Selling a Business
Are you selling a business? Here are some of the key legal considerations we will discuss with you:
Have you received a letter of intent or summary of terms from the Buyer?
Although not a legal requirement, many business sales 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. Key provisions in a letter of intent include:
- Purchase price – The letter of intent should clearly state how much the buyer is paying for your business and whether payment is cash, stock or some combination. If some or all of the purchase price is to be paid in stock, how quickly can you sell the shares in order to limit your market risk? 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 – Is the buyer acquiring all or only a portion of your business, such as a division or specific assets?
- Structure of transaction – The most common structures for an acquisition of your 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. See discussion of these structures 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 company.
- Confidentiality and due diligence – The buyer will want to begin reviewing all of your business and legal records. Does the letter of intent (or separate nondisclosure agreement) contain adequate provisions regarding the protection of your confidential information? What about an agreement not to hire any of your employees unless and until the deal closes?
- No shop – The buyer will generally ask you to agree not to hold further discussions with any other potential acquirer for some period of time. Are you comfortable with the duration of the “no shop” period? Are you permitted to hold discussions with another buyer who makes a better offer?
- 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.
- Never 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, the buyer typically forms a new subsidiary that merges with your company. Because of the three legal entities involved, this structure is called a triangular merger. (A buyer usually prefers to operate your business in a separate legal entity to avoid direct exposure to liabilities of your company.) Most often, your company becomes a subsidiary of the buyer (and the temporary new subsidiary of the buyer disappears) as a result of the merger, a structure known as a reverse triangular merger. In a reverse triangular merger, the assets of your company remain in the same corporation as before the transaction which can be important for tax and contractual purposes. (If instead your company disappears into the new subsidiary of the buyer, the structure is known as a forward triangular merger, and the assets of your company are transferred to the buyer’s new subsidiary.) Your shareholders receive cash and/or stock of the buyer in exchange for their shares of your company. Receipt of cash in a merger is always taxable to you. Receipt of stock may qualify as tax-deferred subject to various conditions. A merger generally must be approved by the board of directors and also by the shareholders of your company.
- Stock Purchase or Exchange – In a stock purchase or exchange, the buyer agrees to acquire some or all of the outstanding shares of your company directly from the shareholders of your company. Most buyers prefer to acquire 100% of the outstanding shares of your company to avoid having to deal with any other ownership interests after the closing. As in a reverse triangular merger, the assets of your company remain in the same corporation as before the transaction. In order to acquire 100% of the outstanding shares, each of the shareholders of your company must agree to sell his, her or its shares to the buyer. A stock purchase transaction generally may be completed with or without the approval of the board of directors of your company. In some cases, a buyer will agree to a two-stage transaction in which the buyer obtains at least 90% of the outstanding shares of your company at the closing, permitting the buyer to conduct a “short-form” merger with a new subsidiary of the buyer after the closing, forcing out the remaining shareholders of your company and yielding 100% ownership for the buyer.
- Asset Purchase – In an asset purchase, the buyer or a new subsidiary of the buyer purchases specific assets (and may assume specific liabilities or no liabilities) of your company. A buyer may prefer an asset purchase where it is concerned about current or future liabilities of your company and/or to obtain certain tax benefits. If your 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 the buyer at the closing. Following the closing, the shareholders of your company continue to own the company, but the company has exchanged assets for cash and/or stock of the buyer. The board of directors of your company may then elect to pay the creditors of your company and to distribute the remaining proceeds of the sale to the shareholders of your company, after which your company may dissolve. A sale of all or substantially all of the assets of your company generally must be approved by the board of directors and also by the shareholders of your company.
What documents are necessary after a letter of intent?
After you sign a letter of intent or otherwise reach an agreement with the buyer regarding deal terms, counsel for the buyer and counsel for the 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 – The buyer will typically conduct a detailed review of your business and legal records in order to understand as much as possible about your business and any risks associated with your 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 the buyer the right to terminate the transaction until some amount of time before the closing if the buyer is not satisfied with the results of its due diligence review. It is important for you to anticipate any issues that are likely to arise during the diligence process and discuss them in advance with your counsel.
- Working Capital Adjustment – If your company has cash, accounts receivable or other liquid assets that fluctuate over time, you and the buyer will typically agree on a target amount of working capital of your company as of the closing. The actual amount of working capital in your company as of the closing is frequently determined by the accountants for the buyer within 60 or 90 days following the closing, subject to review by the accountants for your 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 the buyer’s due diligence review of your business, the buyer will require you to make a number of specific representations and warranties about your business in the definitive agreements. Common 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. After negotiating the applicability and scope of the representations and warranties, you must review each representation carefully (with input from your legal counsel and accountants) to ensure that the statements accurately describe your business and that any exceptions to the representations are disclosed in writing in a schedule attached to the agreement – even if you have previously disclosed the same information to the buyer 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 the buyer the right (i) before the closing, to terminate the transaction and seek damages against you and your business, or (ii) after the closing, to seek damages against you and any other 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. Often, the buyer will negotiate to set aside a portion of the transaction proceeds to be held in an escrow account in order to pay indemnification claims against you or your business (such as an undisclosed liability discovered by the buyer following the closing). Negotiations over the scope, duration, and maximum dollar amount of your indemnification obligations are a crucial aspect of any acquisition transaction.
- Employment and noncompete agreements – In some acquisition transactions, the buyer will expect you and other key employees to continue to work for the acquired business or directly for the buyer. The terms of your employment agreement must be negotiated as part of the larger acquisition transaction. Whether or not you are asked to continue to work for the acquired business, the buyer will typically ask 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 your interest in a business may be enforceable under an exception to California’s general prohibition on employment noncompete clauses.