The sale of a privately held business hopefully provides a triumphant occasion for the seller and an exciting new opportunity for the Buyer. However, both parties must carefully address the legal issues associated with the transaction in order to avoid frustration for both parties in the future. Some of these major legal issues for the parties to negotiate properly include:
•What exactly is being sold? The parties must first address whether the buyer is acquiring assets or stock. A sale of stock is often the simplest way to purchase a business. By acquiring stock, the buyer automatically assumes control of the business. Most contracts and leases do not require consents for a change of ownership. In addition, the seller gets favorable capital gains tax treatment for the purchase price. However, the buyer inherits all of the liabilities of the business in a stock purchase.
As a result, most sales of privately held businesses are asset sales. In an asset sale, the buyer chooses the assets acquired and the liabilities assumed. While the buyer still has successor liability for certain liabilities (including some environmental and employee benefits obligations), its liability exposure is smaller.
Even though the seller’s assets are likely to be completely depreciated on its books, the buyer gets to claim a depreciation deduction for the same assets based upon the market value of the assets from the purchase price allocation. Since the seller receives ordinary income tax treatment for the portion of the purchase price allocated to equipment and inventory, its tax benefits are not as favorable. Also, the transition of the business can be cumbersome because all contracts (including leases) typically have to be assigned to the new entity created by the buyer.
•How is the purchase price paid? The seller ideally wants the entire purchase price paid at the closing in cash. However, given the nature of the business, it may be appropriate to defer the payment of a portion of the purchase price with subsequent adjustments to represent more accurately the actual value of the business acquired by the buyer. This is particularly common in the service industry where retention of customers is a major concern. Also, a portion of the purchase price may need to be escrowed until the Illinois Department of Revenue issues the release of the bulk sales stop order in connection with the transaction.
•What is the condition of the business? The representations and warranties in the purchase agreement provide a snapshot of the business at the closing. These are generally the biggest source of liability for the seller from the sale. In an asset deal, the buyer should ensure that the seller’s owners are parties to the purchase agreement and stand behind the representations and warranties. Since the seller’s entity will likely dissolve after the purchase price is paid, the buyer needs recourse for a breach of representations from the parties who ultimately received the purchase price.
The seller’s representations and warranties typically address its authority to enter into the transaction, the absence of liens and litigation, the validity of assigned contracts, the status of employee benefits, environmental compliance, the condition of real estate (including status of lease if the lease will be assigned), accuracy of financial statements, and the absence of undisclosed liabilities. The buyer’s representations and warranties are generally narrower and primarily deal with its authority to enter into the transaction.
Most representations and warranties should be limited by time, typically between 1-3 years after the closing. This period should reflect the time period where the Buyer is likely to discover any undisclosed liabilities. However, such representations as those pertaining to liens and environmental conditions should survive for the statutory limitations to initiate a lawsuit.
•What happens after the closing? The following items address the conduct of the parties after the closing:
- Non-Competition and Non-Solicitation covenants – These protect the inherent value of the business purchased by the Buyer. In order to ensure enforceability, the parties should negotiate a reasonable term, geographic area and scope.
- Indemnification – Indemnification provisions protect a party from a breach by the other party of its representations and warranties and from operations of the business when controlled by the other party. The amount of the indemnification obligations of each party should be capped (e.g. up to the purchase price). In some transactions, a dollar amount floor before indemnification obligations trigger may be appropriate. In an asset deal, the Buyer should ensure that it is obtaining indemnification from the owners of the Seller.
A well-drafted purchase agreement reduces the exposure of the Buyer and Seller and provides a reasonable mechanism to settle disputes so that both the Seller and Buyer can obtain the intended benefit of their transaction.
The information in this article is intended for general purposes only and does not constitute legal advice. Readers should not act upon the information in this article without individual professional counseling.
Deven Kane specializes in business counseling, mergers and acquisition, corporate, banking and securities transactional work at Clingen Callow & McLean LLC, a full-service law firm of business advisers and counselors based in Wheaton. Contact him at 630-871-2603 or kane@ccmlawyer.com.