The Art of Buying and Selling a Business

Whether you are buying or selling a business, few people will disagree that this process is one of the most important, exhilarating and emotional experiences of your life. For the buyer, often acquiring an interest in a business is a “once in lifetime” opportunity to become your own boss and to reap potentially unlimited rewards directly related to your own effort and ability. For the seller, building a successful company and then selling it for a hefty price is the culmination of many years of toil and struggle and presents the opportunity to pass along your legacy and live comfortably thereafter.

These transactions are often “emotional roller-coasters” for both parties and present real challenges if they are to be completed successfully, fairly and without dispute. These challenges often require professionals with specialized knowledge and experience to identify potential pitfalls and areas of dispute and to bring the parties to agreement in these areas.

Asset Sale Versus Stock Sale

One of the first considerations for both parties is to decide whether the transaction is going to be a “stock sale” or an “asset sale.” In a “stock sale”, the owner of the business sells his or her ownership interest in the business entity, represented by shares of stock, limited liability company membership units or partnership interests. In this article, we will refer to a sale of all of these types of interests generically as a “stock sale.” Thus, the “seller” is the owner of the shares of stock. A “stock sale” is not possible with a sole proprietorship since there is no entity other that the owner individually, who owns the business assets directly.

An “asset sale” occurs when the owner of the business retains his or her ownership interest in the company entity and the company itself sells only selected assets and liabilities of the company. Except for sole proprietorships, the seller is not the business owner but is the company itself. The owners of the selling company, which has disposed of at least a portion of its assets and liabilities, remain the same after the transaction.

In a stock sale, the business assets remain in the original entity or company. All assets, liabilities and ownership equity of the company follow the ownership of stock or units of the company. The book or tax values of individual assets, both tangible and intangible, will be driven by values carried on the company’s financial statements prior to the sale and may generally be adjusted only upon adequate empirical support or expert opinion. In a stock sale, the purchase price establishes the buyer’s tax basis in the interest or the amount of capital contribution made to the company.

A stock sale makes it simpler to describe the property which is the subject of the purchase in the purchase agreement. Instead of an extensive list of various assets or liabilities, the property being sold is “X number of shares of the common stock of the company”, for example. It is also simpler to actually make the transfer, often involving only signing transfer language on the back of a certificate.

Unless the owner of the transferred shares is going to be another entity as opposed to an individual or individuals, the stock sale eliminates the need to create an additional business entity to actually own the business assets and operate the business. The ownership of the stock by another entity instead of an individual will likely impact the ultimate tax treatment of the transaction and subsequent business operations to the individual owner. In fact, ownership by another entity may not be allowed for certain types of tax entities such as Sub-chapter S corporations.

A Stock Purchase Includes the Liabilities of the Acquired Business

A stock sale is generally considered much riskier to the buyer than an “asset sale” and is therefore much less common than an asset sale. At least indirectly by ownership of the stock, the buyer is assuming all obligations and risks arising from the company’s prior operations. This could include unassertive and unknown claims arising from a variety of areas including product liability, negligence, environmental conditions, violation of laws and regulations, labor or employment liability, breaches of contracts and much more. Even indemnification of the buyer by the prior owners may not suffice to protect the buyer’s investment.

Because of this risk, extensive due diligence should be conducted by the buyer in order to assure that unknown conditions or unanticipated liabilities do not arise and to assure that the purchase price corresponds with the value of the interest purchased. This due diligence should include real estate record searches, UCC searches and other investigations as necessary to assure that all mortgage and lien interests and other claims are known. The purchase agreement for a stock sale should also require tax clearances from relevant taxing authorities and the buyer should assure that all tax liabilities accrued prior to closing are paid or that adequate provision is made for their payment.

Stock sale due diligence should include careful scrutiny of significant balance sheet accounts and verification of material amounts, especially if the Company’s financial statements are not audited. Accounts receivable should be analyzed for collectability, accounts payable to verify accruals or balances and inventory should be checked for accuracy. Balances and payment terms of long-term liabilities should be verified. An agreement for the purchase of stock usually also includes indemnification of the buyer by the seller as to any unknown obligations or liabilities not specifically listed or accounted for.

