The Small Print in Selling a Company
It is common, almost predictable, that a business owner will experience serious indigestion, if not outright fury, when he or she reads the “small print” in a purchase agreement to sell their business. This can be avoided by knowing what to expect.
After what is often a lengthy, drawn out negotiation with a purchaser of their company, business owners typically sign a document that spells out the major terms that have been hammered out. This document, known as a letter of intent, describes the basic deal price and structure. However, the letter of intent is nothing more than a written handshake. It is not a legally binding document. The transaction is far from a “done deal” until a legally-binding purchase agreement is executed by both parties.
Frequently, the terms that are customary in a purchase agreement come as a shock to the seller. Consequently, many deals fall apart over the “small print” issues. And the primary reason is not that the buyer is asking for anything egregious or unusual; it is because the seller is unfamiliar with the standard provisions in a purchase agreement.
There are certain provisions included in every deal of consequence that business owners should be aware of before negotiating to sell their business. Unfortunately, many lawyers do not educate their clients who are sellers before forwarding the voluminous purchase documents to them. And worse yet, some sellers are too cheap to hire a lawyer who specializes in M&A, and the lawyer who represented them in their divorce or other personal matters makes a federal case out of provisions they should have expected to see, often killing the deal. A good M&A lawyer can negotiate these points to the extent possible, but they can’t make them go away.
In the purchase agreement, the seller will be asked to make certain “representations and warranties” which is where the business owner, if he or she is smart, attempts to make sure there are no undisclosed landmines. The reason to come forward with all your dirty laundry before the closing is because you will be asked to indemnify the buyer against matters that are not disclosed. And because you will be liable for these claims anyway, you may as well negotiate them before the closing so you can walk away from the deal if an acceptable resolution is not found.
According to Stuart Johnson, cochairman of the corporate practice at Arnall Golden Gregory, typical reps and warrantees might include the following, among others:
The seller will then be asked to indemnify the buyer against any losses they incur as a result of the above statements not being fully accurate. In order to provide some meat to the indemnification, the buyer will insist that a certain portion of the purchase consideration be set aside in an escrow account. So, if you were expecting to walk away from the closing table with the total sale proceeds, you are in for a rude awakening.
The customary amount that is escrowed is in the range of 10 percent of the purchase price.
For example, if you sell products that are subject to warrantee claims, and the new owner would need to honor any claims that resulted from sales that occurred prior to the closing, there needs to be a way for the buyer to honor those claims without chasing the seller down and asking for money back, which is never an easy task.
No matter how much due diligence is performed, a buyer cannot be expected to uncover undisclosed liabilities or verbal contracts you made that were never written down. It takes time for these matters to rise to the surface. And the buyer wants to know that all the money they paid for the business is not in the Cayman Islands if they do discover something.
In a recent case, a key salesperson appeared in the office of the new owner demanding his end-of-year bonus. The new owner, befuddled, asked where the salesman got the idea that he was due the bonus. He responded that the prior owner promised it to him. After significant quibbling and not insignificant legal fees, the court found that the bonus was owed to the salesman, and that the seller was primarily responsible, as he had entered into a verbal contract that was not disclosed to the buyer.
The typical time period the escrow is held is at least through the completion of the first audit cycle and maybe longer. The average timeframe is 12 months, according to Scott Smith, an M&A partner with Powell Goldstein.
While these funds are escrowed, they can be invested in relatively safe investments, with the income accruing to the seller. Many sellers fear that the buyer will make up claims and that they will never see their escrowed money. However, there is typically a provision included in the purchase agreement providing for arbitration if the seller and buyer cannot agree on the legitimacy or amount of a claim.
If you hide the skeletons, or simply forget to disclose something that has an economic impact on the buyer, that money in the escrow account should never have been yours in the first place. Buying a company is not as simple as buying a house, where you can rely on the principle of “buyer beware.”
Often the buyer will allow a “basket” or deductible, so if claims are not material, say not more than $25,000 or $50,000, they will not reach into the escrowed funds. However, the ultimate protection for your escrowed funds is to deliver a clean business, with the value of all assets and liabilities accurately and fully disclosed in the purchase agreement. If there are no skeletons, your money is safe, and you will eventually get it, with interest.
To those who are experienced in corporate transactions, none of the above will come as a surprise. To those who have never been through the process, it is useful to know what lies ahead so you don’t overreact the first time you sell your business.
Michael Jacobs, Author
Michael Jacobs is the CEO of Jacobs Capital and Professor of the Practice of Finance at The University of North Carolina at Chapel Hill. He's the author of several books and a certified speaker.
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