Protecting a Business Owner Who Sells the Business
Copyright, 2009. John J. Scroggin, J.D., LL.M., All Rights Reserved.
The sale of a business can often result in significant financial gain for the owner, but there are also new inherent risks for the owner. This article will discuss some of the ways to protect the seller:
Taking Back Paper . The more the purchase is in cash at closing, the less risk the seller has that the buyer will refuse to pay the full purchase price (e.g., the business is run into the ground by the buyer who blames the seller). In many cases, the seller is in the worst possible position. Control of the business has been given up, but he or she must wait to see whether the buyer can properly manage the business and pay the remaining purchase price. If the business is run into the ground, the buyer may throw up his hands and say, AHere, take it [email protected] Unfortunately, there may be little of value to take back.
The seller should take back as little paper as possible and require the buyer to provide the seller periodic financial statements for the business. Because a faltering buyer may be reluctant to provide evidence of problems, the failure to provide the financial statements should be a default under the promissory note. If a promissory note is a part of the sale, try and minimize the payment period (e.g., 3 to 5 years, instead of 10 years) and use an interest rate higher than commercial rates because the risk to the seller is generally greater than a commercial loan.
The note should be secured by not only the equity of the buyer in the business, but also by a broad form UCC filing on all of the assets of the business. The agreement may also allow the seller to foreclose if the business incurs a downturn (e.g., a 20% drop in gross revenue).However, many sellers are reluctant to take their businesses back and the buyer may also have the possibility of using bankruptcy to forestall any foreclosure.
The seller should also obtain personal guaranties, not only from the buyer, but also deeper pockets that may be in the family (e.g. the buyer’s father). Additional collateral security may also be important (e.g., security in the buyer’s home).
Warranties and Representations . Most transactions (particularly stock transactions) require the seller to provide broad warranties and representations with regard to the business and its operations. Before such a sale, the owner’s corporate shield (or L.L.C. shield) provided a measure of protection from the liabilities the seller is now effectively assuming as a result of the warranties and representations. To protect the seller, the sales agreement should fully disclose any and all exceptions to the warranties and representations. Even if the seller believes there is very little likelihood that an issue will cause problems (e.g. a sexual harassment claim from three years before), is it safer to disclose, because the failure to disclose can result in future liability. Even if the exception has been disclosed to the buyer, the agreement should document the disclosure.
The seller should also try to minimize the nature of the warranties and representations to include using best knowledge and belief in place of absolute truth as a standard. If it was the seller’s belief that there was no issue, but there later turns out to be a liability issue, the use of this limitation will limit the claim to what the seller believed to be true, not what was actually true (e.g., the seller believed the financial statements were true, accurate and complete, but the bookkeeper made significant errors). Moreover, such a standard shifts some of the burden of proof back to the buyer to prove that the seller knew the representation was false.
Finally, if the sale is to an [email protected] such as a partner or a long term employee, it would appear that the seller should not have to provide as broad a set of warranties and representations. The insider should have an intimate knowledge of the business operations and in many cases may have a better knowledge than the seller (e.g., the buyer was the business’s president for 10 years).
Indemnities . Most of these transactions require indemnities by the seller with the indemnities generally being based upon the warranties and representations. There are a number of ways to limit such claims, including:
by time – such as providing that any indemnity ceases one year after the closing;
by amount – providing that the buyer cannot make claim against the seller until the indemnity [email protected] has reached a certain floor, such as $30,000; or
by the nature of any claims – restricting indemnities to only certain claims, such as tax and environmental issues. Such a limitation can also occur by limiting the warranties and representations made by the seller.
Finally, to avoid having the buyer arbitrarily make indemnity claims (which may be used to reduce the note payments), the sales agreement should provide for an even handed process for making claims under the indemnity. It may also provide that the seller has a right to takeover the defense of any third party claims to assure that the buyer does not quickly agree to an unreasonable settlement of an indemnified claim. If agreement cannot be made between the seller and the buyer, the sales agreement may provide for binding arbitration by the parties.
Insurance Coverage . In many cases, the warranties, representations and indemnities results in the seller effectively dropping the protection the seller had from the business’s entity shield. But a significant portion of the liabilities that the seller may be taking on may have been covered by the insurance of the business. One major way to protect the seller is to provide that the buyer is required to maintain comparable insurance coverages to those maintained by the seller’s business and that any claims under the sales agreement must first be made against the insurance. The agreement should also provide that the insurance carrier has no claim against the seller if the carrier is required to make such payment.
Author : John J. Scroggin, J.D., LL.M. is a graduate of the University of Florida and is a nationally recognized speaker and author. Mr. Scroggin has written over 300 published articles, outlines and books. To be added to his free blast email system on estate and income tax planning, contact .
Protecting the Buyer of a Business
Copyright, 2005. John J. Scroggin, J.D., LL.M., All Rights Reserved.
