Five Key Steps When Selling Your Business: From Preparation to Purchase Agreement

Sales of most small companies involve a fairly standard and predictable process that can be followed when selling your business.  In addition to having a sharp corporate attorney at your side, understanding the process will help you prepare and mitigate surprises.

1. Get Your House in Order. Buyers will investigate all aspects of your business to fully understand its assets and identify all potential liabilities.  You can get ahead of this process by conducting due diligence on your own company before seeking a buyer. Consider setting up your own secure digital data room to organize and store all documents related to your business in an accessible way, making it easy for you, your business lawyer, and the buyer to review them when the time comes.

Are financial statements and tax returns complete and filed? Buyers will often want to see three years of financial and tax records.

• Are corporate records in order? Produce electronic board and shareholder minute books and ensure that capitalization records are current and complete.

• Do you have signed copies of all current contracts with customers, suppliers, landlords, and employees? Distribution agreements?  Intellectual property license agreements?  All material contracts should be identified and kept together.

• Are all government licenses and permits current?

• Do any contracts, licenses, or permits require the consent of any third parties before they may be transferred to a buyer? Look for language about “assignment,” “assignability,” or “change of control.”

• Are all records related to assets and liabilities (titles, bills of sale, financing agreements, loan agreements, leases, etc.) readily available?

Identify red flags, such as missing, lapsed, expired, or incomplete documents, and remedy any issues before a potential buyer raises concerns.  The more prepared and organized you are, the more smoothly the buyer’s diligence investigation will go. This standard form due diligence request list can help you get started: DUE DILIGENCE CHECKLIST

2. Determine Which Transaction Structure You Prefer. Tax and liability considerations often drive the structure of the transaction.  Consequently, buyers generally prefer asset transactions, while sellers tend to prefer stock transactions or mergers. There are different ways to structure sales of businesses (often referred to generally as “M&A,” short for “mergers and acquisitions”).  Here are a few of the most common structures:

• Asset Transactions. In an asset transaction, the buyer determines which assets and liabilities it wants to acquire.  Anything not acquired by the buyer remains an asset or liability of the seller.  Some assets, such as contracts and licenses, may not be transferable to a buyer without obtaining consents from third parties.  Asset transactions are generally taxable to sellers, while buyers get a step-up in the tax basis of the acquired assets.

• Equity Transactions. In an equity transaction, the buyer purchases all of the stock or membership interests of the seller’s company and becomes the new owner, taking on all of the seller’s assets and liabilities.  Stock transactions often have better tax consequences for sellers and generally relieve sellers of liabilities disclosed to the buyer before the transaction.  A potential downside of an equity transaction is that recalcitrant shareholders may cause problems or delay completion of the transaction.

• Mergers. In a merger, the buyer or its subsidiary merges with the seller.  As a result, and similar to an equity transaction, the buyer acquires all of the assets and liabilities of the seller. Mergers have the potential to be structured as reorganizations that are tax free for sellers.  Usually, mergers do not require unanimous shareholder consent and also tend to require fewer third-party consents for the transfer of contracts and licenses.

3. Know the Value of Your Business. There are many methods for determining the value of your company and myriad factors that may be considered.  These are three of the most common methods for determining the value of your company. They are often used in some combination.

• Asset-Based Valuation. An asset-based valuation, also known as book value, is a relatively straightforward valuation method where net value is determined by subtracting the amount of a company’s liabilities from the amount of its assets.  Asset-based valuations are most commonly used by businesses that hold investments, have steady cash flow, or are liquidating.

• Market-Based Valuation. A market-based valuation values a company by comparing it to similar companies in similar industries in similar geographical areas.  Reviewing recent sales of these businesses will help you determine a competitive value for your company.  Market-based valuations are appropriate for any business if the details of sales of comparable companies are available.

• Earnings- or Revenue-Based Valuation. If your company is profitable, an earnings-based valuation may be appropriate.  Earnings-based valuations are based on past performance and forecasts of future earnings.  If your company is not yet profitable, but has high growth potential, a revenue-based valuation may be a good valuation measure. The ultimate value is generally based on a multiple of earnings or revenue, which may be discounted when a company’s future earnings or revenue is uncertain.

4. Letter of Intent. A letter of intent (“LOI”) outlines the structure and the broad terms of the transaction.  Although an LOI is generally not binding and does not guarantee that a transaction will close, it should be taken seriously.  It is wise to talk with your business attorney before the LOI stage.  The LOI will lead and direct the terms of the purchase agreement, so do not agree to anything in the LOI that you can’t live with during the course of the transaction. Negotiating the business terms that are most important to you at this stage makes finalizing the purchase agreement much more efficient.

Buyers will likely want an exclusivity period during which you will not enter into negotiations for the sale of the company with any other potential buyer. Exclusivity provisions are binding.  The LOI should also include confidentiality provisions to protect information you provide to the buyer during the diligence period, and to protect both parties from disclosure of the terms of the transaction.  Confidentiality provisions are also binding.  Finally, consider whether an earnest money deposit is warranted at the LOI stage.

5. Purchase Agreement. The purchase agreement is the legal document that details the terms of the transaction summarized in the LOI: what is being sold, at what price, and on what terms.  The agreement will also include thorough representations, warranties, and covenants by both parties; indemnification provisions to provide protections for both buyer and seller; and conditions that must be satisfied by both parties before the transaction closes. Consider who among the seller parties will be responsible for making representations, warranties, covenants, and ultimately for any related potential liabilities.

Selling a business is a complicated process; however, good preparation, an understanding of the process, and an experienced, competent corporate lawyer as your counsel can lead to a positive result for all parties.