This guide is designed to help business owners and executives navigate the process of selling a business. It provides an overview of the sale process and practical tips for achieving the best possible outcome and addresses common challenges encountered during deals.
For many sellers, a transaction will involve unfamiliar procedures and terms where a lawyer can provide valuable guidance. The better the key concepts are understood, the better equipped one will be to make informed decisions and achieve a favorable result.
Sale Process
The timeline for the deal will likely include the following steps:
- Selecting a business broker who is right for the business.
- The buyer presents a proposal letter or letter of intent.
- The buyer prepares an Asset Purchase Agreement (APA) for the parties to negotiate.
- The seller’s board of directors and shareholders approve the APA.
- Both the buyer and seller sign the APA at or before closing.
- Additional steps, such as obtaining real estate title insurance, finishing due diligence, and preparing closing documents.
- At closing, the buyer pays the purchase price, and the seller transfers the business.
Letter of Intent
The selected buyer will produce a written proposal letter or letter of intent naming the price, transaction structure, and key terms. It should be written to state that it is nonbinding, meaning that everything remains subject to negotiating and signing a more detailed, definitive purchase agreement. The letter of intent will often include a binding agreement to negotiate exclusively with the buyer for a period of time.
Due Diligence
The buyer will often do a thorough business review including financial statements, contracts, employee compensation and benefits, real estate, and other key aspects. Though the process can be time-consuming, it is typically better to provide the requested information rather than contest its necessity.
Review of Governing Documents
Early in the process, the selling corporation should review its articles of incorporation, bylaws, and any shareholder (buy-sell) agreements. The seller should identify anything that could affect the transaction, such as rights of first refusals or super-majority vote requirements. An attorney can help with this.
Structure – Sale of Assets
Most business sales are structured as asset purchases. In this structure, the selling corporation transfers its assets to a buyer-controlled entity. The buyer can form a new corporation to purchase the assets or use an existing entity. The seller keeps its corporate entity and dissolves it after the closing. Buyers do this to avoid any known or unknown liabilities the corporation may have.
Transferred assets include owned real estate, equipment, furniture, accounts receivable, prepaid assets, the goodwill of the business, the name of the paper, all website addresses, etc. In most cases, cash is retained by the selling corporation.
Some working capital liabilities may also be transferred to the buyer, such as accounts payable. Bank debt and other long-term liabilities are typically not assumed by the buyer. Liabilities not assumed by the buyer are paid off at closing and remain an obligation of the selling corporation.
The other transaction structure is for the buyer to purchase the corporation or LLC.
Purchase Price
Larger companies purchasing smaller companies typically pay all cash. Often 5 to 10 percent of the purchase price may be placed in an escrow account with a bank for an agreed-upon period of time.
The purchase price is for the enterprise value of the business without regard to bank debt and other long-term liabilities. This is frequently referred to as selling the business on a cash-free, debt-free basis. The seller will need to pay off any bank debt or other long-term liabilities out of the purchase price. Additional liabilities may include deferred compensation payments and any severance obligations.
The purchase price often includes a “net working capital adjustment” as well. Net working capital is current assets (excluding cash) minus current liabilities. Net working capital varies daily as revenues are received, expenses are paid, and liabilities and prepaid assets are accrued.
When a business is sold, the buyer and seller will usually agree on a “net working capital target.” The target is intended to be a normal amount of working capital that should be there as of the closing. If the actual net working capital at the time of closing exceeds or is less than the target amount, then the purchase price is increased or reduced dollar for dollar.
The seller will want to be careful about selecting the net working capital target because any shortfall at closing will reduce the purchase price. Different types of businesses have different working capital profiles. So, it is important to make sure the working capital definition and target fit for the business.
Asset Purchase Agreement
The buyer will prepare a detailed APA listing of the assets being purchased and the purchase price.
The APA will include several representations and warranties from the seller such as:
- The selling corporation will have all director and shareholder approvals needed to sell the business.
- The assets being sold will be free and clear of all liens when the transaction closes.