In the previous article we discussed ways to protect the seller of a business. In many cases, protections for the buyer are directly opposed to the protections for the seller. The result is usually a negotiated arrangement by which each party get some (but not all) of what it wants. Among the protections the buyer should consider are:
Give Paper . Obviously, one of the best protections for a buyer is to put as little initial cash into the deal as possible. If the buyer determines that there are inaccuracies in the seller’s warranties and representations, the buyer may reduce the amount of the promissory note – rather than having to demand that the seller return some of the purchase price. Direct recovery from the seller may only come after expensive litigation. The more cash paid up front, the harder it is to recover funds (e.g., the seller spent the down payment in Las Vegas).
The buyer should make sure that any promissory note provides for a Aright of [email protected] by the buyer. The set-off right allows the buyer to reduce the note by the amount of any future claims against the seller. The note should specifically state how the set-off is computed. There are three methods. First, the offset can reduce the next note payments due to the seller. This is generally the most advantageous approach for the buyer because the claimed amounts are often unanticipated out-of-pocket costs to the buyer. Second, the payments can be made at the back-end of the note. However, from a cash flow standpoint, this often hurts a buyer who must expend current cash to fix the problems incurred by the inaccuracies. Third, the entire principal amount could be readjusted as of the Closing date and re-amortized based upon the change in payment due. This is helpful if there are concerns that large claims may be uncovered by the buyer (e.g., where there is sloppiness in the financial statements). It is also too complex when the claims are relatively small.
The buyer should also make sure that any promissory note contains language that denies an assignee of the note the right to be a holder in due course. Thus, any person who acquires the note, (e.g., someone who obtains the note as security for a loan) takes subject to the set-off rights of the buyer. In the absence of such language, the buyer might have to seek recovery directly from the seller, instead of reducing the note – not always a comfortable approach (i.e., remember Las Vegas).
Warranties and Representations . Normally the buyer has not operated the business and does not have an intimate knowledge of its operations. Therefore, the buyer requires a statement of [email protected] This statement of truth is, in effect, a baseline giving certain assurances to the buyer of what he can expect and is accomplished by the use of broad warranties and representations about the business, its finances and operations. Most warranties and representations should be absolute and not subject to what the seller believed to be true – otherwise the buyer, in effect, may be assuming the seller’s errors in judgment.
To the degree that a warranty or representation is in error and an exception is not noted in the documents, the buyer may have a right to recovery from the seller. This recovery may be by demand for repayment of funds, or by exercising the set-off rights against any promissory note.
The warranties and representations, in effect, serve as the baseline for the indemnification of the buyer. The buyer has to make sure that the indemnity language is sufficient to provide for recovery for those claims. The less restrictions on the indemnity rights the better. For example, if the seller has a right to defend any third party claims, the agreement may provide (as a pre-condition to such defense) that the seller escrow sufficient funds to protect the buyer from the claim.
Liabilities . The agreement should provide that the buyer is only assuming those liabilities explicitly and specifically listed in the agreement. The buyer should also obtain a UCC, judgment, lien, and FIFA search on the business and the seller prior to closing. These searches will reduce the possibility that the assets or the seller’s equity is encumbered by an unknown security interest – which the buyer may be inadvertently assuming if the search was not conducted (i.e., the buyer may have to pay the lien off to sell an asset).
Continued Employment . Any business survives because of the relationship of the owner with his customer and vendor base. Because of this, the post-closing retention of the seller should be a paramount concern to the buyer. The buyer needs the seller to help manage (for 3-18 months) the process of moving the customer and vendor relationships to the buyer.
The buyer is well advised to have a incentive provision in the agreement that provides for a penalty if the seller leaves the business earlier than agreed or fails to help in the transition. The penalty may reduce the note balance. The set-off rights might also be extended to any employment related payments due the seller (e.g., a deferred non-compete payment).
Negative Covenants. The buyer should make sure the seller will not begin operating a competitive business using the customer and vendor relations, employees, knowledge and trade secrets of the acquired business. Therefore, the agreement should provide for one or more of the following negative covenants to protect the buyer: non-competition, non-solicitation of customers, non-solicitation of employees, non-solicitation of vendors and protection of trade secrets and confidential information. These negative covenants must be carefully drafted to comply with applicable state law. The agreement should allocate a significant part of the purchase price to these covenants and allow the buyer to seek injunctive relief if violations of the covenants occur.
It is also advisable to obtain similar negative covenants from key employees of the business. Very often, their loss can be more damaging than the loss of the seller. This might be a requirement placed on the seller as a part of the pre-closing requirements for the sale of the business.
Cash Flow Projections . It is amazing how few buyers run calculations to determine whether the business (or other sources) can fund the future payments due to the seller. Many a buyer has had to renegotiate the agreement or lost a purchased business because of the inability of the business to fund the payments to the seller.
Selling or buying a business is never easy. It can be disastrous if the parties fail to adequately protect themselves.
Author : John J. Scroggin, J.D., LL.M. is a graduate of the University of Florida and is a nationally recognized speaker and author. Mr. Scroggin has written over 300 published articles, outlines and books, including The Family Incentive TrustTM. To be added to his free blast email system on estate and income tax planning, contact [email protected] .
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