Protecting Business Sellers from being Sued

M. Blen Gee Jr.

Attorney

Today we have the pleasure of interviewing Mr. Blen Gee, a partner at Johnson, Hearn, Vinegar & Gee, PLLC. Today we discuss valuation, taxation, financing, franchises, and what business owners can do to protect themselves from being sued and what to do if they are sued. Valuation is very subjective.  I frequently see a broad range of values for similar businesses.  Very often a business will be valued quite low for tax purposes.  A similar business may be valued quite high in the event of a litigation.  There are “rules of thumb” for various industries.  This can give the prospective seller a ballpark idea of the value of his company.  However, a more sophisticated valuation is essential in setting the market price.

Key Points from our Conversation

  • It is important for the buyer to realize that his risk in the transaction is substantially greater than the seller’s risk.
  • No matter how attractive the deal appears, it will quickly become unattractive and increasingly expensive if the buyer does not establish early in the negotiations that he will not sign an unreasonable contract and will not take any unreasonable risks.
  • For both buyers and sellers, the lawyer should be involved long before drafting a letter of intent.
  • I think the most important thing for your readers is for them to understand that online or digital transactions can be just as binding as a paper transaction closed in a lawyer’s office.
  • The big advantage of a franchise is that it provides a business model that works.

Interview

Tina: From a legal standpoint, if a business owner is looking to sell a business, where would you suggest starting the process?  

Blen: Valuation and taxation are probably the two most important initial issues. 

Valuation is very subjective.  I frequently see a broad range of values for similar businesses.  Very often a business will be valued quite low for tax purposes.  A similar business may be valued quite high in the event of a litigation.  There are “rules of thumb” for various industries.  This can give the prospective seller a ballpark idea of the value of his company.  However, a more sophisticated valuation is essential in setting the market price. 

The seller should carefully examine the tax aspects of the sale of his business and, to the extent possible, take steps to minimize tax consequences.  Generally, the sale of the business will receive capital gains treatment, which is favorable.  However, depreciation recapture may result in ordinary income tax treatment for a portion of the sales proceeds.  A difficult tax issue is the treatment of a closely held business that is a C corporation.  Double taxation, at the corporate level and again at the shareholder level, is a major issue for a C corporation.

If the consent of a third party is required, such as a landlord or a franchisor, the sale should be discussed with the third party early in the process.  Also, consent to the assignment of a license, franchise agreement, or other contract may be required. It is important for minority owners to be on board as well.   Depending on state law and agreements that may have been signed, the consent of minority owners may be essential.  Even if consent is not technically required, the opposition by a minority owner could scuttle the deal or adversely affect the sales price.

 

Tina: What about for someone buying a business?

Blen: Financing, tax issues, including the form of business entity that will acquire the business, and a good understanding of the cost of a business of the size and nature of the business he is looking at are important.

However, the most important thing is to identify a good business law firm that can handle the contemplated purchase.  Occasionally the specialized expertise may be helpful, such as the purchase of a motor vehicle dealership.  Also, if there is a franchise involved, a legal analysis of the franchise agreement and the franchise disclosure document are essential.

 

Tina: Does your answer change if that business owner is looking to buy or sell a franchise?

Blen: Franchising is fraught with risks for both the seller of a franchised business and the buyer.  Some states have protective legislation for franchisees; most do not.   Having an attorney familiar with franchising is very important, especially from the buyer’s point of view. 

 

Tina: What are the most common legal mistakes buyers and sellers of businesses make and what advice can you offer to help them avoid these pitfalls?

Blen: Seller – owner financing.  Banks are in the business of making loans, evaluating the credit worthiness of the borrower, obtaining adequate collateral, obtaining personal guarantees, and going to court to enforce their rights.  Even then, banks occasionally incur substantial losses.  The seller is not a bank and should not try to act like one.  If a bank occasionally has a substantial loss as a result of a default, this is simply a cost of doing business.  If a seller incurs a substantial loss because of the buyer’s default, he may lose the value of his life’s work.  Worse, the seller may end up in bankruptcy himself.  Sellers should not pretend to be banks.

The seller is not a bank and should not try to act like one.

Buyer – the “my way or the highway” seller (or seller’s attorney).  Occasionally a buyer will be confronted with a seller who insists on having everything his way.  Sometimes you see seller’s attorneys that also take this position.  And, on rare occasions, you run in to an obstinate seller who is represented by an equally obstinate attorney.  The buyer’s risk here is that he will spend a great deal of time and money investigating the business opportunity and his lawyer will spend a great deal of time and attorneys’ fees preparing documents that protect the buyer.  Also, sometimes the seller will ask for a nonrefundable deposit.  After having invested a fair amount of time and money in the transaction, the buyer then finds that he is confronted with a host of unreasonable demands and conditions.