- The seller’s financial statements are accurate.
- There are no material liabilities that have not been disclosed to the buyer.
- The list of employees and their compensation is accurate.
If the representations are not true at the time of the closing, the buyer is not required to complete the transaction.
If the buyer discovers a representation is not true after closing, the buyer may have a claim against the seller. For example, if the seller represents that the equipment is free and clear of liens, and it turns out there is a lien, the seller would be responsible for paying off the lien. The purchase agreement will include limits and procedures related to how and when the buyer can make a claim against the seller.
The seller can protect themselves by including disclosure schedules within the APA documenting any problems or facts contrary to the representations. If disclosed before the closing, the buyer cannot make a claim after the closing. This is where the due diligence review benefits both the buyer and the seller.
The APA will include a list of covenants or promises. The seller will promise to operate its business in the ordinary course between signing and closing. The seller will also agree to negative covenants promising not to do certain major actions between signing and closing, such as entering into a new contract or making a large dividend.
Board of Directors and Shareholder Approval
The board of directors should review and approve the definitive APA before it is signed. If a board decides that a sale of the company is the best decision, the directors have fiduciary duties to make an informed decision in the best interests of the shareholders. Hiring a business broker and soliciting multiple bids for the business is considered the gold standard to get the best possible price from the sale. The directors should carefully review the deal terms and transaction documents. Directors should also include their lawyers in the board meeting and ask to walk through the key terms of the legal agreements. An attorney can help prepare board minutes that document the process followed and the reasons for the transaction.
The APA must also be approved by the corporation’s shareholders (by a majority of the outstanding shares unless there is a super-majority vote requirement). The shareholder meeting takes place either at or before the APA is signed or between the signing and the closing.
In addition to approving the sale of all assets, the shareholders will often vote to dissolve the corporate entity after the closing. During the dissolution process, the corporate entity turns its assets into cash, pays its liabilities, and then distributes the net proceeds to shareholders.
Dissenters Rights
Most states have a corporations statute that includes dissenters’ rights. Early in the process, an attorney should review the corporations statute and advise whether the transaction is exempt from the dissenters’ rights provisions. In most states, dissenters’ rights do not apply when assets are sold for cash, and the proceeds are distributed to shareholders within one year. If dissenters’ rights apply and the transaction is not exempt, a dissenting shareholder has certain rights to go through a process designed to determine the fair value of their shares.
Real Estate
If the seller leases real estate, the lease must also be reviewed. Oftentimes it will be necessary to receive the landlord’s consent before transferring the lease to the buyer. If the seller owns the real estate, then the real estate will be transferred at the closing.
Title insurance will be obtained to confirm that the seller owns the real estate and to identify any mortgages, easements, or other liens or encumbrances on the property. The buyer will expect all mortgages to be paid at closing, so it gets a clean title to the property.
Often the buyer will obtain a survey of the property to show the precise boundaries and the building’s exact location.
The buyer will also typically hire an environmental consulting firm to examine the real estate for any contamination or asbestos. A Phase I assessment involves a tour of the property, a look at the history of the property, and a determination of whether there are any recognized environmental conditions that may require further investigation. If it looks like there may be serious issues, the buyer may proceed to a Phase II assessment which involves taking soil samples and testing them for contamination.
The buyer may also get a building inspection to inspect the structure, HVAC systems, roof, etc.
Net Proceeds to the Seller
The corporation selling the business closes the transaction and receives the cash purchase price. Out of the purchase price, the seller must pay off its bank loans and other long-term debt. It must also pay its transaction expenses, which include the business broker fee, attorney fees, accountant’s fees, real estate title insurance, etc. Any net working capital adjustment will also affect the net proceeds to the shareholders of the selling corporation.
Early in the process, the seller’s Chief Financial Officer and outside accountant should prepare an estimate of what the net proceeds will be after payment of expenses and taxes.
