One of the more common engagements for our firm is to assist with business sales and acquisitions. This article is the second in a series of articles which will walk through and generally discuss the steps typically associated with the sale of a business. In Part 1, we discussed the breakdown of the business, the identity of the relevant parties, the role advisors play, and brief discussion of the two primary types of sales that take place.
Overview of a Business Sale
A typical transaction will generally entail the following steps:
- Initial Negotiations;
- Letter of Intent/Term Sheet;
- Due Diligence;
- Definitive Agreements;
- Transitional and Post-Closing Matters; and
- Tax Reporting.
When the buyer and seller first begin discussing a transaction, there are a number of preliminary items that should be discussed, negotiated, and decided prior to both parties moving forward. If both parties are generally in agreement, they may be able to avoid a situation where both have spent a significant amount of time and money putting together a deal that only falls through at the end because the two parties were never really in agreement. Here, the parties will generally discuss and address, though maybe not determine, some (but maybe not all) of the following high-level items:
- Purchase Price and Allocation;
- Structure of the Transaction;
- Initial Logisitical/Regulatory Considerations;
- Continued Employment of Seller/Seller-Owner;
- Restrictive Covenants for Seller/Seller-Owner; and
Generally, where there is at least a purchase price in mind and a structure, the parties can move forward.
The Letter of Intent Considerations – Beyond the Purchase Price
Structure – Asset Sale or Equity Sale
As discussed in Part 1, the primary issue to be negotiated between the buyer and the seller, other than the purchase price, upon which the parties are overly focused upon, is the form of the transaction, whether it will be an asset sale or an equity sale. In general, a buyer will prefer an asset sale as this will increase the buyer’s basis in the assets of the business allowing the buyer to recover part or all of the purchase price through future depreciation and amortization, resulting in a significant after-tax cash flow benefit to the buyer. However, an asset sale will generally result in a significantly higher tax number for the seller. In Mississippi, there is a state income tax exemption for the sale of equity in Mississippi entities. 1. Accordingly, the seller will generally prefer an equity sale which will generally result in a lower level of tax and a less complex tax reporting on the seller’s side (pending certain tax elections). However, absent certain elections, the buyer will not receive a step-up in basis in the assets on an equity purchase, and thus will usually lose out on any increased depreciation or amortization and the after-tax cash flow benefits of such deductions.
Both the buyer and the seller should run the numbers to determine what the benefit or detriment to each might be from both forms of a sale. In many cases, the buyer’s benefits of an asset sale will be many times higher than the increased tax owed by seller, and thus the buyer is often willing to pay the increased tax of the seller in the form of an increased purchase price.
Purchase Price Allocations
The allocation of the purchase price is generally only applicable to an asset sale (or equity sales with certain elections), though it may come into play with an equity sale where a business asset that is outside of the entity is also being purchased such as personal goodwill or real estate. Allocations are important too in transactions involving partnership. Particularly due to “hot assets.” Generally, in an asset sale, the allocation of the purchase price is of significant importance. For the buyer, it will determine the timing of when the buyer can take its depreciation expenses on the purchased assets. For example, a buyer may want to allocate more to an asset that is eligible for full expensing immediately rather than an asset that must be depreciated over a fifteen-year period. For the seller, it will determine the character of the gain to be recognized on the sale. For example, a buyer would rather allocate more to a capital asset rather than an ordinary income asset, including assets with built in deprecation recapture that will be taxed as ordinary income.
If looking at allocating to personal goodwill, one may want to make certain that personal goodwill is actually being sold, a seller in the transaction is the owner of the goodwill, and that no other agreements are out there that have effectively vested ownership of this goodwill elsewhere or preclude the goodwill seller from selling the goodwill.
Key employees are a significant part of many businesses and the business may not function the same without such employees. Key employees may include the seller or may also be skilled individuals who work for the seller. Will the seller be staying on to assist with the transition as part of management for a few years? Will other key employees be staying on? It is common for the seller of a business who is intimately involved in the business to agree to stay on for a period after the sale. All of this should be negotiated on the front-end so the buyer knows what they are getting and the seller knows what the buyer expects.
