The Lean Startup by Eric Ries (Crown Business, 2011) and Running Lean by Ash Maurya (O’Reilly Media, 2012) These books teach you the “lean” system in business strategy as opposed to the outdated waterfall method of business planning in which each stage of the process has to be completed before moving on to the next stage. Being lean and agile in business can help you quickly accomplish many goals and speed up the process of the steps involved.

Work the System by Sam Carpenter (Greenleaf Book Group Press, Revised 3rd edition, 2019) This is a book that walks you through, step-by-step, how to document your business and prepare an operations manual for your company. This is a great resource if you have never automated, documented, and delegated processes in your business.

The E-Myth by Michael E. Gerber (Ballinger Publishing, 1988) This is a classic book that all entrepreneurs should read and many franchisors recommend. The essence of the book is that entrepreneurs spend too much time working in their business and too little time working on their business.

Getting to Yes: Negotiating Agreement Without Giving In by Roger Fisher and William Ury (Penguin Books, 4th Edition, 2012) This book offers step-by-step guidance for negotiating agreements in any situation. Based on work by the Harvard Negotiation Project, this book discusses the many pitfalls that can be avoided by implementing sound communication skills, such as listening and clearly communicating your points. 

Scaling Up by Verne Harnish (Gazelles, Inc., 2014) This popular book, a sequel to Mastering the Rockefeller Habits, teaches you the four essential processes any small business needs to install before they begin scaling their business. This book is a collection of skills, tools, and processes but installing these tools is easiest if you have a management team to help you. Implementing all the suggestions contained in this book may take you from 6 to 12 months.

Duct Tape Marketing by John Jantsch (Nelson Business, 2007) This book will help most small business owners create scalable marketing processes. Yes, you need scalable, repeatable marketing processes in your business. These are practical, easy-to-implement suggestions. Like all the suggestions contained here, though, implementing these processes entails a lot of time and help from your core management team.

Focal Point by Brian Tracy (Amazon, 2001) This book assists you in establishing a laser-like focus on critical goals in your life. Focus is paramount to entrepreneurs. Most entrepreneurs suffer from an overabundance of ideas rather than a dearth of ideas. In other words, they have a “lack of focus.”

Getting Things Done by David Allen (Penguin Books, 2015) The GTD system is widely known as the most effective time management system in business. David Allen’s book, in my opinion, is the best book available on time management. David teaches specific techniques you can implement in your life to improve your time management.

Your Brain at Work by David Rock (Harper Collins, 2020) I always say that energy management is more important than time management. This is the case once you possess rudimentary time management skills, such as daily planning, prioritizing, and delegating. I always run out of energy before I run out of time – you’re likely the same. Your Brain at Work recognizes that energy is a limited resource, and it teaches you how to strategically use this scarce resource. You should treat energy like any other limited resource, such as time or money. Did you know that multitasking can turn a Harvard MBA into the mental equivalent of an eight-year-old? Yet, we all do this all the time. This book offers practical insights on how to earn the highest ROI on your energy investment.

How to Hire A-Players by Eric Herrenkohl (Wiley, 2010) Management starts with hiring the right people. Sourcing and interviewing are skills that can be learned. This book teaches you a step-by-step process for hiring superstars. It takes a lot of practice, and hiring is simpler if you have a management team to assist you in establishing the right systems for attracting the talent you need.

Carrots and Sticks Don’t Work by Paul L. Marciano (McGraw Hill, 2010) Most small-business owners with fewer than 50 to 100 employees manage their employees using the carrot-and-stick method, which uses rewards and punishment as tools to motivate. Unfortunately, this method produces poor results in any industry in which engagement is important. This book teaches you 5 to 10 management techniques you can use to develop an engaged long-term workforce. 

These are the typical duties of the escrow holder in a transaction: 

• Collecting and disbursing closing funds according to escrow instructions.
• Distributing final transaction documents to all parties.
• Drafting escrow instructions according to the terms and conditions of the purchase agreement.
• Filing and recording all necessary documents with the appropriate authorities.
• Filing UCC-1 Financing Statement with the secretary of state when seller financing is involved.
• Holding earnest money in a safe, secure escrow account pending the closing.
• Ensuring that secured creditors are satisfied and coordinating any necessary payoffs.
• Notifying and obtaining clearances from county, state, and federal agencies as required.
• Notifying the county tax collector.
• Obtaining a copy of all real estate leases and coordinating and confirming the lease assignments with the landlord.
• Obtaining a corporate status report of all entities involved in the transaction from the secretary of state, and confirming that the entities exist and are in good standing.
• Obtaining written evidence of the proper authority for an entity to sign the purchase agreement and related documents to consummate the transaction.
• Overseeing UCC-3 terminations, amendments, and releases of liens. 
• Performing a UCC-1 lien and business personal property tax search on the business to ensure a clear title can be conveyed.
• Preparing estimated closing statements prior to the closing of escrow.
• Preparing fictitious business name statements.
• Preparing final closing statements for the parties and accounting for the disposition of all funds deposited in escrow.
• Preparing separate buyer’s and seller’s settlement statements reflecting that all funds are being handled through escrow.
• Prorating and paying the rent, deposits, taxes, and other expenses required out of the sales proceeds.
• Prorating taxes, interest, rents, and security deposits, among others, as instructed.
• Requesting demands from existing lienholders and receiving claims.
• Requesting publication, recording, and UCC lien searches for state and county.
• Securing releases of all contingencies or other conditions imposed on the particular escrow.
• Securing tax clearances.

