Key Legal Issues in Selling a Business
You have been successful. You started that business you always dreamed of, and you now have grown it into a very successful business. Now is the time to cash in and get some well-earned rest and enjoy life with your family. So, what do you need to know in order to successfully sell your business? You have never done this before and this is all new territory for you.
Set forth below are some key legal issues that you need to consider before you undertake this process. Once you have gone through each of these issues, you can then decide whether you are ready to sell your business, or if changes are needed in the business — or in the management team — before the time is right to sell.
Many businesses are sold without the assistance of an investment banker. These usually result when an offer comes to a company out of the blue, the offer is in within the range of expectations of the owners, and they proceed to negotiate the deal terms and close the transaction.
However, if you have just made the decision that you want to sell, and there are no immediate prospects on the horizon, using an investment banker may be important to you. Often, the best way to proceed is to consult with your legal and accounting advisors about investment bankers they have used with other clients and with whom they have been pleased.
It is best to personally interview several investment bankers from that firm, or different ones. Remember that the people who “pitch” their firm to work with you may not be the ones working with you. Make sure you have clearly met with, and understand, who is the team that will be handling your transaction. Also, get references for companies with which they have recently worked on similar transactions and call the CEO of those companies to find out if they performed as they had promised.
Once you have received a proposed engagement letter from the investment banker you have chosen, make sure it is thoroughly reviewed by your legal counsel. In particular, there are often “tail” provisions that provide that you still owe the investment banker a fee if a buyer whom they introduced to you later buys your company within a period of time — usually 12 to 18 months after your engagement with that investment banker has terminated.
Select Competent Legal Counsel
You may have been using legal counsel for all your corporate needs up to this point but the area of mergers and acquisitions is a specialized area. If your legal counsel does not have relevant experience in this area — or does not have partners in his or her firm with relevant experience — consider interviewing other experienced law firms. Just as with investment bankers, you should interview several firms and make sure you clearly understand and have a good relationship with the team that will be working with you. Also, get some estimation from them on what the legal fees will be in the transaction. Although it is unlikely they will give you a firm “cap” on those fees, they can at least give you a ballpark range on what they think the transaction will cost.
Books and Records
The buyer of your company will want to review all of your contracts, corporate records, personnel records and financial information. They will provide a “due diligence” list with all the information they will want to review. Your legal counsel should insure that, from the corporate/legal point of view, your books and records are in good shape. You will want to resolve open issues at a very early stage. A company that does not have its records in good order may cause a potential buyer to have second thoughts on proceeding with the acquisition.
Before you undertake any detailed discussion with a potential buyer, you should enter into a nondisclosure agreement that provides that any of your confidential information will be held in confidence by them for a period of at least five years. If the discussions break down, the agreement should provide that all of your confidential information will be returned to you. Sometimes these agreements go further and provide that the potential buyer will not solicit or hire any of your employees for a period of one to two years after the date of the nondisclosure agreement. The reason for this provision is to keep a prospective buyer from hiring your key people if they decide not to buy the company. The prospective buyers will be learning important information from you about these employees, including their salaries and bonuses, and they may use that information to hire these individuals.
Letter of Intent
The letter of intent (LOI) is a non-binding offer from the prospective buyer outlining all the major terms of a proposed transaction. Most importantly, the LOI will outline the structure of the transaction, the total purchase price, the closing date, the closing conditions and other matters such as escrow and indemnification. The purpose of the LOI is to allow the buyer and the seller to reach an agreement on the important deal points and to quickly determine any major areas of disagreement. The LOI also serves as a guide for your lawyer and the buyer’s lawyer in drafting the legal documents.
Although the LOI is generally non-binding, there are a few key provisions that are binding. First, the parties often represent that they have not engaged any broker or dealer and will indemnify the other party for any claims that may arise from their dealing with a broker or dealer. This provision should apply to both parties.
Second, the letter of intent will provide that both parties will pay for their own expenses in the transaction. Occasionally, a buyer will pay part of the seller’s legal expenses but that is not typical.
Finally, the buyer will want a “no shop” clause that provides that the seller will not discuss or negotiate with any other parties for the sale of the business for some period of time, usually 30 to 60 days, in order to allow the prospective buyer to complete its due diligence and the closing of the transaction. The no shop clause is one of the most important clauses in the LOI and should not be taken lightly. When you sign the LOI with a no shop clause, you will have taken your company off the market for some period of time. If other companies approach you during this no shop period, you will have to inform them that you are legally constrained from talking to them. Usually the LOI takes five to 10 working days to complete. Both parties will go back and forth with their counteroffers as reflected in the LOI.
