As an avid reader of the Duluthian, there is a good chance you have seen an agreement for the purchase and sale of a business (“PA”). At first blush, a PA may appear to be a complicated document filled with dense legalese, with little practical value to the average business owner.
One may think a PA is best left to a boring attorney to draft and consider after the owner has decided desired terms of sale. However, the inverse is true – reviewing a typical PA before a transaction takes shape can be a valuable step for business owners looking to sell, as it reflects key financial and business points to consider when formulating the terms of a potential sale and preparing for closing.
A good place to start is the “representations and warranties” section, where a seller makes various disclosures about company conditions and operations. Buyers will carefully vet these disclosures during due diligence. Reviewing representations and warranties allows a seller to take inventory of their company and identify matters to disclose or resolve prior to entering or closing a PA, such as:
• Does the seller own the assets being conveyed? Many companies have various affiliates or subsidiaries, so it’s important to check that the assets being sold are titled or otherwise belong to the selling entity. Sellers should also determine if any assets are encumbered by liens or security interests. If you have working capital or other debts, explore confidentially with your lender any circumstances for release or assumption by a buyer.
• Who are key suppliers and customers? Will their consent to a change in control of the company be necessary for a buyer to keep working with them? It is important to review material agreements regarding the effect of change in control (particularly given looming tariffs and potentially volatile markets).
• Who are my employees? This question should prompt consideration of whether, when and how to start discussing potential sale with your employees. Employers must balance openness with the risk that knowledge of a possible sale might disrupt business and hurt retention.
Another PA item is who the buyer will be, which prompts consideration of where to find a buyer. One potential source is a business broker, who may also assist in facilitating the transaction during due diligence and closing. Make sure you review a broker agreement and understand scope of services, fee arrangements (base and commissions) and termination.
A common alternate source of potential buyers could be within the business itself. Are there any employees interested in purchasing? Often, employee-buyers need to finance part of the purchase price from a third-party lender and the seller. The lender will typically require seller-financed debt security to be subordinate to its own security. Protecting your interest through multiple means can help offset subordination risks. Sellers may want a security interest in assets, a pledge of purchased stock, and/or Buyer’s personal guaranty.
An additional key term is the purchase price, which in turn requires valuation. Despite the availability of online resources, valuation (particularly for small businesses) is still enough of an art that it is advisable to use a professional like an accountant and/or appraiser. Accountants play a vital role in establishing the book value of tangible assets.
Still, book value is only part of the equation, and professionals can use market-based or capitalization methods to determine additional business value from intangibles like goodwill. Even if you use an appraiser, it’s important to keep your accountant engaged throughout the process, as they will have key insights into revenues and cash flows that determine intangible value, and can assist in arriving at a tax-advantageous purchase price allocation among the various business assets and liabilities.
Another purchase price consideration to think ahead about is earnouts, where a portion of the price is contingent on the performance of the business post-sale. They are often used to bridge a gap in negotiated purchase price. Work with your attorney and/or accountant to ensure any earnout provisions are not subject to manipulation, and that the portion of a purchase price leveraged by an earnout is reasonable – you do not want to be too dependent on someone else’s performance in running the company after you leave.
Jesse Smith joined Hanft Fride as an associate in August 2022 and is licensed to practice in Minnesota.
