Fifteen Things You Should Know About Selling Your Business

1. Company Records. When you first begin contemplating a sale, you need to make sure the business’s records are in order and up to date.  You want your business’s records in good shape to produce to a potential buyer at the due diligence stage. Keep a minute book with annual minutes or annual unanimous written consents as well as consents (or minutes of special meetings) approving major transactions, such as loans, etc. Retain copies of all of the business’s fully executed contracts (loan documents, customer agreements, vendor agreements).  This way, there is no question whether the company is obligated under a contract for which you have only kept a partially executed copy.
2. Company Financials. Have your financial records reviewed or even audited.  Reviewed or audited financials carry more weight with a potential buyer than internal financials.
3. Non-Disclosure or Confidentiality Agreements.  Before providing any information on your company to a potential buyer, make sure that they sign a confidentiality agreement or non-disclosure agreement.  In addition to prohibiting disclosure of the information you provide the potential buyer, the agreement should prohibit use of your company’s information for any purpose other than evaluating the transaction.  It is best if the agreement does not terminate except when the transaction is closed so that a potential buyer that decides not to buy your company can never use your confidential information.  If the potential buyer will not agree to that, seek the longest term the buyer will agree to.  A longer term for the agreement often results in the confidential information becoming stale and of no use to the potential buyer when the agreement finally expires.
4. Letter of Intent.  Too often, sellers rush into executing a letter of intent (LOI) with little consideration for its terms because LOIs are “non-binding.”  The letter of intent will have both binding and non-binding sections.  The binding section will affirm the parties obligations under the confidentiality or non-disclosure agreement, provide that everyone will bear their own costs if the deal does not close, establish an exclusivity period for negotiation, etc. The non-binding section generally includes the proposed deal terms, including purchase price, escrow period and escrow amount, indemnification caps and baskets, non-compete periods, etc.   You need to be careful about what “non-binding”  terms to which you agree, as it is very difficult to negotiate away from the terms established in the LOI.
5. Sale of Equity vs. Sale of Assets (Transactional Aspects).  Equity transactions are often simpler from a documentation perspective.  Generally, you only need a single assignment to transfer equity but you may need many assignment documents to transfer the various assets of your business. With regard to your business’s contracts, in an equity sale you are less likely to need consent from the counterparty as the contract is not actually being assigned to another entity.  Instead, the company remains the contracting party. Nevertheless, some contracts define changes of control (equity sales) as “assignments” of the contract and will require consent from the counterparty to the contract.
6. Sale of Equity vs. Sale of Assets (Tax Aspects).  Equity sales are often preferred by sellers as the proceeds from the sale are taxed at a more favorable rate than the proceeds from a sale of assets. Buyers often prefer to purchase assets as they get a step up in basis on the purchased assets.  Consider making a IRC Section 338(h)(10) or 336(e) election combined with a gross-up as the best of both worlds.
7. Third Party Consents.  It is important that all of the company’s contracts be reviewed to determine if consent is required for an assignment of the contract (in the case of an asset sale) or a change of control (in the case of an equity transaction) or if the transaction will be an event of default under the contract.  Any of these can be addressed with a letter to the contract counterparty requesting consent and a waiver of any default.  The sale of the business will often be an event of default under a company’s loan documents.  If the parties intend for the company debt to remain in place after closing or if buyer in an asset sale agrees to assume the debt, this should be addressed with the bank as soon as possible.
8. Earnouts.  From a seller’s perspective, earnouts are generally a bad idea because financial targets set by a buyer are often difficult to achieve, so you cannot count on receiving them.  From a drafting perspective, earnouts can be very complicated to negotiate and draft, which can result in significantly higher legal fees. However, an earnout could be workable for you if it is contingent on the occurrence of a discrete event.  For example, the renewal of your company’s contract with its largest customer could serve as the trigger for the earnout payment.
9. Net Working Capital Targets.  The purchase agreement will generally include a target for the amount of net working capital (current assets minus current liabilities) for the company at closing.  Company net working capital is usually estimated for closing and then trued up several months after closing.  If the actual net working capital at closing is less than the target, the purchase price will be adjusted and you will owe the buyer the difference.  If the actual net working capital at closing exceeds the target, buyer will owe you the difference. Always work with your accountant to make sure that the way the parties have agreed to calculate net working capital is consistent with the company’s historic accounting methodology and that the amount of the net working capital target is attainable.
10. Reps and Warranties.  Within the purchase agreement, you will need to represent and warrant many facts about your company.  Reps and warranties should not be taken lightly and need to be reviewed in detail with your attorney.  If there is a particular aspect of your business that you do not handle, you should consult with the management personnel who run that area of your company to determine if there is anything that is an exception to the reps and warranties in the purchase agreement that you need to list on a disclosure schedule.  Even if something is problematic, if you list it on the disclosure schedules, you will not be liable for it as a breach of a rep or warranty.
11. Reps and Warranties Insurance.  You can limit your exposure for breaches of representations and warranties if buyer will agree to obtain a reps and warranties insurance policy.  Although this usually elevates the level of due diligence that the buyer must perform, it often leads to more of the purchase price being paid to seller at closing.   This is because the policy helps buyers manage their risk and results in buyers requiring less of the purchase price to be held in escrow after closing.
12. Indemnification.  Under the purchase agreement, you will be required to indemnify the buyer for certain things, like breaches of reps, warranties, and covenants, certain pre-closing liabilities, pre-closing taxes, etc. You can limit your liability by negotiating caps (or limits) on your indemnification obligations as well as baskets, which often operate similarly to an insurance deductible.  If you can negotiate a deductible basket with the buyer, your indemnification obligations will not kick in until the buyer has suffered a certain amount of damages.  After that, you only indemnify them for damages in excess of the deductible basket.
13. Escrow.  Most deals will involve a percentage of the purchase price being held in escrow for a certain amount of time after closing.  Escrows are used because it is easier for buyers to seek indemnification from the escrow fund than it is for the buyer to pursue seller directly.  Escrow funds may also be used to satisfy net working capital shortfalls.  Frequently, buyers and sellers agree to hold a portion of the purchase price in escrow for 12 to 18 months.
14. Non-Competition Provisions.  The buyer does not want the seller to compete with seller’s former business after closing and will require the seller to agree to a covenant not to compete.  If you have a related business not included in the sale or if you plan to start a similar business in a new geographic area, make sure you carefully negotiate the scope of prohibited activity, time period, and geographic scope of the covenant not to compete.
15. Privileged Communications.  During the course of the transaction, you will have many privileged communications with your counsel.  If you ever end up in litigation with the buyer, you do not want the buyer to be able to use these privileged communications against you.  Accordingly, the purchase agreement needs to provide that seller will retain the privileged communications between seller, company, and their counsel in connection with the transaction.  In addition, you will want to transfer and remove emails, etc. from  the company server and store them elsewhere.

For any questions on this or any other legal matter, please feel free to contact Joel Crouch at (214) 749-2456 or jcrouch@meadowscollier.com or Kristen Cox at (214)749-2403 or kcox@meadowscollier.com.