Escrow Account
The buyer will often withhold between 5 and 10 percent of the purchase price. That money will be put in an escrow account for a period of time. If the seller has misrepresented the business to the buyer, the buyer will take money from the escrow account to make itself whole. If the buyer does not have any legitimate claims, the money will be distributed to the seller at an agreed upon date, often 12 to 18 months after the closing.
For sellers, one tactic is to negotiate a staged release of the escrow funds. For example, 50 percent is to be released to the seller six months after the closing, with the remaining 50 percent to be distributed to the seller 12 months after the closing.
Employee Transition to Buyer
In an asset sale, the employees are the seller’s employees before the closing, and the buyer’s after the closing. The buyer will typically do the same new employee intake paperwork that it would do for any new employee. Employees may be required to fill out an employment application, a form I-9 to verify employment eligibility, etc. Employees will enroll in the buyer’s benefit plans. If the seller has a 401(k), then arrangements will be made to terminate that 401(k) or transfer balances to the buyer’s 401(k) or to individual employee IRAs.
A buyer in an asset purchase is not required to hire all the seller’s employees. Sellers should ask buyers about their intentions as part of the negotiation process and consider severance obligations and policies for any employees not hired by the buyer.
The Closing
At closing, the final documents are delivered, the buyer pays the purchase price, and the business is transferred. Often it is a virtual closing that does not require people to be physically present. The lawyers arrange for documents to be signed and delivered. After the documents are signed, the parties and/or their lawyers will join a conference call, agree that everything is completed, and direct the buyer to transfer the purchase price.
After the Sale
After the closing, the selling corporation then enters a wind-down period that may take 3 to 12 months. The corporation must pay all its creditors.
Bumps along the way
Every deal comes with its frustrations, which can include:
- The sale process is taking longer than expected.
- The buyer’s due diligence review may seem intrusive. Responding to requests is time-consuming, and it may seem like the buyer is requesting the same information repeatedly.
- The buyer may be slow to commit to the future role of key members of the seller’s management team.
- The seller may become frustrated with the buyer’s focus on environmental or other risks that have never been an issue in the past.
- The buyer may seem overly concerned about contracts and vendor relationships that have not caused issues before.
- Some buyers have a smooth and well-thought-out transition process with good communication. Others may have poor communication and may seem haphazard and reactive. A buyer may also be distracted by other deals in the process.
Tips for a Successful Transaction
Here are some tips that can help achieve a better result for the company, employees, and shareholders:
- Keep the sale process moving. The longer things drag on, the more likely a bad event will happen. Whether external like market trouble, or internal, like losing key employees or advertisers.
- Stay focused on operating the business. A deal can be a huge distraction that negatively impacts operations and earnings. Employees may lose focus, and deteriorating earnings during a sale process can be problematic.
- Plan ahead for third-party tasks and lead times – for example, environmental assessments, real estate surveys, obtaining consent from landlords, getting shareholder approval, and paying off bank debt or bonds.
- Review employment agreements, deferred compensation arrangements, or bonus or profit-sharing plans with a lawyer.
- Be careful with capital expenditures. Using working capital to buy equipment could negatively affect net working capital at closing, and consequently the purchase price.
- Create complete, detailed, and accurate Disclosure Schedules. Good Disclosure Schedules reduce the risk of post-closing claims from the buyer, helping preserve the net purchase price.
- Have a good strategy and process for announcing the deal to employees and customers.
- Manage shareholder expectations. Net proceeds will be reduced by debts, taxes, and transaction expenses. Even after the closing, there will be a wind-down period before final distributions are made.
- Consider severance pay for employees who are not hired by the buyer. Some companies pay special bonuses to employees in connection with the deal.
- Acknowledge that key members of the management team may be conflicted, disappointed, or even outright hostile to the deal. It could mean changes to their title, responsibility, autonomy, compensation, or even their job.
- Work with a bank early on regarding payoff arrangements for bank debt. If more complex financing, such as bonds, are in place, a lawyer can help navigate the complexities of this process.
- Be mindful of vacation and travel schedules for key individuals involved in the process to plan ahead and avoid delays.