Buying a Business
Are you buying a business or planning to purchase a company? Below are some of the key legal considerations that we will discuss with you:
What specific business objectives are you trying to achieve with the purchase?
Some of the typical goals when buying a business include the acquisition of:
- Intellectual property
- Cash flow
- Customer relationships
- Supplier relationships
Each of these objectives involves different legal considerations that impact the structure of the acquisition, documentation, due diligence review, risk analysis and mitigation. We will discuss with you how to address these considerations in the context of the particular business acquisition you’re planning.
What legal risks are associated with the purchase?
It is essential to understand and mitigate legal risks including the following:
- Actual or potential litigation
- Assignment and potential infringement of intellectual property rights
- Financial issues
- Employment and labor issues
- Environmental issues
- Title to assets and/or shares
- Consents from third parties
- Governmental approvals
- Corporate and ownership records
In addition to representations and warranties from the seller in the purchase agreement regarding each of these matters, we will discuss what further steps are needed to address particular risks identified in the due diligence review process.
Will you use a letter of intent or summary of terms for the Seller?
Although not a legal requirement, many business acquisitions start with a letter of intent between the buyer and the seller. A letter of intent acts as a starting point for negotiations and helps clarify significant deal terms. We can help you prepare a letter of intent or summary of terms that reflects your objectives. Key provisions in a letter of intent include:
- Purchase Price – The letter of intent should clearly state how much you are paying for the seller’s business or assets and whether payment is cash, stock or some combination. Is any of the purchase price deferred? If so, what are the conditions for earning the future payments? Contingent future payments are often referred to as an “earn out.”
- Scope of Transaction – Are you acquiring all or only a portion of the seller’s business, such as a division or specific assets?
- Structure of Transaction – The most common structures for an acquisition of another business are: (a) merger, (b) stock purchase and (c) asset purchase. Each structure has its advantages and disadvantages, and each will involve different corporate approval requirements, procedures and tax treatment. More information on these structures is located below. In addition to your lawyer, you should involve your tax advisor early in the process to review the tax implications of the proposed transaction structure for your existing company and the target company.
- Due Diligence Review – You and your advisors should begin reviewing all of the business, financial and legal records for the target company as soon as possible. We will prepare an appropriate legal diligence checklist to send to the seller early in the transaction. We will also assist with the legal review of the target’s business records.
- Confidentiality – The letter of intent may be crafted to include provisions regarding the protection of confidential information or we can prepare a separate nondisclosure agreement. If you will be sharing confidential information about your business with the seller, the letter of intent or nondisclosure agreement should also protect information you disclose to the seller.
- No Shop – A key provision of the letter of intent is an agreement by the seller not to hold further discussions with any other potential acquirer for an appropriate period of time. We will discuss with you the duration of the “no shop” period and whether the seller is permitted to hold discussions with another buyer under any circumstances.
- Binding versus Nonbinding – Typically, some provisions of the letter of intent are binding (generally including confidentiality and no shop) and other provisions are not binding (generally including purchase price, transaction structure and other economic terms). Be sure you understand which provisions are binding and how the letter of intent can be terminated.
Do not sign a letter of intent without review by your legal counsel.
Do you understand the different possible structures for an acquisition of your business?
- Merger – In a merger, we typically form a new subsidiary of your company that merges with the target company. Because of the three legal entities involved, this structure is called a triangular merger (it is generally preferable for you to operate the acquired business as a separate legal entity to avoid direct exposure to liabilities of the target company). Most often, the target company becomes a subsidiary of your company (and the temporary new subsidiary of your company disappears) as a result of the merger, a structure known as a reverse triangular merger. In a reverse triangular merger, the assets of the target company remain in the same corporation or LLC as before the transaction, which can be important for tax and contractual purposes. If instead, the target company disappears into the new subsidiary of your company, the structure is known as a forward triangular merger, and the assets of the target company are transferred to your company’s new subsidiary. The shareholders of the target company receive cash and/or stock of your company in exchange for their shares of the target company. Receipt of cash in a merger is always taxable to the seller. Receipt of stock may qualify as tax-deferred subject to various conditions. A merger generally must be approved by the board of directors (and in some cases, by the shareholders) of your company, and by the board of directors and the shareholders of the target company.
- Stock Purchase or Exchange – In a stock purchase or exchange, your company agrees to acquire some or all of the outstanding shares of the target company directly from the shareholders of the target company. It is always preferable to acquire 100% of the outstanding shares of the target company to avoid having to deal with any other ownership interests after the closing. As in a reverse triangular merger, the assets of the target company remain in the same corporation or LLC as before the transaction. In order to acquire 100% of the outstanding shares, each of the shareholders or members of the target company must agree to sell his, her or its shares to your company. A stock purchase transaction generally must be approved by the board of directors of your company and generally may be completed with or without the approval of the board of directors of the target company. In some cases, your company can agree to a two-stage transaction in which your company obtains at least 90% of the outstanding shares of the target company at the closing, permitting your company to conduct a “short-form” merger between the target company and a new subsidiary of your company after the closing, forcing out the remaining shareholders of the target company and yielding 100% ownership for your company.
