You are looking to sell your business and have found an interested buyer. Now what? As a seller, there are many factors to consider before you finalize your contract with a buyer. At FLB Law, we regularly counsel business owners to carefully weigh these considerations when drafting a thorough letter of intent (LOI), an important document that formalizes the discussions between a business owner and a prospective buyer and is the basis for the binding contract between them. A detailed, well-thought-out LOI can protect a seller’s interests in the transaction and help to ensure a smooth path through contract signing, the due diligence period and closing.
To help with selling your business, here are seven considerations to think about as you proceed through the process and when you are ready to draft the LOI.
How Should the Deal be Structured?
From a seller’s perspective, it is typically easier to sell a membership interest in your limited liability company or stock in your business, which means basically having the buyer step into your shoes. But this path to ownership is usually unacceptable to buyers, as it forces them to assume the company’s liabilities, which could lead to lawsuits for claims that predate their ownership. Therefore, most businesses are sold through a purchase and sale agreement of a company’s assets.
How the deal is structured is important to not only the buyer but the seller as well as it will have tax implications for the seller. For instance, if you sell stock or membership interest, you may be subject to only capital gains taxes, but if you sell the company’s assets, you may also have to pay income taxes at ordinary rates. Therefore, we strongly encourage sellers to consult with their accountants at the earliest stages of the process to shed light on how different deal structures will impact their tax liability.
What if the Deal Includes Seller Financing?
While the seller often gets paid in full for the business at closing – much like when a house is sold – that is not always the case. When owners sell their business to, say, a long-time employee, they may be willing to accept partial payment at closing and allow the buyer to pay the balance over time. With this arrangement, it is imperative that the seller has proper security in place in the event the buyer defaults.
Examples of this “security” include if the business is sold through stock transfer, the deal might include a stock pledge agreement or if your company’s assets are sold, we recommend filing a lien on the tangible assets under the Uniform Commercial Code (UCC). For instance, if the company owns 20 trucks, you could place a UCC lien on them, which would serve as collateral until the debt has been paid.
There could be another issue with this route if the buyer plans to obtain additional financing, such as a Small Business Administration (SBA) loan. The SBA will want to hold the first lien position on the company’s assets, which would mean the agency would be first in line to get its money back if the business were to go belly up, leaving the seller unprotected. We, therefore, counsel against seller financing deals in which the seller is not in a first-lien position unless there is a personal guaranty from someone associated with the buyer who owns other substantial assets.
In many cases, it’s also advisable to require the buyer to take out key man insurance, a life insurance policy on a business’s owner or a key employee, and disability buy-out insurance for at least the amount that will cover the debt. That way, if the buyer dies unexpectedly or becomes disabled and the business cannot continue, the seller would be paid out of the insurance policy proceeds.
What if the Buyer Wants the Seller to Stay on as a Consultant?
Depending on the business, a buyer may want the seller to remain involved after the sale closes for a few weeks, months or even longer to show them the ropes and guide them through the initial pay period or order cycle. If the seller stays on as a consultant, the letter of intent should lay out these plans, including the time period, responsibilities, and compensation.
How Can the Seller Expedite the Due Diligence Period?
Contracts to sell a business typically include due diligence contingency clauses, which allow buyers to delve deeply into a company’s financials and other records to ensure they fully understand the value of the business before proceeding with the purchase. Due diligence periods can vary based on the complexity of the business. Rather than waiting for the contract to be signed, the seller can let buyers begin due diligence at the letter of intent phase, provided they sign a non-disclosure agreement and include the non-disclosure in the LOI. This could shorten the due diligence period needed once the contract is signed.
How Should the Financing Contingency Be Structured?
Many deals to sell a business are contingent on the buyer’s ability to obtain financing. As mentioned above, some deals include seller financing, whereby the seller acts as the bank, while others are financed through bank loans or the SBA or other means. Regardless of the source of third-party financing, if a buyer is planning to borrow money, the terms of the financing contingency in the LOI and then the contract should be based on a standard commercial loan at an average rate and should only extend for a reasonable time period.
What Happens with the Seller’s Vendor Contracts and Leases?
Sellers sometimes have long-term contracts with vendors that do not permit early termination. The buyer will need to determine which vendor contracts are assignable, if any, and whether they want to assume them. This also applies to real estate leases. If there is still term remaining on a business’s lease and the buyer wants to keep the business in the same location, they must investigate whether the lease can be assigned and what this would entail, as conditions vary from lease to lease. If you are contemplating selling a business, investigate these issues prior to marketing the business for sale so that you are prepared to move forward in a timely fashion once a deal is accepted.
What Happens to the Employees When a Business is Sold?
The sale of a company’s assets does not typically include its employees, except when employment contracts are involved. A purchase/sale agreement usually states that the buyer is not acquiring the employees and will enter into separate arrangements with them at the buyer’s discretion. Typically, sellers will tell employees that the company is being sold and that the buyer will contact them if they are interested in hiring them. This should only occur after all contingencies have been resolved and the deal is on its way to closing. While not as common, sellers concerned with their employees’ fate will sometimes negotiate an agreement that requires the buyer to hire certain employees for a specified period of time after closing.
By ironing out as many details as possible early in the sales process and including them in a detailed, comprehensive LOI, sellers can protect their interests and prevent unwelcome surprises as they proceed with selling their business.
For more information about FLB Law’s Corporate & Business Transactions Practice, contact Rick Costantini. FLB Law is looking to hire experienced attorneys who focus on corporate and business transactions. Please get in touch with Rick if you are interested in exploring a career at FLB Law.