It is important for the buyer to realize that his risk in the transaction is substantially greater than the seller’s risk.  The seller’s two main goals are to make as few representations and warranties as possible and to get paid.  The buyer’s risks are always much greater; a lengthy law review article could be written (and many have been) summarizing a buyer’s risks in any acquisition.

The most important thing to do when confronted with a “my way or the highway” attitude is, early in the negotiations, to say “no,” and mean it; be willing to walk away from the deal if necessary!  No matter how attractive the deal appears, it will quickly become unattractive and increasingly expensive if the buyer does not establish early in the negotiations that he will not sign an unreasonable contract and will not take any unreasonable risks.

 

Tina: What advice do you have for business owners if they get sued?  

Blen: Number one, avoid being sued.  Business litigation is expensive and inherently uncertain, no matter how good you think your position is.  Even if you are insured for the full potential loss, a litigation is a huge distraction.  Settle disputes if you can. 

It is important that company management receive the lawsuit promptly.   Business entities are required to maintain a registered office where they can receive service of a lawsuit.  Occasionally, a business will fail to update the address of its registered office.  If this happens, a default judgment could be entered against your company. 

Employees should be carefully trained to make sure that any official-looking document is promptly delivered to a management level person in your organization.  Obviously, anything delivered by a deputy sheriff, a process server, or certified mail deserves immediate attention.  However, in the federal system and in some states, deliveries by FedEx and similar couriers constitute valid service of process.  Important bankruptcy notices with a limited response time will come by regular United States Mail.  If any of these is left to sit on the corner of someone’s desk, valuable rights may be lost. 

The time for filing a response varies from jurisdiction to jurisdiction and also varies depending whether the claim is filed in federal court, state court, in an arbitration, or before some administrative agency.  

Once you have received the lawsuit or other legal proceeding, get it in the hands of a competent litigation attorney as soon as possible.  If your corporate attorney’s firm does not do litigation, ask for a recommendation.

If you believe the claim is covered by insurance, report the claim promptly in the manner required by your insurance policy.  Recruit your insurance broker to assist you.  Occasionally there may be unusual reporting requirements.  If you do not think that the claim is covered by insurance, check with your broker anyway.  Sometimes, a business dispute may have a claim for “negligence” buried in all the other claims or there may be other obscure grounds for coverage.

Another extremely important area in the 21st century is the preservation of digital evidence once you have notice that suit has been filed or may be filed.  You need a good IT person and a good litigation attorney to guide you in this process, which can be extremely complex and ever changing.  Delete nothing; backup everything; do not throw away obsolete equipment that may contain data; make sure that systems which normally automatically delete data are set to preserve the data.  Courts can impose stiff sanctions for failure to preserve such evidence.

 

Tina: What precautions can a business owner take to avoid being sued?

Blen: Wow, this is a tough one!  I tell clients that “Doing things right” is their first defense.    Following best practices in their particular industry is essential.  Maintaining good relations with their customers and the business people that they deal with is also extremely important.  Also, communicate, communicate, communicate and document, document, the document!

 

Tina: What kinds of advice do you give to business owners to lessen the likelihood of litigation? 

Blen: The biggest problem I see is that parties fail to put their agreement in writing.  The second biggest problem is the business owner that either didn’t read or didn’t understand the contract he signed.  We are all guilty of these two failings, both in our business affairs and personal matters, especially in the digital age when a single click of your mouse may bind you to an important contract.  Put it in writing; read it; do not sign it (or click the mouse) unless you understand it.

For a business owner, having a good business lawyer draw up a few standard contracts that can be tailored to his particular business can be extremely helpful.  A standard employment agreement and an employee handbook are extremely valuable.  If the customer contract can be reduced to a single standard form, that will also be extremely helpful. 

The biggest problem I see is that parties fail to put their agreement in writing.

Tina: Most business owners do not have dedicated legal counsel. At what point does a business (including franchisees) need to consider having in house counsel? What are the benefits of having in house counsel versus hiring an attorney on an as needed basis? 

Blen: This is a little out of my area but I would imagine the decision is primarily “cost driven.”  Hourly rates add up in a hurry.  A large organization that has offices and support staff can bring a good lawyer in house at a substantial cost savings if there is the need for a full-time attorney in a few relatively narrow areas such as drafting and review of contracts.  The in-house attorney can also identify competent legal counsel for special-purpose transactions and litigation. 

 

Tina: At what point do you recommend hiring an attorney and what role do they play in the process of selling a business? What about if the business is a franchise?

Blen: I think the advice for both the buyer and the seller would be the same.  You should get a lawyer and a CPA involved fairly early.  Negotiating price and terms involve tax and legal issues.  For both buyers and sellers, the lawyer should be involved long before drafting a letter of intent.  The practical problem is that, once you have agreed to something in principle, it becomes very disruptive to negotiations if you have to change your position because some tax or legal issue has arisen.  I have had clients present me with ghastly home-made letters of intent.  Even though the letter of intent may be “nonbinding,” trying to negotiate major changes at that stage may kill the deal. 

