By James D. Doyle, Esq. In 2021, Congress enacted the Corporate Transparency Act, a pivotal…
Whether you are selling a business as you prepare for retirement, or are acquiring a new business to grow your current operations, there are numerous items for the seller and buyer to address, regardless of the size of the business. This guide highlights 10 key areas that buyers and sellers will face during the transaction.
Non-Disclosure Agreements and Sharing of Information
One of the first steps in purchasing a business is gathering information about the business and the parties to the transaction. This is commonly referred to as due diligence. While due diligence is often thought of as a time to gather information related to the seller’s business, the seller should also seek to gather information on the buyer to ensure the buyer has the capability of completing the purchase.
The due diligence review can be conducted prior to the parties entering into a sale agreement, usually in connection with a Letter of Intent, or it can be conducted after the sale agreement has been entered into but before closing. Regardless of when the due diligence takes place, the parties want to ensure the information they share is held confidential. Having a legally binding non-disclosure agreement in place provides peace of mind when sharing sensitive information.
Asset Purchase vs. Stock Purchase: Structuring the Transaction
The two most prevalent ways to buy and sell a business are either via an Asset Purchase Agreement (“APA”) or Stock (corporations)/Membership Interest (LLCs) Purchase Agreement (“SPA”). In an APA, the buyer is purchasing either substantially all or certain specified assets of the seller. Assets include everything from inventory and equipment of the seller to seller’s contracts with third parties. Under an APA, the buyer can assume all, none or specified liabilities of the seller. The buyer commonly forms a new business entity to be the buyer under the sale agreement. An SPA is fundamentally different, as the buyer is purchasing the ownership interest of the seller. This ownership interest is referred to as seller’s “stock” or “shares” if it’s a corporation, or “membership interest” if it’s a limited liability company. When a buyer purchases the ownership interest in the company pursuant to an SPA, the buyer is stepping into the shoes of the previous owner. The buyer then has ownership of the existing company and all of its assets and liabilities.
Purchase Price, Escrow and Adjustments
In an APA, the purchase price reflects the value of the assets, whereas in an SPA the purchase price reflects the value of the ownership interest being purchased. In an APA, the purchase price is allocated amongst the assets. Determining the value of the assets or ownership interest, as applicable, is not a perfect science and there are various mechanisms to do so.
The parties must also agree upon how and when the purchase price will be paid: cash, debt or a combination of both are most common. It is not uncommon for parties to negotiate whether to escrow any portion of the purchase price and/or to include a purchase price adjustment to address changes in value of what is being purchased or unforeseen liabilities that may arise. (See Indemnification section below.)
Representations and Warranties
The representations and warranties (R&W) given by each party are a key part of any transaction. They disclose information about the parties; the assets/ownership interest being sold and the liabilities being assumed; allocate risk between the parties; often serve as the basis for an indemnification claim in case of a breach; and can impact a party’s obligation to close the transaction.
The amount and scope of the R&W vary based on the nature of the transaction. This can be affected by things such as the type of business being purchased, the relationship of the buyer and seller and the value of the transaction. There are negotiation points involving R&W often used by sellers and their attorneys.
Contracts and Licenses
In an SPA, the buyer is obtaining ownership of the selling entity and is thereby inherently obtaining ownership of the seller’s contracts with third parties as well as the licenses the company holds. This is different than in an APA, where any contracts of the selling company that the buyer is acquiring will have to be assigned to the buying company. This often requires the consent of the third party to the contract.
The type of licenses involved can have a serious impact on the timing of the transaction, as it often involves steps and approvals outside of either party’s control. For instance, a purchase of a bar will require Liquor Control Board approval to transfer the liquor license, and a purchase of a vehicle inspection shop will require Department of Transportation approvals.
In an SPA, there is generally no change for the seller’s employees since the buyer is gaining ownership of the company that employs the employees. On the other hand, under an APA, the employees do not just automatically become employees of the buyer. Rather, the seller typically terminates the employees at closing, and the buyer simultaneously offers them employment with their company. The buyer has no obligation to offer employment to these employees (unless agreed upon with the seller), and the employees have no obligation to work for the new company. If the seller’s employees are employed under employment agreements or there are unions involved, this aspect of the transaction can become much more complicated. The parties must also address any existing employee benefit plans.
Indemnification provisions seek to provide a post-closing remedy for losses incurred by either party under the purchase agreement. The obligation to indemnify the other party often arises from the failure of a party to perform a covenant, a party’s violation of a covenant, or due to the breach of, or inaccuracy in, an R&W. Some agreements will call for a holdback of a portion of the purchase price in escrow, for a certain period of time, to account for any losses that may arise post-closing.
SPAs generally do not require the transfer of real estate or assignment of a lease since the company is not changing, just the ownership. In an APA, if the buyer intends to continue business operation at the location where the seller conducts its business and the seller owns the location, then the buyer must buy the premises or lease it from the seller. If a third party owns the building, the seller will have to assign its current lease to the buyer with the landlord’s consent or the buyer may enter into a new lease with the landlord.
Pursuant to an SPA, there typically does not need to be any transfer of intellectual property (“IP”) such as patents, licenses, trademarks or copyrights since the ownership of the company is simply changing. In an APA, the buyer commonly wants to purchase all of the IP the seller uses in connection with its business. Even if the seller does not have any registered IP, the buyer still wants to purchase IP such as the use of the name of the selling company, its logo and its website domain.
The buyer and seller must also consider tax implications when deciding between an APA and SPA. As a general matter, buyers prefer to buy assets, and sellers prefer to sell stock. There are a plethora of tax issues for the parties to consider that are outside the scope of this article. The parties should be aware that the structuring of the transaction can have an impact on the realization of gains and related timing of those gains, cost basis and allocations, required withholdings, use and other transfer tax, and the need to comply with bulk sales laws.
Attorney Gordon W. Prince is a member of the Business Law Department at Gawthrop Greenwood, PC, where he focuses his practice on business and corporate law, contracts, financing and secured transactions. He was named a Super Lawyers Rising Star in 2022, as well as a Top Lawyer in Main Line Today and the Daily Local News. For more information, contact Gordon at firstname.lastname@example.org or 610-696-8225.