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The Legal Process of Selling a Business

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Author, Insider 94 staff

With so much to consider when selling a business, it is important to understand the legal process that is involved. There are four main areas that comprise the legal side of the deal: structuring the deal, due diligence, warranties/indemnities/disclosures, and documents. Exploring each of these can serve as a guide to business owners preparing to sell their company, giving an idea of what to expect and be ready ahead of time.

Structuring the Deal

DETERMINE THE TYPE OF SALE

The first step in selling your business is deciding what type of sale it will be. There are two ways you can sell it, a share sale or an asset sale.

  • In a share (or equity/stock) sale, the sellers are the shareholders of the company, and they will sell their shares in the company to the buyer.
  • In an asset sale, the seller is the company, and the assets of the company, which comprise the business and operating assets, are sold to the buyer.  Owners may need to restructure the business prior to selling to allow it to be acquired in the most suitable way.

TAX IMPLICATIONS

Tax implications often drive the structure of a deal. This is a highly complex area that is dependent on the unique circumstances of the business and involved parties. Working with a tax specialist is a must. Together, you can consider what might be the best tax scenario to help determine the type of sale.

ASSETS AND LIABILITIES

  • For a share sale, the buyer acquires the company with all assets, liabilities, and obligations (unless otherwise agreed upon with warranties or indemnities), offering sellers a clean break as after the sale.
  • For an asset sale, only the assets needed to conduct business operations (operating assets) are included (unless a buy agrees to take on certain liabilities that are explicitly identified). Many buyers prefer an asset sale because there is less risk, unlike an equity sale where the buyer assumes all known and unknown liabilities from the beginning of the company’s existence.

CONSENTS AND CONTINUITY

  • For a share sale, only the ownership of the shares in the company is transferred, its assets (including its business contracts, agreements, and licenses) remain with the company. Customers and suppliers will usually continue dealing with the company as before. Certain contracts may need the other party’s consent with a change of ownership, and they should be identified ahead of the sale.
  • For an asset sale, the assets and contracts of the business being sold will be transferred to the buyer and the consent of customers, suppliers, landlords, licensors, and others will possibly be required. Contracts, agreements, land, property, and certain intellectual property rights will all need to be formally transferred to the new owner. There may be some disruption to the business and the buyer may need to build confidence with the customers and suppliers to maintain relationships.

EMPLOYEES AND PENSIONS

• For a share, sale there is no change of employer, and the employees remain employed by the company.

• For an asset sale, The new owner becomes the employer, and the employees will transfer to the new employer under their current terms of employment (including certain pensions rights). Buyers and sellers should both be aware of specific obligations to inform employees about their plans and may need to consult with employees prior to completion of the sale. Please note, specialist employment and pensions advice should be obtained for guidance with pensions implications. This is a complex area with potential liabilities and obligations that must be addressed with professional help.

Due Diligence

WHAT IS DUE DILIGENCE?

Due diligence is a thorough appraisal process of the condition of the company or business being acquired. The collection and assessment of information is completed by the buyer’s advisers with assistance from relevant people from within its own organization.

The information obtained helps the buyer with the following:

  • Evaluate potential weaknesses
  • Decide whether to proceed with the purchase
  • Establish pricing and understand their bargaining position
  • Identify liabilities and  risk areas that can affect how the deal is structured
  • Identify areas where warranties and indemnities protection might be needed
  • Identify any third party consents (landlords, customers, suppliers, etc.)
  • Identify areas that may need attention or action following the acquisition (streamlining operations, updating technology, etc.)

LEGAL DUE DILIGENCE

Legal due diligence can be an arduous process, particularly for sellers who will need to invest significant time and resources responding to the buyer’s requests. It is started early on in negotiations, but often continues into the deal process, overlapping with the disclosure process.

Typically, the buyer’s attorney will send an information request to the seller or their lawyer. This request may include everything from the company’s make-up to its employees, contracts, licenses, property, financing arrangements, intellectual property rights and IT systems.

The seller and their team gather the information requested and make it available to the buyer’s lawyers. The buyer’s lawyers will evaluate the information and provide a due diligence report highlighting issues of concern with protective measures, if necessary, for the buyer.

FINANCIAL DUE DILIGENCE

The buyer’s accountants will analyze the financial books of the seller’s company and confer with its accountants and management. The buyer’s tax accountants will review the tax history and identify any issues.