 

Tina: From the seller’s point of view, when the seller begins thinking seriously about selling his business, he should touch base with his CPA and his attorney to begin planning.

Blen: From the buyer’s point of view, the CPA and the lawyer should be consulted before any sort of offer is made.  The buyer can solicit a price from the seller but should not go beyond that without at least talking it over with his CPA and touching base with his attorney.

 

Tina: Can a business owner hire a lawyer to just handle certain parts of buying or selling a business or franchise? How would this help or hinder the business owner?

Blen: People do it and frequently get away with it.  I would decline to represent anyone on that basis, myself. I have been involved in at least one transaction where the corporate buyer was unrepresented.  The documentation from the buyer’s point of view was very sloppy.  However my client, the seller, got its money so we were happy.  

 

Tina: What advice do you give to entrepreneurs who want to use standardized legal forms or contracts to save on attorney’s fees? 

Blen: Some are good; some are bad.  However, you need a good lawyer to tell you which ones are good and which ones are bad.  There are a few standard forms that are quite good.  The North Carolina Association of Realtors has prepared some very good forms.  I think these forms are fine to be used by experienced real estate brokers and leasing agents. 

On a related issue, there are services that help you form business entities.  The ones that I have seen do not do anything that could not be done by a good paralegal.  Choice of which business entity to set up – corporation, LLC, etc., is primarily tax driven and your CPA or tax attorney is your best guide.  Understanding what a corporation or other business entity is and how to manage it so that you have full legal protection is an important legal issue.  If there is more than one owner, the roles of the various owners and what happens in the event of disputes, death, etc. are critical legal issues that should be discussed with a lawyer and an appropriate agreement among the owners should be prepared.

I think the advice for both the buyer and the seller would be the same.  You should get a lawyer and a CPA involved fairly early.

Tina: Technology is always changing the face of the law. What have been the legal implications of using the internet to conduct business transactions, such as buying or selling businesses?

Blen: I think the most important thing for your readers is for them to understand that online or digital transactions can be just as binding as a paper transaction closed in a lawyer’s office.  Online transactions should be treated with the same level of seriousness and caution as any other transaction.  Also, online transactions should not be delegated to lower-level employees.  I can think of at least one transaction where a lower-level employee executed a personal guarantee in the name of the company president without the president’s knowledge!

 

Also, it has become increasingly common for online transactions to require “arbitration” in some other state.  These are also binding.  Typically, you give up the right to bring a class action when you have become bound by these online contracts.  At least one popular news website states that you agree to be bound by that company’s terms and conditions, which includes an arbitration clause, simply by continuing to stay on the website.  It is all a little bit scary to me.

 

Tina: What was the toughest problem regarding buying or selling a business that you have handled recently? Please provide an example if possible and how you represented your client.

See the “my way or the highway” comment above.   Also, failing to get the lawyer involved before the letter of intent is signed.  Protracted, tough negotiations and a number of continuing post-closing problems.  

 

Tina: With a market that fluctuates, how does an entrepreneur know when it is the right time to buy or sell a business?

Blen: Every situation is unique.  However, the biggest problem I see in hard times is the business owner who has excessive debt.  So, the prospective buyer needs to be sure he will have the working capital to weather financial storms.  The seller should be leery of owner financing.

 

Tina: What about buying a franchise in a fluctuating market? 

Blen: The big advantage of a franchise is that it provides a business model that works.  As noted above, there are a lot of risks associated with buying a franchise.  In times of greater economic risk, the safer course is only investing in well-established franchise systems that are performing well and growing.  Startup franchises and franchise systems that are in decline pose substantially greater risk.

 

Tina: With the shifting economy, has your strategy in helping a client buy or sell a business shifted in any way? How has your advice changed?

Blen: The legal issues are basically the same but the risks are higher.  For the business person, a shifting economy offers both opportunity and risk.  The lawyer’s job is to keep the risk as low as possible. 

In times of greater economic risk, the safer course is only investing in well-established franchise systems that are performing well and growing.

Tina: How can an attorney and business broker work together as a team to ensure a successful transaction? 

Blen: I view the broker as the principal facilitator for bringing the deal together and keeping both the buyer and the seller on track. 

 

Tina: Do you have any other tips of advice for anyone buying, selling or appraising a business?

Blen: The typical closely held business has a shareholder agreement, operating agreement, partnership agreement, or similar agreement governing the rights and responsibilities of the owners.  A very important issue for these agreements is the purchase of an owner’s interest in the event of death, retirement, or other withdrawal.  Litigating valuation in a buy-out dispute can be a nightmare.  I think a well drafted clause setting forth the mechanics for obtaining an appraisal of a deceased or withdrawing owner’s interest is one of the most important provisions of an agreement among owners of a closely held business.