Selling a Business

SELLING A BUSINESS:

What to Consider

by Mary Hanson

Preparation is the key to the successful sale of a business. Before even beginning to discuss the potential sale with a buyer, the seller should know how he or she wants to structure the sale, the price range for an acceptable price, and what payment terms might be acceptable.

The seller also needs to know what the tax consequences of the sale will be to him or her, and what other terms and conditions he or she will accept in the agreement for purchase and sale. If the seller intends to continue to engage in business, he or she must have a plan for handling a request for a covenant not to compete. The seller must also have an opinion on what warranties and representations, if any, he or she is willing to give the buyer.

The successful business sale should provide the seller with an adequate price, adequate assurance of payment, and limited exposure to liability in the future. The price should not be set until the other terms are agreed upon, since the price needs to be adjusted to reflect the risks of nonpayment and other potential liabilities. The seller must consider all aspects of the sale at the same time. No commitments should be made on any one aspect without covering the other important aspects.

The seller needs to be prepared so that when a buyer suggests a purchase of the business, the seller can make clear what key terms the buyer needs to include in his or her offer, in order for the offer to be considered. If the seller will not accept an offer that does not provide for payment in full at the time of transfer of the business, this key demand should be set out in the earliest discussions of sale of the business. Leaving an issue for later discussion usually signals that it is negotiable.

If the seller will not be paid in full at the closing and will be accepting a promissory note from the buyer, the seller has to be concerned about the creditworthiness of the buyer, the adequacy of the collateral securing the note, and also the buyer's ability to run the business successfully in order to make payments. The risk of not getting paid is serious and must be reduced by every means possible. If at all possible, the seller should demand full payment up front.

If the business is being sold to a closely held corporation, and a promissory note is accepted by the seller, the seller should get personal guarantees from the individuals behind the business. If the business fails to make payments, the seller must be able to go after the individuals, as well as the business entity.

Any notes accepted by the seller should be fully secured with assets that assure payment. The assets of the business can secure the obligation of the entity, and personal assets can be used to secure the obligation of the personal guarantors. A trust deed on a home (with adequate equity) is usually the best collateral for a personal obligation. If the business has assets that are considered good collateral, they may be used to secure the note. However, the seller should not have total confidence in business assets as collateral. An unethical buyer could still dispose of most business assets in violation of agreements, and an unsuccessful buyer could render assets worthless.

Similarly, a seller has to keep in mind that, if the buyer fails in business and cannot meet the terms of the agreement, the seller loses not only the money that is not paid, but also the benefit of the promises contained in the contract.

A background check on the buyer (both the entity and the individuals involved) should be a requirement. Have the parties provide their written consent early on. Why waste time negotiating a transaction, only to find out later that the background check reveals financial or legal problems, or other information that makes the buyer unacceptable.

No matter how good the buyer seems to be, there is always a serious possibility of nonpayment. There is the possibility that the buyer does not understand all the aspects of the business, whether financial, administrative, or market-oriented, that the buyer will not have adequate funds to implement his or her plans for the business, and that the buyer will lack the skills or personnel to operate the business successfully. There is also the risk of economic or new market conditions that doom the business. If the business fails in the hands of the buyer, the seller may not get paid.

The seller needs to prepare for a sale by reviewing all existing business contracts, accounts, and obligations. The seller needs to reduce or eliminate responsibility for those contracts, negotiating this issue with the buyer and dealing directly with the vendors, utilities, and any other sources of business obligations.

Warranties and Indemnification

The seller also needs to get a good understanding of both warranties and indemnification. Both have the potential of generating claims by the buyer against the seller. The buyer can make a breach of contract claim alleging that some aspect of the business was not as warranted by the buyer.

Some typical warranties are that the books and records shown to the buyer are accurate, that the equipment is in working condition, that the seller owns all assets to be transferred free and clear of liens, and that there are no undisclosed legal liabilities facing the business, such as lawsuits pending or threatened.

The seller should give the buyer as few warranties as possible, in order to avoid liability for business matters. Each warranty requested must be individually considered.

The typical indemnification requested obligates the seller to protect the buyer from liabilities arising from the seller's operation of the business prior to the sale. The seller should seek to limit any indemnification, and should also increase the price of the business to compensate for any increased risk taken on in agreeing to indemnification.

Indemnification claims arise when a third party makes a claim against the buyer, and the buyer turns to the seller to be covered or reimbursed in accordance with the terms of the indemnification provisions of the agreement.

Indemnification provisions in the agreement can greatly resemble the terms of an insurance policy, with ceilings, deductibles, and covered and excluded items. If indemnification is required as part of the sale, the seller should not shy away from complex language in the indemnification provision; additional language is often used to limit the seller's exposure.

Separately, as part of the seller's overall liability planning, the seller should determine what insurance policies can be continued and what new insurance policies can be purchased to cover liabilities that might later arise from the seller's operation of the business.

Other Issues

One of the key issues in selling an incorporated business is whether you are selling the stock of the corporation or the assets of the business.

The buyer and the seller have conflicting desires in structuring the sale of an incorporated business. Sellers usually benefit from the tax consequences of selling the corporation by transferring stock. The buyer will almost always insist on structuring the acquisition as an asset purchase in order to avoid the liabilities of the corporation.

The owner should, before even considering a sale of the business, determine the tax impact of a sale of assets vs. a sale of stock. If the tax consequences of an asset sale are too burdensome, the seller needs to identify this issue as a key demand, and make clear to all potential buyers that only an agreement structured as a purchase and sale of stock will be considered, unless the price is increased to make up for the tax burden.

The following are some suggestions for structuring the sale of a business, from the seller's point of view:

* Get a confidentiality agreement signed before disclosing any business information to a potential buyer. Better yet, don't provide key confidential information until the purchase is complete.

* Agree upon the terms of the price, the promissory note, the security agreement, any licenses, assignments, insurance, employment contracts, and all other documents at the same time. Don't leave some to be negotiated later.

* Investigate the background, credit-worthiness, financial strength, management capability, and business knowledge of the potential buyer and other parties or entities involved.

* Treat the promissory note for the purchase just like a loan of your own money. Check out the value of the collateral proposed and make sure the collateral has value and can be converted to cash to pay off any unpaid obligation.

* Review all existing contracts involved in the business. While customer contracts and large contracts will probably be discussed, small contracts for security alarms, telephones, and other less visible matters can be overlooked and cause headaches for the seller.

* Sellers must consider how existing contract commitments will be met. Contracts of the business are not automatically transferred in an asset purchase. The seller is still obligated to fulfill each contract, unless the other party to the contract agrees to release the seller from obligations. The seller should seek releases from the other parties (vendors, landlords, utilities, etc.) and require the buyer to enter into new contracts directly. Some contracts may be completed by the seller, cancelled, formally terminated, renegotiated, or otherwise taken care of by the seller.

* Avoid any assignment of existing contracts, since this does not release a seller from liability. An assignment to the buyer really just adds the buyer as a additional responsible party.

* Never let buyers have early possession of a business prior to the closing and transfer of ownership. As soon as the buyer has possession of the business, the seller is placed in a weak position for negotiation. The buyer knows the seller has psychologically and financially committed to the sale.

* Don't sign a letter of intent or other preliminary agreement before negotiating the formal agreement of sale, unless it meets a specific objective of yours. A letter of intent can tie up the seller so that he or she is prevented from considering better offers or is forced to negotiate with the one buyer under the letter of intent.

Mary Hanson, MBA, Attorney at Law (310) 543-1355 Torrance (Los Angeles County), California USA