Supporting documents are attached to the purchase agreement as schedules or exhibits and include the following:

• Allocation of the Purchase Price: This document breaks down the purchase price into separate asset classes for IRS purposes. The tax implications for asset and stock sales can be substantially different and vary based on how the purchase price is allocated among the assets. 
• Assignment of Contracts: This document transfers third-party contracts from the seller to the buyer upon closing. These include advertising, equipment leases, lease agreements, and other third-party agreements. 
• Assignment of Intellectual Property: This exhibit transfers any registered intellectual property from the seller to the buyer, such as patents, trademarks, or other intellectual property. It can also transfer non-registered intellectual property, such as phone numbers, websites, and content.
• Assignment of Shares (for a stock sale): This document transfers shares of the entity and is used for stock sales only.
• Bill of Sale (for an asset sale): This is the actual document that transfers possession of the assets at the closing in the case of an asset sale. The bill of sale should list all tangible and intangible assets included in the sale. I do not recommend stating values for each asset. Some advisors list intangible assets separately and transfer them using a separate set of exhibits. Titled assets such as vehicles and real estate must be transferred separately.
• Buyer’s Disclosure Statement: This further reduces your liability post-closing for any disclosures the buyer may not have made. This is replaced by a more thorough set of representations and warranties for larger transactions.
• Closing Adjustments and Prorations: For smaller transactions, multiple adjustments and prorations must often be made (lease payment(s), utilities, personal property taxes, accounts receivable, etc.) at the closing to account for timing differences between when bills are paid and when a change of possession occurs. 
• Consulting, Employment, or Independent Contractor Agreements: The independent contractor agreement is necessary if the seller is to continue working for the buyer in some capacity, although it can also take the form of a consulting or employment agreement.
• Corporate Resolution: A corporate resolution is required in an asset sale if the seller is an entity and is selling a majority of the assets of the company. Technically, the seller in an asset sale is the entity (corporation or LLC), and a corporate resolution is typically required in the corporate bylaws for taking major actions, such as selling all assets of the company. This resolution is not required if the seller is selling the entity, such as in a stock sale.
• Deed of Sale of Entity (if selling the entity or stock): This document is required if the seller is selling the shares in the entity.
• Lease Assignment: The assignment of the lease transfers the lease for the premises. The seller usually remains as a guarantor for the lease until the lease expires. This document must be signed by the landlord; however, it is not necessary if a new lease is created.
• List of Assets: This is a detailed list of all tangible and intangible assets included in the sale. Although it isn’t necessary for stock sales, it’s wise to be clear on which assets are owned by the corporation or LLC and are included in the price, and which assets may be personal and are not included in the price. Doing so can help prevent litigation regarding which assets were included in the sale.
• List of Titled Property: This includes a list of titled property, such as real estate or vehicles included in the sale. Titled assets require a separate set of transfer procedures.
• Non-Competition Agreement: The non-competition agreement contains a description of what the seller may and may not do, and specifies the length of time the agreement stands. Almost all sales include a non-compete agreement. Sometimes, this agreement is included as a clause in the purchase agreement, and sometimes, it’s listed as an exhibit. The non-compete agreement should be voided if the buyer defaults on payments to the seller.
• Promissory Note: An agreement used if the seller is financing a portion of the sale in which the buyer (the note issuer) promises to pay the seller (the note’s payee) the sum and interest specified in the note.
• Release of Holdback: Savvy buyers will request that a percentage of the purchase price be held in escrow until the training period is complete. In some middle-market transactions, this amount can be held in escrow for up to 6 to 24 months to cover any additional unknown variables, such as customer warranty claims, gift certificates, and others. This typically varies from 5% to 20% of the purchase price.
• Security Agreement: A document that provides the seller a security interest in the assets of the business, which are pledged as collateral until the seller note is paid in full. The security agreement accompanies the promissory note. 
• Seller’s Disclosure Statement: A written statement made by the seller regarding any material adverse conditions of the business that the buyer should be aware of to prevent potential litigation. The seller’s disclosure statement is replaced by representations and warranties in larger transactions.
• Share Pledge Agreement (if the seller is financing the stock sale): A document that provides the seller a security interest in the shares of the entity until the seller note is paid in full. A share pledge agreement is used in stock sales in lieu of a security agreement in an asset sale.
• Training Agreement and Log: This document spells out the seller’s agreement to train the buyer. Logging the completion of the training period is also a good practice to prevent potential future litigation. Having the buyer sign off on the training when it’s complete can prevent future legal disputes. If you fail to do this, the buyer could refuse to make payments later, offsetting the note by claiming you failed to train them properly.
• Uniform Commercial Code (UCC) Financing Statement: This is a form that the seller files with the local or state governmental authority that allows the seller to give notice to the public that they have a security interest in the property listed in the filing (i.e., the assets of the business) until the note is paid in full. A UCC-1 is used to record the lien. A UCC-3 is filed to record a change of information in the original filing. Most UCC liens must be renewed periodically every few years to remain valid.

