The number of negotiable components in business deal structures can seem exciting at best, terrifying at worst, and certainly overwhelming to anyone closely impacted by the deal’s results (i.e., the seller and the buyer). We created this four-part series to provide helpful information to entrepreneurs like you by dissecting the significant parts of a business deal; this article is Part Three.
When a buyer presents an offer document (LOI or Offer for Purchase are most often used) to purchase your business, besides the proposed purchase price, it will include proposed payment terms, conveyance of assets, legalities, post-closing transition period, and more. In Part One, we discussed negotiating payment terms, and in Part Two, we looked at negotiating assets conveyed. This week’s article covers four legalities to negotiate when selling a business.
4 Legalities to Negotiate When Selling a Business
1) Representations & Warranties
The purpose of Representations and Warranties (R&Ws) is twofold. First, they help the buyer understand the business; second, they establish the seller’s liability for losses under the seller’s watch before closing.
Most transactions that we see at Viking involve privately held companies rather than public, so we are accustomed to Purchase Agreements tending to look slanted towards the buyer. Why? Because the seller is receiving consideration in the form of cash at closing, sometimes a seller note, sometimes retaining/purchasing some equity in the new company, and potentially an earnout. In return, the seller is representing and guaranteeing (warranty) that everything they have given them is true and accurate in material fact. We could go into another full article around material facts versus knowledge qualifiers, but let’s save that…
Remember, with a public company, a buyer can go to the SEC and get all the information they need. However, with a private company, the seller must represent and guarantee that their financials, HR, vendors, customers, employees, etc., are true and accurate to the best of their knowledge. Essentially, as the seller, you state that you stand behind what you have represented in the sale of your company.
R&Ws can typically address 25-40 areas of the business, but the exact number is negotiable and determined by the nature and type of business. Additionally, many arguments, delays, and costs often result from misunderstandings by attorneys and clients about how R&Ws and indemnities operate together in defining seller liability. Negotiating R&Ws is an essential part of the selling process, and guidance from experienced, knowledgeable legal counsel will prove invaluable.
2) Allocation of Purchase Price
By far, most business sales are asset sales rather than sales of company stock. In fact, 95% of Viking deals are asset sales (versus stock). The IRS references seven designated asset classes on Form 8594:
- Cash & Cash-like Assets
- Securities
- Accounts Receivable
- Inventory
- Other Tangible Property (Personal Property & Real Estate)
- Covenants Not to Compete & Other Intangible Property
- Goodwill & Going Concern Value
In most deals, we see four primary asset classes:
- Inventory
- FF&E (Furniture, Fixtures, & Equipment; this falls under Other Tangible Property)
- Non-Compete
- Goodwill
We don’t normally see Cash because this is often retained by the seller. They don’t have securities tied up in their operating entity, and Accounts Receivable are often part of networking capital with deals north of eight figures.
Different tax implications arise for the buyer or the seller with each asset class. Buyers, for example, can depreciate FF&E, expense or write off Inventory, and amortize Non-Compete and Goodwill. In other words, the buyer can write off the majority of the purchase price. For the seller, each class has different tax categories between Long-Term Capital Gains or Ordinary Income. The buyer and seller must consistently handle the purchase price allocation across asset classes and attach Form 8594 to their tax returns for the year of the transaction.
Since the tax consequences impact the seller, and the benefits are to the buyer, we typically see the seller and their CPA propose the initial breakdown of the purchase price allocation. Most buyers respect this, but the parties are at odds with each other regarding allocation amounts, so negotiations will be necessary. The guidance of experienced tax advisors will help both parties optimize their respective tax implications.
3) Non-Compete and Non-Solicitation
A non-compete agreement for an owner selling a business is very different from a typical employee non-compete agreement. A significant distinction is that, as referenced above, the seller receives consideration for their non-compete; therefore, it is more enforceable for a longer period of time than employee non-compete and non-solicitation.
Today, most non-competes are three to four years long and can cover geographic areas depending on the sales and customer area. You might see a 50-mile radius, a state, a region, or even a national non-compete. Regardless of negotiations on duration and radius, current customers are always off-limits for that defined time period.
4) Baskets & Caps
A “cap” refers to the upper limit on losses and damages a buyer is entitled to recover from a seller. Naturally, sellers negotiate for the lowest possible cap, while buyers negotiate for the highest cap possible or no cap at all. A high cap helps a buyer hedge against any breach of a seller’s representations and warranties. The cap limits the indemnification exposure for the seller. The market rate for caps is normally a percentage of the transaction value, but that rate can fluctuate depending on the size of the deal.
A “basket” is the dollar amount of losses and damages that the buyer must incur before they are entitled to compensation from the seller regarding the deal. M&A deals usually feature a tipping basket or a deductible. For a tipping basket, the buyer can recuperate all losses once the threshold amount for the basket is met. A deductible, on the other hand, works in the same way as an insurance policy deductible. Any amount exceeding the deductible threshold basket amount can be recovered. A deductible is generally preferred by a seller, since only the amount beyond the deductible may be recovered. The market rate for baskets in M&A deals is around 1% of the transaction value.
*Note that if the seller commits fraud, a buyer has recourse to go after the full amount. Fraud is not protected within baskets and caps.
Legalities are clearly an essential consideration in business deal structures, and the best way to ensure sufficient protections and achieve your desired outcome is to be well-informed and employ expert guidance. At Viking, we encourage business owners to engage with us in all stages of the selling process – from the earliest days when selling still seems far off to the closing table where deals are closed.
Viking advisors work tirelessly to ensure that you have all of the guidance and information you need to do what is right for you. Do you have questions about your eventual exit? Reach out to us today for a no-cost, confidential consultation.