Methven and Associates, the Business Law Counselors

Buying and Selling A Busienss

Buying or selling a business can be complex, and different things are important in different industries. While it’s not remotely possible to discuss all matters that should be considered, here are some of the major issues to keep in mind.
Confidentiality

The seller should be sure to have all potential buyers sign a confidentiality agreement before providing proprietary information.
Listing of Assets and Liabilities.
1. In an asset sale, the assets being purchased obviously must be listed in a sale of assets.
  1. A clause merely stating that the sale includes all equipment, furniture and supplies on the premises will inevitably lead to arguments about what was and wasn’t there.
  2. The agreement should also list any liabilities being assumed by the buyer and state that no other liabilities are being assumed.
2. In a sale of stock, the buyer should not merely rely on a review of the seller’s books. It also is not enough to refer generally to the assets listed on the books. Instead, a list of the seller’s assets and liabilities should be created and attached to the agreement.
Valuation.

Valuing a business is somewhat subjective and is always the subject of negotiations. Valuation methods include:
1. Market-based valuation. This is based on the sale prices of similar businesses in that geographic area. Often business brokers use this method, based on their experiences selling similar businesses in the area. (Business brokers frequently ask for 10%, but like everything else, that is negotiable.)
2. Asset-based valuation. This takes into account figures such as the book value and liquidation value of the business. Still, these are considered bare minimums in business appraisals and are not generally used as the sole path to an asking price.
3. Earnings-based valuation. This takes into account historical financial figures, including debt payments, cash flows (past, present and projected) and revenues. Sometimes multipliers of revenues or profits are used; these vary widely from industry to industry. Also, sometimes this is calculated in a return-on-investment approach.
Adjustments in Price Based on Performance.
In order to limit their risk, buyers may want to include a performance clause in the purchase agreement.
1. Such a clause states that if the business’s revenues drop, there is an adjustment in the promissory note used to pay the remainder of the purchase price.
2. Faced with this, the seller may also want a provision where there is an increase in the amount of the promissory note if the business’s revenues increase.
Types of Transactions.
1. Taxable Transactions. In taxable transactions, the seller has to pay income tax to the extent the consideration exceeds the tax basis of the seller’s assets or stock. The buyer benefits from receiving a "stepped-up" (purchase price) basis in the assets or stock acquired.
  1. Buyers often want the deal structured as a purchase of assets in order to try to avoid picking up unknown liabilities. (This is not always successful.)
  2. Buyers also prefer a purchase of assets because they don’t want to inherit the seller’s historic low tax basis of the assets (rather than a tax basis equal to the purchase price).
  3. Corporate sellers often want the deal to be a sale of stock, since a sale of assets results in two levels of income tax for the seller: a corporate tax on the transaction and a second tax, if the seller’s corporation is dissolved after the sale, imposed on the shareholders to the extent their portion exceeds their tax basis in the stock.
    1. The sale of assets by an S corporation generally does not result in this double taxation, unless the S corporation was converted from a C corporation within the prior 10 years.
2. Tax-Free Transactions. A "sale" of stock can be tax free to the seller IF the principal consideration is not money but stock in an acquiring corporation. (These transactions are generally referred to as "mergers", and there are many ways of structuring them.)
  1. In a tax-free transaction, the seller benefits from the tax-free treatment, but the buyer suffers detriment because it acquires the seller’s (historically low) basis.
Sales Taxes.
In asset sales (but not sales of stock), sales tax is generally imposed on the sale of tangible personal property unless the company being sold is a service business (where the "occasional sale" exemption may apply).
1. Sales tax is imposed even if the only consideration is the buyer’s assumption of liabilities.
2. Custom computer software is generally not considered tangible personal property.
3. In the absence of any provision in the purchase agreement to the contrary, the seller is liable for any sales tax.
Allocation.