In some instances, a portion of the purchase price will be paid at closing with some portion of the purchase price to be paid in the future based on the future performance of the company that is being acquired. This is called an “earnout.” Earnouts are a litigator’s dream. There are innumerable things that can go wrong in earnouts resulting in disputes as to whether the earnout has been properly earned or whether the buyer has failed to provide the necessary resources to meet the earnout goals. Thus, enter into an earnout only with trepidation. If you are happy with the cash you will receive at closing and you consider the earnout only an additional bonus, then you will be fine. But you should not go into a transaction thinking that a significant part of your purchase price will come from the earnout.
Typically, a portion of the purchase price will be held in escrow by a third party for some period of time, usually 12 to 18 months, to ensure that the seller has complied with the representations and warranties in the purchase agreement. The escrow provides a ready source of cash to the buyer in the event any of the representations or warranties prove to be false. Usually the size of the escrow is 10 percent to 20 percent of the purchase price. As the seller, you want to keep the amount of the escrow as low as possible and keep the time period for the escrow as short as possible.
Limitation of Liability
If there is a breach of the representations and warranties made by you as the seller in the transaction, the buyer may insist there be no limitation on your liability to him or her for those misrepresentations. Your goal will be to limit your liability in that event. In the ideal situation, the amount placed in escrow is the sole source for such indemnification. This is probably one of the most important provisions to be negotiated. You don’t want to sell your business and be constantly worried about a claim from the buyer, which may result in a substantial part of the purchase price going back to the buyer.
Manage Your Time
You have run your business and have been successful. Now you are trying to sell it and you have to undertake a major activity that is not part of your day-to-day activity, which is dealing with lawyers and investment bankers and prospective buyers. This process can divert your time and attention, and will create strains on you and on the business. Make sure you have a team that is operating the business while you or other members of your team are working on the transaction. It is not unusual to see performance drop during this time, which can produce a drop in the potential purchase price for the business. In some instances, it may be helpful to bring in one or more persons on a project basis, such as an interim CFO, to help you through this process. Don’t be afraid to recognize that you may need help to get through this process.
In selling the business, it is not what you receive but what you keep after dealing with the IRS. It is not unusual to see prospective sellers — long in advance — make tax planning decisions, such as moving the permanent residence to states with low or no income taxes, such as Florida. The key is talking to your tax advisors long in advance of the time that you want to sell so that tax planning can be done properly.
The structure of transaction — a merger or an asset acquisition — will also affect your tax liability. Again, in all of these instances, careful planning in advance with your tax advisors and with your attorneys will insure there will be no surprises at the end for you.
Preparing to sell, courting prospective buyers, working through the legal documents and finally closing can be a long process, as much as 6 months to a year. You should be mentally prepared for this to take quite awhile and maybe even result in not finding a buyer that meets your expectations on price or other terms. Once the letter of intent has been signed, the transaction should close within 60 days, unless there are unusual items that have to be addressed, such as pending litigation, consents of third parties, or transfer of permits or licenses.
Don’t Be Afraid to Ask
Don’t be afraid to ask for a purchase price that you think is fair. You are not going to get anything without asking. If there are rules of thumb within your particular industry on what companies sell for (in multiples of trailing revenues, for example), then familiarize yourself with these rules of thumb. Unless your company is extraordinary, you are not going to receive a price that falls outside the range for other similarly situated companies in your industry.
As part of the transaction, the buyer will expect you individually, and maybe even some of your key employees, to sign noncompetition agreements. In almost all states noncompetition agreements signed in connection with the sale of a business are enforceable. You may be expected to stay out of this type of business for up to five years. If the business has been your life, be prepared, in exchange for the money you receive, to be precluded from doing what you have loved all your life and at which you excel. Work with your lawyer in trying to narrow the noncompete as much as possible.
Sometimes in these transactions, the buyer will want you to stay on for some transitional period, or even stay on longer and run the business for up to two or three years. That may be a key element to consummating the transaction; the buyer simply may be prepared not to proceed unless you are committed to work for the buyer for some period of time. Think about this in advance and be prepared to say no or yes for some limited period of time. If you are prepared to stay on, make sure the terms of your employment agreement are not left to the last for negotiation. Unfortunately, buyers tend to put this on the table at the very end when everyone is well down the path to closing the transaction and when the buyer has the most leverage. Get this agreed to early on.
You have the most leverage prior to signing the letter of intent. Use it then. After that time, almost all of the leverage goes to the buyer unless you are prepared to simply walk and not close the transaction.
You will have to bring some of your key employees into your confidence so they know that the company is for sale. They will be working with you in preparing documents for the due diligence by the buyer and interfacing with the buyer on due diligence. However, you don’t want to scare off your good employees, and nothing can create more anxiety in the workforce than knowing that your employer is for sale. Thus, it is important that you limit knowledge of the transaction to only a few key employees until you are confident you have a transaction that will close.
As you can see, consummating a sale of a business can be a complicated process. With the right team on board, the right expectations and the right attitude, this can be a very rewarding process for you and your employees and one that makes all your hard labor well worthwhile. Good luck.
This article was written and published in the Business Leader Media Guide to Buying and Selling a Business.