COMMERCIAL AND OTHER DUE DILIGENCE

During legal and/or financial due diligence, issues of a commercial or strategic nature may be discovered. In some cases, a consultancy could be hired to conduct a more precise examination of the business being acquired. This can include assessing its market standing, exceptional features, and prospective market openings in relation to the buyer’s plans. Other reports may also be required as part of the wider due diligence process, for example, property surveys, environmental audits, health and safety investigations or statistical valuations.

Warranties, Indemnities, and Disclosure

WHAT ARE WARRANTIES?

Warranties are assurances about the company, from the seller, that protect the buyer against liabilities which may exist in the business. The seller is typically required to give many warranties covering all aspects of the business. If any of these assurances are untrue, resulting in the value of the company being less than what the buyer paid for it, the seller may be liable to pay damages under a breach of warranty claim. The sale and purchase agreement will contain a schedule of warranties . This is often one of the most negotiated documents because the buyer wants to ensure that the warranties are as wide as possible for liability protection and the seller wants to limit their scope.

WHAT IS DISCLOSURE?

Warranty claims are rarely brought before the courts because great effort is put into the disclosure process to ensure that the buyer is fully informed, and disputes are avoided. If a major issue is identified through disclosures, it will generally be dealt with through a price adjustment or an indemnity in the sale and purchase agreement.

• For the seller, warranties encourage them to provide further information about the company, which is over and above what is extracted during the due diligence process. To address the risk of a potential warranty claim, the seller creates a disclosure letter for the buyer that qualifies the warranties with factual information. This can also prevent the seller from being sued for breach of warranty.

• For the buyer, more comfort is created because the seller wants to ensure they have provided all relevant information n order to avoid any claims for breach of warranty.

WHAT IS AN INDEMNITY?

In addition to the schedule of warranties, sellers may be required to give certain indemnities (promises to reimburse) to the buyer. Indemnities are more specific than warranties and they are used to protect the buyer against specific risks or known liabilities. The primary distinction is the basis of any claim by the buyer for a breach.

  • Breach of warranty: If the company acquired is worth less than the buyer paid for it because the warranty was untrue damages on a warranty claim would be paid to the buyer.
  • Breach of indemnity: Where an indemnity has been initiated, sellers are required to reimburse the buyer for the specific liability regardless of whether it has affected the value of the company.

Documents

Depending on the deal structure and other factors, these are the common legal documents for the sale of a business.

  • Asset Purchase Agreement (or Business Purchase Agreement): This is the primary agreement used in the sale of a business and outlines the terms and conditions for the sale of the business’s assets. It includes information such as the purchase price, what assets are being sold, the liabilities the buyer is assuming, the timeline of the transaction, and any conditions or warranties the parties agree to.
  • Bill of Sale: This document is used to transfer ownership of certain assets in the sale of the business. The Bill of Sale is generally attached to the Asset Purchase Agreement and specifies what assets are being transferred, when they are being transferred, and the terms of the transfer. Non-Compete Agreement: This agreement is used to prevent the seller from competing with the business they sold. The Non-Compete Agreement typically lasts a certain period of time and outlines what the seller is and is not allowed to do during the designated period.
  • Non-disclosure Agreement: A business non-disclosure agreement, or “NDA”, is a contract between the buyer and seller of a business that describes confidential material the seller wishes to restrict access to.
  • Lease Assignment Agreement: If the business being sold owns or leases any property, an Assignment Agreement will be necessary to transfer ownership or the lease of the property. The Assignment Agreement includes information such as the lease terms, the term of the assignment, and any conditions or warranties the parties agree to.
  • Employment Agreement: If the buyer is taking over some or all the company’s employees, the buyer may need to enter into Employment Agreements to hire them. The Employment Agreement outlines the wages, hours, benefits, duties, and other information regarding the employees’ employment. Assumption Agreement: An assumption agreement, sometimes called an assignment and assumption agreement, is a legal document that allows one party to transfer rights and/ or obligations to another party. It allows one party to “assume” the rights and responsibilities of the other party.
  • Disclosure Statement: Typically, disclosure schedules contain information about the company’s debts, stockholders, contractual obligations, intellectual property, and other critical facts about the business or its assets.
  • Employee Contract Assignment: Contract assignment refers to the substitution of one party for a new party, with the new party assuming all the duties under the contract.
    Tax Clearance Certificate: A document provided by the state indicating that the Business does not have any overdue taxes or, if taxes are owed, indicating the amount that the business is required to pay.

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