By Richard S. Wheeler, Esq.
Caveat emptor (“let the buyer beware”) is a maxim familiar to most investors and entrepreneurs. Less familiar is caveat venditor (“let the seller beware”). In the sale and purchase of a business, they are but two sides of the same coin. There are numerous traps which can be avoided to prevent either (or both) of these maxims from applying. I have space here to address only a few of the most obvious ones. No reasonable person would buy or sell a home, usually the single largest investment any of us makes in our lifetime, without hiring an attorney to review and approve the closing documents.
Likewise, no reasonable investor should buy or sell a business without having competent legal representation. Too often, however, the buyer or seller (whether of a home or a business) relies exclusively on the real estate or business broker (as the case may be) and has already made or accepted a binding purchase offer for the home, or has entered into a binding commitment to sell or purchase a business, before getting his legal counsel involved. At this point, the attorney’s ability to influence the structure of the transaction to best protect the buyer’s or seller’s interest may be severely limited.
Therefore, the first and most deadly trap when buying or selling a business (or an interest in a business) can be avoided simply by hiring a competent business attorney before entering into a binding contract. That attorney can then help you prepare a term sheet or agreement in principle to present to the other party to flesh out the structure and terms of the potential sale or acquisition. Such an interim agreement is binding in certain respects, for example, as to both parties’ duty of confidentiality regarding proprietary business information disclosed to the other during the “due diligence” investigation phase. But it is generally not binding as to either party’s duty to consummate the underlying transaction; instead, it is expressly made subject to the negotiation and execution of a definitive acquisition agreement.
I do not advocate elevating form over substance in business transactions, but structure does matter for both buyers and sellers. And their interests are not always (or even not usually) the same. The second trap to avoid, then, is the “one size fits all” attitude adopted by some state business broker associations in their “standard” form business acquisition agreement.
A seller’s primary interest is to get his asking price and to be paid in full at the closing with no (or only limited) exposure to post-closing liability to the buyer arising out of the buyer’s future conduct of the business. For an existing business which has been operated in corporate form, such a seller may not care whether the transaction is structured as a stock or an asset sale. But it may make a world of difference to the buyer. A sale of all the outstanding stock of a corporate business carries with it any and all liabilities of that corporation, including potentially undisclosed liabilities for taxes, wage or discrimination claims, environmental claims, etc. A sale of business assets, on the other hand, carries with it only those liens and liabilities which have attached to those specific assets (e.g., purchase money security interests) which are easier for the buyer to discover prior to the closing. Therefore, a buyer of an operating business should strongly prefer that the transaction be structured as an asset sale, not a stock sale. Even where both the seller and buyer agree on structuring the transaction as an asset sale, the substance of the acquisition agreement may favor either the buyer or the seller and, thus, requires careful negotiation. The seller of assets of a business may believe that the only provisions of the acquisition agreement which are important are the “price” and “payment terms” provisions and all the rest is mere legal “boilerplate.” This is definitely not the case.
Other than “price” and “payment terms,” the two most important provisions of any business acquisition agreement are the “seller’s reps and warranties” and the indemnification provisions. The former are the affirmative statements of fact made by the seller to the buyer regarding the business upon which the buyer is entitled to rely in consummating the transaction.
The latter are the rules for imposing liability on the seller to the buyer after the closing for breaches of any of the reps and warranties. Generally speaking, the fewer and narrower the reps and warranties made by the seller (and the more limited the scope of the indemnification provisions) the better for the seller. Conversely, the broader and more comprehensive the seller’s reps and warranties (and the more expansive the scope of the indemnification provisions) the better for the buyer.
This is because the buyer’s primary interests are to be sure the business is worth what he’s paying for it (i.e., either a net book-value or capitalization-of-earnings analysis), the seller has and is conveying good legal title to the business, and there are no undisclosed matured or contingent liabilities.
Whether or not the buyer is able to obtain outside financing for the entire purchase price, it is generally in the buyer’s best interest to have the seller finance a portion of the purchase price so that the buyer has future payments from which he can offset amounts claimed to be due from the seller under the indemnification clause. In effect, such a structure allows the buyer to negotiate a lower ultimate purchase price if subsequent events prove that the business is not really worth what was originally agreed to be paid. Buyers and sellers of a business have diametrically opposite interests and require their own separate legal counsel from the outset. If both parties merely rely on a business broker to structure and close the transaction, both caveat emptor and caveat venditor may apply in any subsequent litigation to unwind the deal, with neither party being happy with the result.
