The purchase or sale of a business is always more complicated than it appears. The value is often based on fickle attributes such as business relationships and goodwill, rather than real estate or readily marketable equipment. Considerations that should be covered by the business sale agreement include the following:
Asset Sale or Stock Sale. This is the key threshold decision. The simplest form of acquisition is a direct purchase of shares from the owners. However, the more popular structure is an asset sale. In general, a stock sale provides superior tax results to the seller. From a buyer’s perspective, an asset sale provides substantial tax advantages and also avoids exposure for most liabilities of the business. Buyer’s key tax advantage to purchasing assets is that the buyer will be able to claim future depreciation and amortization deductions on most of the purchase price. Conversely, the price paid for stock of a corporation is not deductible. Although beyond the scope of this article, a buyer may be able to use a Section 754 election to treat the purchase of an LLC interest as a purchase of the LLC’s assets, and thereby secure future tax deductions similar to those from an asset sale.
Due Dilligence, Warranties and Representations. Whether the sale is of stock or assets, the buyer should thoroughly investigate the past financial performance of the business, and the sale agreement should contain representations from the seller that the financial information furnished to the buyer is correct. There should also be representations about the ownership and condition of the business assets. For example, the seller should disclose if fixed assets are damaged or in need of repairs. Assurance should also be provided that software used by the business is covered by licenses and not pirated. Is the equipment owned or leased?
Dealing With Liabilities. If the structure is a stock sale, the agreement should list the key liabilities of the business so that the buyer knows exactly what debt is being assumed. Some liabilities may not appear on the balance sheet. For example, the buyer will not learn of potential claims by employees for back wages, employment discrimination, etc. unless the seller makes affirmative disclosures. The same is true for tax liabilities related to prior years. A stock sale agreement will contain representations to the effect that seller is not aware of any liabilities other than those disclosed in writing to the buyer, and that the price will be adjusted if additional liabilities surface after the closing.
Non Compete Agreement. In both asset sales and stock sales, the buyer will desire a non compete covenant from the seller. The idea is that goodwill (often attributable to the seller’s business relationships) is a key asset of the business, and will be damaged or diminished if the seller starts a competing business. In general, the non compete covenant should identify the prohibited activities, the geographic area of restriction (if applicable), and the time frame of the restriction. A ripple effect is that the price of a non compete covenant is taxable as ordinary income when received by the seller, and can be amortized over 15 years by the buyer. For this reason, a buyer purchasing stock usually wants to allocate as much of the price as possible to the non compete agreement.
Seller’s Post-Closing Consulting Services. It is also common for buyer to retain the services of seller for one or more months after the closing to provide hands-on knowledge of the business and to transition business relationships to the buyer. For example, the seller might agree to work full-time for one month at a given salary, and then provide consulting services as needed for an hourly rate.
Employees. In an asset sale agreement, the seller typically terminates all employees and the buyer hires some or all of them immediately after the closing. This frees the buyer from potential employment related liabilities. Agreements often condition buyer’s obligation to close the transaction on key individuals being employed on the date of closing.
Allocation of Price. Allocation of the price is a key negotiating issue in an asset sale. Allocations to goodwill and non compete agreements can be deducted over 15 years by the buyer under Section 197 of the Code. However, allocations to equipment, inventory and accounts receivable can be deducted much more quickly. Goodwill is taxed to the seller as capital gain, while gain related to equipment, inventory and accounts receivable is taxed as ordinary income. For these reasons, a buyer will desire generous allocations to fixed assets and inventory, while a seller will favor allocations to goodwill.
Accounts Receivable. Accounts receivable are often excluded from an asset sale, primarily because collectability is usually speculative. Instead, it is common for the buyer to collect and remit the receivables on behalf of the seller and withhold a percentage to cover collection costs. There is usually a cutoff date when no further collection efforts are required of the buyer.
Payment Terms and Security. If the buyer is unable to pay the entire price at closing, which is usually the case, care should be taken to secure payment of the deferred balance. In general, the shares or assets being purchased will be used as collateral to secure the purchase price. Further, if the buyer is an entity, the seller will always require the owners of buyer to give a personal guaranty. The shares or business assets are of questionable value as collateral. Used equipment has only nominal value, and goodwill can quickly evaporate. For example, if the buyer mismanages the business or secretly sells the assets, the seller may be left with remedies of nominal value. There should always be a “due on sale” clause that accelerates the remaining balance of the price if the buyer sells the business or its assets.
Leases. In an asset sale, care should be taken to ensure all leases are assigned to buyer. It is not usual for the lessor to charge a transfer fee (of roughly $1,000 to $2,000) as a condition to consenting to the transfer. Responsibility for this fee should be negotiated by the parties. Security deposits are usually credited to the seller.
Prorates of Expenses. Ongoing expenses are commonly prorated based on the closing date. Rent and equipment lease payments are perhaps the most common pro rates. Smaller items such as utilities are frequently ignored. If the business has inventory, there is normally a price adjustment based on the inventory on hand on the date of closing.
Business Names; Telephone Numbers. If the parties use an asset sale structure, the transfer of business names should be memorialized by assumed business name filings with the Oregon Secretary of State. Responsibility for filing fees should be negotiated. Seller should agree to transfer all telephone numbers, domain names, websites and email addresses to buyer.
Broker Fees. Sellers commonly use a business broker to find a buyer. The commission ranges from 10% to 20%, and is payable in full at closing. It frequently consumes substantially all of the down payment, leaving seller with only the hope of receiving payments in the future. The broker’s commission is not affected by seller’s inability to collect future installments, which may invite a broker’s indifference about whether the buyer has the wherewithal and experience to successfully run the business and pay the seller in full. In practice, many of the potential buyers identified by the broker will present an unacceptable risk to the seller. The seller should be wary of assets on the buyer’s net worth statement that are beyond the reach of creditors. For example, assets such as the buyer’s residence (which may have no equity) and IRA (which is exempt from creditor claims) are all but irrelevant to the seller.
Earn Out. Parties occasionally adjust the price to take into account the post-closing performance of the business, which is frequently referred to as an “earn out.” This protects the buyer from the risk that key customers will leave, and motivates the seller to make a smooth transition. The earn out is usually a percentage of sales or profits in excess of an agreed benchmark. The duration of the earn out is usually just a couple of years.
This list is far from exclusive. In my experience, parties represented by a lawyer end up with a far better deal, and the related savings usually dwarf the legal fees. Do-it-yourself sellers frequently don’t get paid, and do-it-yourself buyers frequently end up with unanticipated tax consequences, business liabilities or misrepresented assets.