A stock purchase agreement should also specifically delineate agreements or plans related to the current employees of seller. The buyer may choose to require seller to terminate the employment of all of some of its employees or to renegotiate with particular employees to assure that the labor force is as it desires after the closing. The agreement should specify any required actions of seller prior to closing related to employees and should provide that the seller is liable for employment-related disputes arising before closing and that buyer is liable thereafter. Many times, the former owner may be specifically required by the purchase agreement to remain as an employee for some period to train and assist the new owners in the transition. The terms of this employment should be negotiated in detail

Shares of stock, partnership interests or LLC membership units are securities and sale of these may mandate compliance with securities laws. In the usual sale of small business interests to individuals or closely-held entities, exceptions are in place eliminating the need for registration or mandatory disclosures. A stock purchase agreement should contain representations from the buyer reciting his or her intent in buying the securities and verifying the applicability of these exceptions.

A stock sale may require notice to or permission from other owners of the company, lenders, landlords or other third parties. The sale could in fact be an outright violation of third-party contracts. This should be investigated and any required permissions or waivers obtained.

Any personal guarantees by the stock seller given to lenders, vendors or perhaps a landlord must be renegotiated to obtain release of the seller. As part of the due diligence process, the buyer may also wish to obtain acknowledgment of compliance with lease provisions from the landlord.

Asset Purchases Limit Liabilities, but Beware of Successor Liability

In an asset sale, the buyer must create a new entity, unless operating as sole proprietor. This new entity may be the actual, named buyer in the transaction or the seller may transfer assets and liabilities into one or more entities after closing. This decision is most often driven by tax considerations. Ultimate calculation of the buyer’s tax basis in the company and/or the buyer’s capital contribution is driven by the combined fair market values of assets, tangible and intangible, net of debt.

In an asset sale, the company sells only selected, described assets, tangible or intangible, and the buyer assumes only selected, described liabilities. The amount paid for individual assets, especially intangibles, may be scrutinized by taxing authorities and the values allocated by the parties may have to be supported by empirical evidence or expert opinion, or both, to withstand the scrutiny of these taxing authorities. The value of intangible assets or “blue sky” purchased by the buyer may have to be analyzed and adjusted each year, which may result in significant book/tax income or loss.

The total purchase price in an asset sale is usually allocated by agreement between the parties to specific assets, tangible and intangible. This allocation may have different and significant tax impact upon the seller and buyer and this sometimes creates adversity between the parties. “Titled” assets must be each separately transferred with appropriate deeds, registration, titles, bills of sale or other transfer documents.

The asset sale also requires that the buyer must itself hire employees of the selling company that it needs to continue operations. The buyer may wish to make the entire agreement contingent on its ability to secure employment contracts with key employees. The seller may wish to specify that it be relieved of any potential liability to these “acquired’ employees.

Each liability assumed by the buyer should be analyzed to assure consent and acknowledgement of third party creditors if necessary, to remove the seller from liability and to replace the seller with the buyer as a party. The asset purchase agreement usually also requires the buyer’s indemnification of the seller from liability for obligations not specifically assumed.

Read our article about Successor Liability – Even in an Asset Purchase for more information about unknown liability that could attach to a purchaser in a purely asset purchase.

A Purchase Agreement is Absolutely Necessary in any Business Sale

In the case of both types of sale, the purchase agreement should contain written representations by both parties as to pertinent factors being relied on by the other party including characteristics, condition or other details of the ownership interest or assets and liabilities being transferred, as to the capacity or ability of the parties to enter into the transaction and as to other factors important to either party.

The agreement may include the seller’s covenant not to compete with the buyer for a specific time and in a limited geographic area. Agreements of confidentiality or non-solicitation of employees may also be negotiated. The agreement should state the parties’ understandings as to the portions of the purchase price allocated to or the value of these covenants for tax purposes.

Finally, the agreement should recite the date and place of closing, should identify items or documents to be delivered at closing, should specify the amount and method of payment of the purchase price and the remedies available to the parties upon failure to deliver or breach of a material representation. The agreement should also address methods of resolution of any disputes, the risk of loss during the time between signing and closing, any insurance requirements, the parties’ choice of laws and their understandings as to the timing, scope, and effect of any due diligence to be conducted by buyer. The agreement may also list critical conditions which, after investigation or due diligence, give rise to the right to rescind the agreement by either the buyer or the seller.

This is a discussion of just some of the many things that should be considered and agreed-upon to help assure that the sale and purchase of a business concludes successfully, is fair to all interested parties, and presents no unfortunate surprises or undesirable consequences to either party. As you may imagine, this can be very difficult to achieve without the assistance of competent financial and legal professionals, such as the attorneys at Law 4 Small Business.