Avoiding Pitfalls When Buying and Selling a Business: Seller’s Viewpoint (Part 1)
By Dave Thayer
There are no mulligans when selling a business—you only get one shot to get it right. With the right amount of research, due diligence and reliance on experienced professionals, you can reduce the inherent risks involved in these types of business transactions. Part 1 in a two-part series, this article explores common issues to consider from the seller’s viewpoint.
So, you are thinking of selling a business you’ve spent a lifetime building? Selling and buying businesses of any size are not decisions to be taken lightly.
Several years ago, a buyer reached out to business owners in Colorado with an interest in buying their business. The buyer put money down, enough to demonstrate they had funds, and secured seller financing for the balance of the purchase price.
After the sale closed, the buyer made several monthly payments while, unbeknownst to the seller, steadily ransacked the business. The buyer sold off assets, collected on receivables, failed to pay employees and suppliers and stripped the business bare before abandoning it.
The buyer had swindled other business owners using the same hustle before. By buying the business using the business itself as collateral for seller financing, the buyer was positioned to strip the business bare and walk away. By the time seller financing provisions for default kicked in, the business was a shell worth a fraction of its pre-sale value.
As you consider selling a business, protecting your business, proactively evaluating potential buyers and the terms of the agreement, and addressing transition issues before signing a sales agreement will help you avoid common pitfalls and keep your transaction on track.
Obtain a confidentiality agreement
An essential first step in selling a business is preparing and using a confidentiality (non-disclosure) agreement. This agreement protects your company’s proprietary and confidential information if the deal does not go forward by expressly prohibiting a potential buyer from:
• Disclosing discovery information to third parties, such as competitors
• Using the information to start or enhance their own similar business
• Soliciting or hiring your employees
If negotiating the confidentiality agreement is a long and tedious process, with the buyer or the buyer’s attorney requesting needless and unrealistic revisions, it may be a telling indication that negotiating primary agreements with this buyer will be a painful and fruitless process, one that you may want to forego sooner than later.
Due diligence on potential buyers
Due diligence is equally important from the seller’s side as it is from the buyer’s side. Sellers should vet each potential buyer to reduce the risk that the buyer will be unable to fulfill their contractual obligations.
This includes performing background checks on the buyer and its owners and principals, such as UCC searches, credit reports and criminal record searches. Prequalify the financial capacity of potential buyers so you don’t want to waste time with “tire-kickers” or people who clearly cannot afford your business.
As noted in the example at the beginning of this article, fraudulent buyers prey on the unsuspecting. Had the seller in the foregoing example performed an appropriate background check, the seller likely would have discovered that the buyer had defrauded other sellers at least once before.
Seller financing: Think long and hard about this!
You’ve found a buyer for your business and it seems like a good fit, but the buyer simply does not have the cash or the ability to finance the purchase price through traditional lending sources, such as a bank. The buyer asks you to accept 10% of the purchase price in cash and the remainder via a promissory note with a market interest rate using your business as collateral. Perhaps the buyer even throws in a personal guaranty. Sounds good, right? The worst that can happen is that the buyer defaults and you get the business back.
Think long and hard about financing a potential buyer under any terms. By the time you get the business back, the buyer may have run the business into the ground through poor management and decision making or, worse, may have purposely ransacked it, as in the previous example. You’ll end up with a bankrupt business and a bankrupt buyer whose personal guaranty is worthless.
Granted, it can be difficult finding buyers with the financial wherewithal to pay the entire purchase price in cash or through bank financing. The fact that a buyer is unable to obtain third party financing for the purchase of your business may be a clue that this is not the right buyer. It may be worth considering a reduction of the sales price for buyers who can pay all cash or obtain third party financing.
If you are forced to provide seller financing, consider locking in collateral to be forfeited in the event of a default. This could include investment securities and similar assets that immediately resort to the seller if buyer is unable to repay the debt. This avenue potentially bypasses personal guarantees that might require a court judgment, which could be time consuming and involve expensive collection actions.
Legal structure and tax consequences
Sales of private businesses are typically structured as either asset sales or stock sales. Most private businesses are owned and operated through some type of entity, such as a corporation or limited liability company.
In an asset sale, the buyer of the business purchases substantially all assets used in the business along with the goodwill associated with the business but does not purchase the entity itself. Buyers typically favor asset purchases to avoid winding up with liabilities of the entity that may or may not have been known to the seller.
In a stock or other equity sale, the buyer purchases the outstanding stock or equity interests in the entity, thereby becoming the owner of the business through the ownership of the entity. In most cases, sellers generally prefer a stock or equity sale because they can treat the transaction as the sale of a capital asset and pay the long-term capital gains rate if a profit is made in connection with the sale. Buyers generally favor asset purchases to avoid winding up with liabilities of the entity, which may or may not have been known to the seller.
A transaction agreement in an asset sale should contain provisions as to how the purchase price is allocated among the assets being purchased (e.g., allocating among equipment and fixtures, inventory, customer lists, business goodwill and, in some cases, post-closing consulting services). Agreement on this allocation is necessary because it can have serious income tax consequences for both the buyer and seller.
Don’t overlook transition issues
Don’t get so focused on your business sale that you neglect the transition process that will occur post-closing. Generally, it is the buyer’s decision whether to make a clean break or require you to remain on for a few months to assist with transition and training.
If, however, you are not completely cashing out and are providing seller financing, it behooves you to keep your hand in the transition to increase the likelihood of the business’ success and your receipt of full payment on the deferred portion of the purchase price. Prior to closing, the seller and buyer should agree to the scope and terms of any transition services the seller is expected to provide, including hours and whether the cost of the services are rolled into the purchase price or an added cost to the buyer post-transition.
Don’t go it alone
You have worked hard to build a successful business and you want to net as much of the purchase price as you can for as little expense as possible. But there are no mulligans when selling a business—you only get one shot to get it right.
While you may be successful in business, few owners have the time or experience to adequately address the legal, tax and accounting complexities of selling a business.
An experienced transactional attorney, CPA, business broker and other professionals can be an invaluable team to assist you in preparing your business for an effective marketing effort, aligning your price expectations with realistic market conditions, obtaining the best price for your business and protecting your interests.
This is part one of a two-part series on mitigating the risks associated with business transactions. For part two, click here.
David A. Thayer, Esq., is a corporate and transaction attorney, and former CPA, that focuses on being a deal maker, not a deal breaker, as he helps clients achieve their business dreams. He can be reached at email@example.com.
THIS INFORMATION IS NOT INTENDED AS LEGAL ADVICE. SEEK SPECIFIC LEGAL ADVICE BEFORE ACTING.