Buying or selling a business? Trust, but verify

When dealing with the Soviet Union on a nuclear weapons treaty in 1987, President Reagan famously explained the reason for the treaty with the Russian proverb doveryai, no proveryai, or “trust but verify.” Though the stakes may be lower than disarmament of nuclear superpowers, business buyers and sellers should employ the same maxim. Once the basic terms of a transaction have been agreed upon, then it is time to put the deal to paper. Whether a transaction is large or small, the agreements required and issues to be addressed are frequently similar.

Asset purchase agreement or equity purchase agreement. This will be the master document that will describe the transaction. Generally speaking, small business sales are more frequently characterized as asset purchase transactions, rather than equity purchase transactions. In an asset purchase, the buyer buys the assets of the operating business, but the liabilities of the business remain with the seller. In a stock or other equity purchase, on the other hand, the buyer buys the equity in the operating business, and the business itself carries on uninterrupted. That means that the buyer will also assume the liabilities of the business. Retaining liabilities is understandably undesirable to a buyer, but sometimes the approach is necessary if, for example, the business being acquired has long term contracts which cannot otherwise be assigned.

Under either scenario, both buyer and seller will want representations and warranties from one another. At a minimum, the parties will want to make sure that each has the power to enter into the agreement and that if the other party is a business entity (rather than an individual), that the transaction has been duly authorized. Buyers will typically ask for additional representations regarding the accuracy of information provided during negotiations, the status of assets, the status of material contracts, the status of leases, the status of the seller’s payment of taxes, and other issues. In an equity sale, sellers are likely to be asked to give additional representations and warranties regarding outstanding equity holders and other entity governance issues. Representations and warranties are typically where all of the promises that a seller has made to a buyer about the business are formalized.

Bill of sale. In an asset purchase transaction, the seller will provide a bill of sale transferring ownership of personal property. This document is important because it defines the universe of what the buyer is buying and the seller is selling. In addition to “hard” assets, buyers will frequently want to include other intangible items, like business records, customer lists, phone numbers, Web sites, domain names, formulas, vendor accounts, leases, and contracts. Depending on the type of business being purchased and sold, additional specialized items may need to be included in the list of purchased assets. It also bears noting that some assets, like vehicles and real property, are “titled” and must be transferred in a particular way. A bill of sale is likely to be ineffective to fully transfer legal ownership of titled assets.

Promissory note. Even though business sellers typically hope to be paid in cash, most small business sellers can be expected to be asked to “carry back,” or finance a part of the purchase price. This is the buyer’s promise to pay over time.The ratio of down payment to financing, the interest rate, the duration of the loan, and many other terms are negotiable. Sellers should expect buyers to seek a right to offset damages incurred as a result of breaches of representations or warranties from the note balance. Buyers, on the other hand, should expect the note to be secured, and if the buyer is an entity, the buyer’s principal(s) should expect to be asked to personally guarantee the note.

Security agreement. A security agreement creates a security interest (a statutory lien) in assets to secure payment or performance of an obligation. Security agreements are typically used to secure performance of a seller carryback note. Generally, the seller will seek a security interest in the business assets being purchased, or in an equity sale, a security interest in the equity interests (i.e. stock) being purchased. A cautious seller may also seek a security interest in additional buyer assets to secure performance of the carry back note. From the seller’s perspective, it’s very important not only to get a security agreement, but also to “perfect” the lien of the security interest, so that later secured parties cannot jump ahead of the seller in foreclosure. The method required to perfect a lien depends on several factors, and varies depending on the type of asset. Perfection is important, and unperfected lienholders may be very surprised to learn that their security agreement is disregarded in the event the buyer files for bankruptcy.

Noncompetition agreement. A noncompetition agreement is a contractual promise by a seller not to engage in a business or activity which is similar to the business being sold after the sale closes. Frequently, three issues are addressed: competition with the business, solicitation of customers, and solicitation of employees. In most cases, a buyer wants to make sure that the seller doesn’t open a competing business in the same area where the buyer anticipates doing business. Similarly, the buyer will want assurances that the seller is not going to attempt to lure away customers or employees. The geographic scope of the noncompetition agreement, as well as the duration of the covenant not to compete, are typically heavily negotiated items. Where the seller is an entity, a buyer must be sure that the noncompetition agreement’s covenants will also restrict the seller’s principals. If the seller has key employees who will be retained post-acquisition, a prudent buyer may also seek noncompetition agreements from the retained employees as part of their employment agreements. Noncompetition covenants in employment agreements may be heavily scrutinized, so it’s important for a buyer who is relying on noncompetition provisions of employment agreements with retained employees to consult with counsel.

Consulting agreement. Frequently, a seller will promise a buyer that the seller will stick around after closing to teach the buyer how to run the business. A prudent buyer who needs the seller to stick around will insist on reducing these promises to writing in a consulting agreement. While no two post-sale consulting agreements are exactly the same, buyers and sellers will commonly negotiate for tapering, or stepped down consulting by the seller over a fixed time period. For instance, having the seller be on site full time for a few weeks, half time for a month, and available for phone consults for three to six months after closing would not be uncommon. Buyers and sellers can expect to negotiate the cost of a consulting agreement, the duration, the number of hours, and you may want the seller to stick around and help transition the business’s customers over to you. A consulting agreement would require the seller to dedicate some time to that process over the next three to 12 months.

Every business purchase and sale is unique, and the agreements discussed above may or may not apply. The key thing for both parties to remember is that in order to be sure that the mutual promises made in negotiation become an enforceable part of the transaction, those promises should be reduced to writing. That’s right: trust but verify.

Shawn Pearson is a shareholder with Woodburn and Wedge and practices corporate law, real property law, and other commercial transactions. Contact him at 775-688-3000 or woodburnandwedge.com.