Introduction
Buying or selling a small business can seem daunting, but there is a logic to the process that smart entrepreneurs can understand and use to help manage the time, direction, and strategy of their business attorneys and other professionals who help them through the process. This article gives you an overview of what you need to work smartly and effectively with your professionals when buying or selling a small business.
Three types of small business sales
A small business can be sold through asset sales, stock sales, or mergers, with asset sales being the normal vehicle of choice for many small businesses.
Commercial sale: canned versus personalized
Sometimes the sale of a small business is done through a basically canned process through a broker. In that case, a buyer and seller get a homogenized process that may or may not be tailored to their legal needs. The documentation will be “standard”, but the terms of the contract will not be customized for the parties. Such documentation will cover the minimum terms but little else.
Much better in all but very small sales is to use custom dealing documents prepared and reviewed by qualified business attorneys. Typically, a seller will obtain legal and accounting advice on how to structure the sale, and then work with a prospective buyer to document the basics of the deal in a term sheet or letter of intent. A term sheet, while not legally binding, provides a useful framework for moving forward. Of course, the parties can proceed directly to a formal contract.
Commercial sale: the purchase agreement
The formal contract is a purchase agreement. It typically contains covenants or promises (“I will sell to you and you will buy from me x assets or x shares,” etc.), warranties, and representations (“as a seller, I warrant and represent that I have good title to what I am selling to you and that there are no liens or judgments against you”, etc.), and the conditions for the closing (“our agreement will close only at the time conditions x, y and z are met”, such as obtaining the landlord’s consent for the assignment of a lease).
The escrow process, due diligence and confidentiality agreements
The contract is signed and a trust is normally established as a mechanism by which a closing is reached in which the sale will be consumed. Procedurally, such an escrow works much the same as it does when a house is sold, except that (for example) instead of waiting for the results of a title search, the parties may be waiting for license approval. of liquor or some other condition related to dirty business.
Due diligence is a critical part of this process, primarily on the part of the buyer. This is the process by which a buyer inspects the books and records of the business being sold and takes other steps to ensure that what is being sold is authentic and worth the value paid. Lawyers and accountants often help with this process.
Detailed due diligence can be done before or after the signing of a formal contract or it can be done in stages: limited due diligence before signing a term sheet with detailed due diligence during the escrow period. Buyer satisfaction with due diligence is often a condition of closing.
Due diligence is not normally permitted until the buyer has signed a confidentiality agreement.
Common Pitfalls and Pitfalls in Selling a Small Business
Many pitfalls and pitfalls can arise during a sale. Sometimes a buyer will claim that he wants to buy a business when, in fact, he plans to gain access to key information that will be used competitively against the seller. A nondisclosure agreement helps here, but this may be of little comfort to a seller caught up in a lawsuit. Be choosy in this area.
A serious risk for the seller is to take out a retroactive loan with inadequate protections. Adequate collateral (UCC and otherwise) is often key to dealing with this in the event of a default.
Buyers typically face the greatest risks. Unscrupulous sellers can play all sorts of tricks to make a bogus sale. The nature and variety of tricks used, or even mistakes made inadvertently, is wide and varied. This is often the main area that attorneys and CPAs focus on when shaping a seller’s representations and warranties and handling due diligence.
From the buyer’s point of view, the structure of the deal can affect liability risks: In a stock sale, a buyer will inherit all corporate history, good and bad, along with the purchase; In an asset sale, a buyer can typically limit the risk of inherited liability considerably, if not entirely.
Most businesses are sold with a premium on goodwill, which is generally the going-concern value of having a particular customer base, a recognizable name, and so on. Most buyers will want a non-compete agreement from the seller or, if the seller won’t grant one, at least a non-solicitation agreement related to existing customers.
Be especially careful with distress sales. Unless a distress sale proceeds through UCC foreclosure or bankruptcy, any buyer of a business burdened with debt can potentially inherit all or part of that debt, even if the contract specifies that the buyer assumes no liability. Given the risks, distress sales are often radioactive to a buyer.
Common Business Tax Issues
Another important issue is the tax. A sale of shares will have very different tax consequences than a sale of assets, some in favor of the seller and others of the buyer.
For example, if a seller is a C corporation with low base assets, any sale of its assets for a substantial sum would likely create a serious risk of double taxation. Let’s say corporate seller ABC Corp. sells its business for $10 million through asset sales and has almost zero asset base. This can happen, for example, when a manufacturing business with fully depreciated assets is sold. Normally, that sale would constitute a taxable capital gain for the corporation. However, since it is a C corporation, the cash in the company would normally be taxed again as a dividend when distributed to shareholders.
In the same scenario, if ABC Corp. shareholders sold 100% of the corporation’s stock to a buyer, then those shareholders would pay taxes on a one-time capital gain and nothing else.
Such tax problems can become complex and should be handled with qualified professional help. A good business attorney can suggest approaches that can mitigate double taxation issues. The point here is not to try to address a given situation, but rather to illustrate how taxes can seriously affect the bottom line depending on how a sale is structured.
Similarly, in an asset sale, the purchase price must be spread over the assets being sold, and this will result in different income and sales tax treatment, depending on the nature of the assets being sold. and the nature of the distribution. . Such assignments must be made with the help of a qualified attorney or CPA.
Don’t ignore these tax aspects of selling a business; they can sometimes be the most important part of a deal and they are almost always important to a significant degree. In more sophisticated deals, tax-free deals are also done through reorganizations.
Estimated transaction costs
What about transaction costs? These can literally go everywhere. In a typical small business sale, a buyer should use a rule of thumb of 2% to 5% of the purchase price as a rough estimate of total transaction costs. This would be money spent on lawyers, accountants, and other professionals, as well as escrow fees. Seller costs are usually lower, though they can be significant if broker fees are involved or the deal is complex. In any case, don’t rely solely on a rule-of-thumb approach: use it for initial planning and then consult with your professionals to refine estimates.
Work with a qualified business attorney
This highlights some key issues related to selling a small business, but does not address their legal implications or strategies for implementing them (consult your attorney for this). It also does not address important issues such as the need to obtain consents and approvals (owner, agency, vendor, and spouse, among others), the use of impartial opinions, attorney opinions, agreements not to buy, withholding provisions, earnings provisions, or issues such as UCC wholesale compliance, indemnification, joint and several liability, and the like. These agreements can have many nuances that only an experienced attorney will grasp.
For your particular deal, get a good business attorney. It is not wise to skimp on complex areas where the stakes may be high. What is saved today will be spent many times trying to get out of a mess if problems occur. So budget for what it takes and do it right.