- Asset Purchase – In an asset purchase, your company or a new subsidiary of your company purchases specific assets (and may assume specific liabilities or no liabilities) of the target company. An asset purchase may be preferable where you are concerned about current or future liabilities of the target company and/or to obtain certain tax benefits. If the target company is party to a large number of contracts, however, an asset purchase may require obtaining a significant number of consents from third parties before the contracts can be assigned to your company or your subsidiary at the closing. Following the closing, the shareholders of the target company continue to own their corporation or LLC, but the target company has exchanged assets for cash and/or stock of your company. The board of directors of the target company may then elect to pay the creditors of the target company and to distribute the remaining proceeds of the sale to the shareholders of the target company, after which the target company may dissolve. An asset purchase transaction must generally be approved by the board of directors of your company. A sale of all or substantially all of the assets of the target company generally must be approved by the board of directors and also by the shareholders of the target company.
What documents are necessary after a letter of intent?
After you sign a letter of intent or otherwise reach an agreement with the seller regarding deal terms, counsel for your company and counsel for the target company will prepare definitive agreements that describe the transaction in extensive detail and at much greater length. The principal definitive agreement will be a merger agreement, stock purchase agreement or asset purchase agreement (depending on the transaction structure). Unlike many provisions in a letter of intent, the definitive agreements are legally binding on the parties.
What are some of the key provisions in the definitive agreements?
In addition to the issues addressed in the letter of intent, which are covered in greater detail in the definitive agreements, here are some of the key aspects of the definitive agreements and the acquisition process:
- Due Diligence – You and your advisors will typically conduct a detailed review of the seller’s business and legal records in order to understand as much as possible about the seller’s business and any risks associated with the seller’s business. The due diligence process begins following the letter of intent and continues during and after the negotiation of the definitive agreements. The definitive agreements for the transaction will generally provide you the right to terminate the transaction until some amount of time before the closing if you are not satisfied with the results of the due diligence review. It is important for you to identify any areas of particular sensitivity that need close attention during the diligence process and discuss them in advance with your counsel.
- Working Capital Adjustment – If the target company has cash, accounts receivable or other liquid assets that fluctuate over time, you and the seller will typically agree on a target amount of working capital of the target company as of the closing. The actual amount of working capital in the target company as of the closing is frequently determined by your accountants within 60 or 90 days following the closing, subject to review by the accountants for the target company. The final purchase price is then adjusted up or down to reflect the excess or shortfall of actual working capital relative to the target working capital.
- Representations and Warranties – Above and beyond your due diligence review of the seller’s business, you will require the seller to make a number of specific representations and warranties about the seller’s business in the definitive agreements. Standard representations and warranties include: corporate organization, good standing and authorization of the transaction; capitalization; title to shares and/or assets; compliance with corporate instruments and contracts; necessary governmental and third-party consents; contracts and licenses; owned and leased real estate; environmental and safety issues; intellectual property; financial statements; employees; benefit plans; insurance; litigation and other potential liabilities; customers and suppliers; tax matters; and accuracy and completeness of disclosure. The seller must review each representation carefully (with input from the seller’s legal counsel and accountants) to ensure that the statements accurately describe the seller’s business and that any exceptions to the representations are disclosed in writing in a schedule attached to the agreement – even if the seller has previously disclosed the same information to you during the due diligence process. A breach or inaccuracy of a representation and warranty, or a failure to disclose relevant information in connection with a representation and warranty, may give you the right (i) before the closing, to terminate the transaction and seek damages against the seller and the seller’s business, or (ii) after the closing, to seek damages against the seller or sellers, including offset against any portion of the proceeds held in escrow.
- Indemnification and Escrow – Indemnification provisions give the parties, but principally the buyer, the right to recover damages from the other party in the event of a breach of a covenant, a representation and warranty, or other provision in the definitive agreements. You will typically want to set aside a portion of the transaction proceeds to be held in an escrow account in order to pay indemnification claims against the seller or the seller’s business (such as an undisclosed liability you discover following the closing). Negotiations over the scope, duration, and maximum dollar amount of the seller’s indemnification obligations are a crucial aspect of any acquisition transaction.
- Employment and Noncompete Agreements – In an acquisition transaction, you may expect the seller and other key employees to continue to work for the acquired business or directly for your company. The terms of the seller’s employment agreement must be negotiated as part of the larger acquisition transaction. Whether or not you expect the seller to continue to work for the acquired business, you will typically want the shareholders of the acquired business to agree not to compete with the business for some period following the closing. Note that noncompetition agreements made in connection with the sale of an interest in a business may be enforceable under an exception to California’s general prohibition on employment noncompete clauses.