The parties should agree on the allocation of the purchase price to various categories as part of the purchase agreement.
1. It is often difficult to reach agreement if this is left until later – so decide it before the agreement is signed.
2. In an asset sale, if the buyer is paying all the sales taxes, then the allocation should definitely be set to best benefit the buyer for tax purposes.
  1. If the seller is paying some or all of any sales tax, though, then allocating more to tangible personal property will increase the seller’s sales tax amount.
3. Typically, the buyer wants to allocate as much of the purchase price as possible to assets with the fastest tax write-offs – that is, those with the shortest depreciation periods.
  1. For this reason, the buyer generally wants to attribute most of the price to business equipment and fixtures. Usually equipment and fixtures can be depreciated over three, five, seven or 10 years.
  2. The buyer also generally wants to assign smaller values to intangible assets, because they have a long tax write-off period, 15 years.
  3. Goodwill may not be amortized, so a buyer emphatically will want to allocate the minimum amount to goodwill.
    1. Still, in transferring a trademark, goodwill must be specifically transferred as well or the trademark will be lost – so something must be allocated to goodwill.
Covenant/Agreement Not to Compete.
1. The buyer will almost always insist that the seller to agree to not start or participate in a competing business.
  1. Sales of a business are one of the rare occasions California will uphold a covenant not to compete.
  2. Still a specific geographic area where the business has been carried on must be specified.
  3. Also, sole proprietors and shareholders must specifically be selling the goodwill of the business – and therefore something will need to be allocated to goodwill. (There is no such requirement when partners or members of LLC’s are selling.)
2. Payments specifically allocated to the seller’s covenant not to compete are taxed as ordinary income to the seller and are deductible by the buyer.
  1. The allocation must be reasonable in nature and amount.
  2. The buyer must amortize the payments over a 15-year period (like other intangible assets). That’s not as good as an allocation to equipment and fixtures, but is still better than a larger allocation to goodwill.
  3. In a sale of stock, generally the seller would prefer less or no allocation to a covenant not to compete (which represents ordinary income tax) and more or all to any accompanying stock sale (which is usually capital gains).
3. Often the buyer will want the non-competition provisions to be in a separate agreement, so if there is some argument over adjustments in the purchase agreement then the non-competition agreement will still stand. The seller, of course, may well want the opposite.
Hold Backs.
1. Frequently the buyer wants a certain amount held back in escrow to cover any adjustments (due to changes in inventory or accounts receivable, or due to unpaid creditors) or pro-rations (such as taxes, utilities or rent) based on the closing date.
2. The seller, of course, tries to minimize the amount of the hold-back.
Bulk Sales Law.
1. With sales of assets (though not sales of stock), the buyer must be wary of the Bulk Sales Law. This law applies when:
  1. "The seller’s principal business is the sale of inventory from stock, including those who manufacture what they sell, or that of a restaurant owner"; and
  2. the sale is not in the ordinary course of business; and
  3. more than half the seller’s inventory and equipment is sold.
2. Essentially, the Bulk Sales Law makes the buyer liable to pay the debts of the selling company – although unless agreed otherwise, the buyer has the right to recover these amounts against the seller.
3. For sales where the purchase price is $2 million or less, the creditors must be paid from the escrow.
4. The buyer can limit its liability by requiring the seller to provide a list of creditors and agreeing to pay the creditors on the list (with an adjustment in the purchase price) or making sure the seller has paid these debts.
Successor Liability.

If the buyer is continuing the seller’s business, the buyer may be liable under a "successor liability" theory for any product-liability suits brought by pre-closing customers. It’s a good reason to have an indemnification clause running from the seller in favor of the buyer, and to check out the business’s insurance as well.
Due Diligence.
1. In addition to all the other due diligence that the buyer conducts, the buyer should hire an accountant to examine the seller’s books and determine if any adjustments in the purchase price are needed. This is crucial.
2. The seller will want to have a specific time limit placed on all due diligence so that if no objection is made by the specified deadline the due diligence results are deemed satisfactory to the buyer.
3. If the business is a California entity, buyers can see if it is in good standing (has paid its California taxes) by going to http://kepler.ss.ca.gov/list.html .
4. Buyers may want to conduct a UCC search to see if there are liens against the business. On the Internet, try +California +"UCC search" to get a list of companies that will provide this service. This is recommended.
5. If you want to conduct a search to see what litigation has been filed against the business, try +California +"litigation searches" (this time make it plural) to get a list of companies that will provide this service. Alternatively, use a service like www.lexis.com . (Often, though, the buyer will be satisfied with contract provisions that state that the seller warrants there is no litigation unless expressly listed – and that the seller will indemnify the buyer if there is any breach of this warranty.)
6. Buyers may want to check with the Better Business Bureau to see if any consumer complaints have been filed regarding the business.
7. If you believe that there may be environmental issues, see if the county where the business is located has an "Environmental Health" unit – and call them to ask if there are any problems at the location.
Assignment of Leases and Contracts.
1. If existing leases are important, the buyer should include provisions stating that closing is contingent on the landlord’s approval of the leases using the current rents and lease provisions.
2. Similarly, if existing contracts are important, the buyer should either make sure that the contracts allow assignment or include provisions stating that closing is contingent on the other parties to the contracts agreeing to the assignment.
Licenses & Permits.
1. The seller should represent that it has all licenses and permits needed to operate the business, and that these can all be transferred to the buyer.
2. The buyer should investigate if there will be any fees from the issuing authorities for these transfers – or if the issuing authorities will require the buyer to qualify in some way.
Intellectual Property.

In addition to many other warranties (and indemnification provisions), if intellectual property is being transferred, the buyer generally will want the seller to warrant that the seller owns the intellectual property and will indemnify the buyer for any third-party claims of infringement.
Pre-Closing Training & Post-Closing Consulting by Seller.
1. For smaller transactions in particular, if the buyer needs training to operate the business, the purchase agreement should state precisely how much (in hours or days) pre-closing training and post-closing consulting will be provided by the owner and what (if any) compensation will be paid to the owner for this. (For example, this could be done as a maximum number of hours per week for a set number of weeks.)
2. From the seller’s point of view, the agreement should specify that this time is for training or consulting only, and not for running the business.
3. It may also be important for the seller to limit the days and times during which training and consulting will be provided (e.g. 9:00 to 5:00, M-F) so that the buyer does not try to have the seller be present at unusual times.
4. The seller will often want to limit how far he/she must travel, in case the new owner relocates the business.