Non-competes go hand in hand with employment agreements and are often found in the same document. First, all current non-competes of the selling business should be reviewed to ensure there will be on issues on the transition. Going forward, the buyer will likely want a non-compete from the seller and all key employees who will be staying on. This will especially be true if the seller is not staying on after the purchase. The buyer will want protection that the buyer will not go open a competing business across the street and then take back all of their old customers.
Representations and Warranties
Representations and warranties are statements of fact and assurances made by the parties. These are typically the longest sections of any purchase agreement and often there is a significant amount of time spent in negotiating these points. From the buyer’s side, the buyer wants the representations and warranties made by the seller to be as all-encompassing as possible since this will provide the buyer with a good source of information about what is being purchased as well as provide future protection to the buyer as the buyer’s basis for rights to indemnifications for any problems or unforeseen risks. Conversely, the seller wants to limit the number of representations and warranties it must give and generally wants to limit their scope as much as possible.
There is often a time gap between signing the final purchase agreement and the closing of the transaction, and each party may require the other to fulfill certain conditions and obligations during such time gap prior to closing the transaction. Typically, each such condition will be binding on one party, and if not satisfied, the other party is not required to move forward with the closing although they still may waive such condition and close. These closing conditions and obligations are frequently the subject of back and forth negotiations between the buyer and the seller.
While the risk that is allocated between the buyer and the seller is a product of the representations and warranties provided by the seller, the real muscle behind such representations and warranties is the indemnification provisions which back up the representations and warranties. These indemnification provisions are a frequently negotiated item, and just as with representations and warranties, this negotiation may take some time.
The Letter of Intent – Common Provisions
The Letter of Intent (“LOI”) is a high-level description of what the transaction will look like. It is often negotiated back and forth between the parties, and when both parties are in agreement, they will each sign the LOI signaling their understanding and agreement. It is a good idea to have a signed LOI prior to moving forward with any heavy lifting such as due diligence and document drafting. The LOI allows both parties to come to an agreement about the big picture items of the deal. There will certainly be additional negotiations throughout the deal but the LOI allows the parties to move forward with the time and expenses that will go into the deal at least knowing they are in agreement on the major negotiated items of the deal.
The LOI will identify the relevant parties to the deal, including the buyer, the seller, and the business that is the subject of the deal. This could also be a good time to ensure a goodwill seller is part of the deal as well.
The LOI will lay out the terms of the deal between the parties such as whether the deal is an asset sale or equity sale and what the payment terms are, including any financing that buyer will be relying on or financing that will be provided by the seller. The proposed terms of any employment agreements or non-competes should also be included in the LOI. The LOI will also typically set a target date for closing and may contain certain conditions necessary for closing.
Representations and Warranties
The LOI will typically contain some high-level representations and warranties including that seller has legal title to the entity and there no clouds or restrictions that might prevent seller from going through with the deal.
LOIs frequently contain confidentiality provisions preventing both parties from disclosing any information obtained during negotiations and discussions. This is particularly important for seller if seller has any proprietary information that may be shared with buyer during due diligence. As discuss below, LOIs are typically non-binding.
Binding or Non-Binding
LOIs are typically non-binding, but there may be certain times where one or both parties will want the LOI to be binding. Both parties invest a great deal of time and money into these deals and it can be all for not if the deal gets to the final stretch and falls through. A binding LOI may prevent that risk and may be appropriate at times. Certain provisions are usually binding on all parties regardless of whether the remaining provisions of the LOI are binding or not. Typical examples of these provisions are confidentiality and exclusivity.
In the next part of this series, we will continue to discuss the transaction process in more detail, including due diligence, the definitive agreements, and closing and post-closing issues and adjustments.
Our firm is regularly engaged to handle many types of business transactions from simple equity sales to complex asset sales and mergers involving publicly traded corporations. With significant analytical, business, and tax expertise, our firm is well equipped and ready to assist our clients with their business transactions.