Business owners contemplating selling anything more than a lemonade stand should anticipate a complex and time-consuming process to both maximize the sale price while mitigating potential risk. The process is part chess match and part marathon. Though the entire sale process can take months or even years to navigate, the heart of the deal is the Purchase and Sale Agreement (PSA for short). The PSA is the defining document that captures the buyer’s and the seller’s rights and obligations and what happens if things go sideways. Before shaking hands and popping the champagne, business owners and buyers alike need an understanding of the following customary components of a PSA.
Stock or Asset Sale. The first fork in the road is to define the type of sale. Business owners own stock or Limited Liability Company Units in the business. On the other hand, the business itself owns assets (equipment, inventory, goodwill, brand name, etc.). So, when it comes time to sell, the deal is structured as either a stock sale from the owner or an asset sale from the business. The distinction is often overlooked but the consequences are profound.
From a tax perspective, sellers generally prefer stock sales due to favorable capital gains treatment and reduced recapture exposure. Buyers, conversely, favor asset purchases, which allow for stepped-up basis and enhanced depreciation opportunities. Asset sales also enable buyers to selectively assume liabilities, thereby reducing exposure to contingent risks. For example, assume the company has an employee who is thinking of filing a lawsuit for workplace harassment. By purchasing the company, the buyer might expose himself or herself to the lawsuit. By purchasing the widget machine and business name, the buyer avoids the potential lawsuit.
Payment Terms.
Cash is king, but not always practical. Deferred payments, earn-outs, and seller financing are common. If any portion of the sale price is due after closing, the PSA needs to define how and when payments are made and the applicable interest rate to be charged. As a general reminder, the seller should not offer bank rates. The seller is taking on outsized risk and should probably charge rates that are a premium to commercial banking rates. Most importantly, the PSA should provide collateral to the seller so that the seller can easily and quickly recover in the event of nonpayment.
Noncompete Agreement.
Buyers don’t want sellers setting up a competing shop across the street after closing. Accordingly, the PSA customarily includes provisions that prevent the seller from subsequently competing with the buyer. The provision is usually expanded beyond mere competition to prevent the seller from taking any employees or impacting business relationships (e.g. customers or suppliers).
Representations.
A significant portion of the PSA includes representations and warranties. These are basically promises, primarily from the seller to the buyer, about the state of the business. The seller should be prepared to disclose all aspects of the business – the good, the bad, and the ugly. It goes beyond financial statements and tax returns and includes information on items such as employees, assets, hazardous activities, and more. Here’s the expectation: disclose everything. If there’s a skeleton in the closet, drag it out into the light. Surprises after closing are how lawsuits get started.
The Process. The process can be frustratingly long. Inevitably, attorneys will be involved on both sides of the deal. This means there will be a linear progression of review and revision that just takes time. For example, if the business owner gets a draft PSA, he will first review it and make comments. Then, he will send to his attorney who will review it and make comments back to the owner. The business owner and his attorney discuss, make changes, and send to the buyer. Buyer reads it, makes comments, and sends to her attorney for review/comment/changes. The process continues until the document is complete and subject to all manner of interruptions. Without a doubt, the process should start with the business owner discussing the sale with his or her attorney to make a game plan for the entire deal.
The PSA’s Place in the Business Sale. The PSA is neither the beginning nor the end of the process. The PSA comes after the Letter of Intent (which expressed the buyer’s interest in purchasing the business in a written agreement) and before the date scheduled for closing and any post-closing activities. This further supports the idea that the business sale process can be a long one and underscores the importance of finding good advisors with whom to navigate the process.
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The opinions voiced in this material are for general information only and not intended to provide specific advice or recommendations for any individual or entity. This information is not intended to be a substitute for specific individualized tax or legal advice. We suggest that you discuss your specific situation with a qualified tax or legal advisor.
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