill of sale. The bill of sale should list all assets included in the sale, along with a detailed description. Some advisors list intangible assets separately and transfer them using a separate set of exhibits.
- Deed of Sale of Entity (if selling the entity or stock) – This document is required if the seller is selling the shares in the entity.
- Non-Competition Agreement – The non-competition agreement contains a description of what the seller may and may not do, as well as specifying the length of time the agreement stands. Almost all sales include a non-compete agreement. Sometimes, this agreement is included as a clause in the purchase agreement, and sometimes it is listed as an exhibit. The non-compete agreement should be voided if the buyer defaults on payments to the seller.
- Training Log – It is good practice to log the completion of the training period to prevent potential future litigation.
- Promissory Note, Security Agreement (if the seller is financing the sale, asset sale) – This document is required for asset sales or if seller financing is involved. The promissory note outlines the terms of repayment, and the security agreement is a document allowing the seller to place a lien on the assets of the business until the buyers pays in full. A UCC-1 also needs to be filed to perfect the lien.
- Share Pledge Agreement (if the seller is financing the sale, stock sale) – For stock sales, shares of the entity can be held in trust or escrow until the seller is paid in full, which is similar to placing a lien on assets of the company. However, it is good practice to have a third-party physically hold onto the shares until the loan is paid in full.
- Assignment of Shares (for a stock sale) – The assignment of shares transfers shares of the entity, and it is used for stock sales only.
- Allocation of Purchase Price (for asset sales) – This document breaks down the purchase price into separate asset classes for IRS purposes. It is only used for asset sales. The tax implications can be substantially different for asset and stock sales.
- Independent Contractor Agreement – The independent contractor agreement is necessary if the seller is to continue working for the buyer in some capacity, though it can also take the form of an employment agreement.
- Assignment of Contracts – This document transfers third-party contracts from the seller to the buyer upon closing. This document may not be necessary for stock sales, as some agreements are transferable despite a major change in ownership of the entity.
- Assignment of Equipment Lease – The assignment of equipment lease transfers the lease for the premises. The seller usually remains on as a guarantor for the lease until the lease expires. This document must be signed for the landlord, though it is not necessary if a new lease is created. A different agreement is necessary if the space will be sub-leased from the seller to the buyer.
- Assignment of Intellectual Property – An exhibit that transfers any intellectual property from the seller to the buyer, such as patents, trademarks, or other registered intellectual property. It can also transfer non-registered intellectual property, such as phone numbers, websites, and content.
- List of Assets – The list of assets is a detailed list of all tangible assets that are transferred. It is not necessary for stock sales, though it does not hurt to be clear regarding which assets are owned by the corporation or LLC. Doing so can help prevent litigation regarding which assets were included in the sale.
- List of Intangible Assets and Intellectual Property- This exhibit includes a list of intangible assets, such as phone numbers. Providing clarity in this area can prevent future litigation and disputes.
- List of Titled Property – It includes a list of titled property, such as real estate or vehicles. These assets requires a separate set of transfer procedures.
- Seller’s Disclosure Statement – A statement made by the seller regarding any adverse conditions of the business the buyer should be aware of. It is critical to notify the buyer in writing of any material, adverse conditions of the business. Doing so prevents potential litigation.
- Release of Holdback – Savvy buyers will request that a percentage of the purchase price is held in escrow until the training period is complete. In some middle market transactions, this amount can be held in escrow for up to 12-24 months to cover any additional unknown variables, such as customer warranty claims, gift certificates, etc. This varies from 5-20% (or more) of the purchase price.
THE PROCESS – SMALL BUSINESSES (LESS THAN $1-3 MILLION)
Many small business purchases are handled with only one agreement. The same document that is used to make an offer on the business is often the final agreement that is signed at closing. A buyer makes an offer to purchase the business, along with an earnest money deposit. The buyer and seller then complete due diligence. The same agreement that was originally submitted to make an offer on the business is then used at closing to transfer the assets.
Parties in a small business transaction are often not as sophisticated as those involved in larger transactions and using one agreement simplifies the process. Additionally, many business brokerage offices hire untrained business brokers, and they simplify the process by using fill-in-the-blank PDF forms. Doing so may not be best for the buyer and the seller, but using fill-in-the-blank forms simplifies the process for the business broker offices. Many franchised business brokerage offices operate this way.
THE PROCESS – MID-SIZED BUSINESSES ($3-25 MILLION)
The process for a mid-sized business is a bit more complicated, requiring the paperwork outlined below.
Letter of Interest – Most mid-sized transactions begin with either a letter of interest or letter of intent. Whether the process opens with a letter of interest varies based on whether the process is an auction or not, and it also depends on the parties’ preferences.
Letter of Intent (LOI) – At some point, a letter of intent is offered, often without an earnest money deposit. Sophisticated buyers make a substantial investment in professional advisory fees during due diligence, and most view it as unnecessary to make an earnest money deposit. Additionally, almost all middle-market buyers are either corporations or financial buyers, such as private equity groups, and most are credible and can be easily researched. Letters of intent are usually non-binding. Sophisticated buyers don’t want to waste their time or money on due diligence, so few sellers require a binding agreement.
Due Diligence – Due diligence then begins, typically lasting 30-60 days. Most due diligence for middle market deals is done online through a virtual data room. Most parties invest a significant amount of time and money at this stage. Additional negotiation often occurs after completion of due diligence if the findings differ from the seller’s initial representations.
Definitive Purchase Agreement – Due diligence then concludes and the parties’ attorneys draft a definitive purchase agreement, which is signed before the closing. This time period involves the execution of many agreements. Occasionally, additional contingencies remain prior to the closing.
Closing – The closing is anticlimactic and can either be a round-table closing or a virtual closing. The closing simply involves a virtual or physical meeting of the parties.
Much of what is in the definitive purchase agreement is boilerplate language. That is, it is taken from previous templates, but the agreements may differ substantially between deals. The job of the attorney for your specific deal is to draw on the standard clauses for guidance and customize them to fit your business deal. For example, intellectual property may be addressed in an agreement for a tech company involving an app and also for a food truck or restaurant deal. The documents will be tailored to the deal and client and failure to do so can mean future issues and costs if a problem arises which could have been avoided. In my opinion, it is best to hire an attorney to walk you through the process and to let the attorney spend the time to get to know you and your business so that nothing is overlooked and your expectations are met. It is best to get it right the first time and the work and effort is worth it. If you are buying or selling a business and want to discuss the process in more detail, email Tim from the Contact Us page or call the office today.