Important: The list above is in no way complete. It simply represents the typical documents and steps required to close. Only an experienced professional should handle your closing. The list above is provided for illustrative purposes only.

These are typical clauses in a purchase agreement:

Definitions: Any well-written purchase agreement contains definitions of the key terms used throughout the document. 

Purchase Price and Financing: This defines the amount of the purchase price and how it’s paid. The consideration is typically broken down by the following: 

• Earnest money deposit
• Down payment
• Additional funds to be deposited with escrow upon conclusion of due diligence
• Amount of seller financing
• Third-party financing
• Holdback amount

Exclusivity: This area details whether the parties are negotiating exclusively with one another. “No-shop” or “go-shop” clauses may be included in this section.

Inventory: This section contains a description of the inventory included in the sale and identifies who will count the inventory – the buyer, the seller, or an inventory valuation service. It also provides adjustments to the purchase price based on the difference in inventory between signing and closing, as well as a representation regarding the condition and salability of the inventory.

Working Capital: This section describes how working capital will be defined and the procedure for calculating working capital. The purchase price normally includes a set amount of working capital at closing, and then an adjustment is made three to six months after the closing if the working capital was different than the amount included in the purchase price.

Contingencies (Conditions): The purchase agreement contains contingencies if it’s signed before closing. Buyer contingencies can relate to obtaining financing, a license, or franchisor approval, and transferring a lease. If the seller is offering financing, the agreement may also be contingent on the seller approving the buyer’s credit and financial position.

Earnest Money Deposit: The agreement outlines who holds the earnest money deposit, whether it is refundable or non-refundable, and the conditions if the deposit is refundable.

Closing Costs and Prorations: This area of the agreement explains who will pay which closing costs. Many closing costs are split equally between the buyer and the seller, with each party paying their own advisors.

Training and Transition Period: This section outlines in detail the length and form of the training agreement in detail. Being highly specific regarding the length of the training agreement, including how many hours and on what terms, is good practice. Not doing so can lead to post-sale disagreements, and buyers sometimes sue sellers for failure to train them properly.

Representations and Warranties: The seller’s representations are often more thorough than the buyer’s representations. Representations and warranties, called reps and warranties for short, are heavily negotiated in larger transactions and used by many buyers to flush out potential problems. Examples of the seller’s representations include:

• All assets are in good repair.
• All taxes will be paid at the closing.
• Seller has the legal capacity to sign the agreement.
• Seller has complied with all laws. 

Confidentiality: This clause is sometimes included even though a separate confidentiality agreement may have been previously signed.

Default and Remedies: This area includes conditions for canceling the agreement and penalties for defaulting.

Miscellaneous Legal Provisions Common to All Legal Agreements: This section can include attorney fees, mediation, indemnification, severability, governing law, risk of loss, and other provisions that generally apply to all legal agreements.

This is a sample due diligence checklist:

Assets

• Description of any real estate owned
• Recent equipment inspections
• Equipment leases
• Equipment list 
• List of all assets included in price
• List of all titled assets
• Inventory list

Financial/Tax

• Accounts payable schedule
• Accounts receivable aging schedule
• Annual personal property tax certificate
• Backup data of adjustments to financials
• Bank statements
• Breakdown of sales by customer
• Breakdown of sales by product type
• Copies of existing loan or financing agreements
• Customer or client agreements
• Documentation for add-backs to financial statements
• Federal income tax returns
• Financial budgets and projections
• Full accounting software file
• General ledger or detailed list of all transactions and expenses
• List of monthly sales since inception
• Merchant account statements
• Payroll tax reports
• Profit and loss statements
• Sales and use tax reports
• Utility bills

Insurance

• Health insurance policies
• Liability insurance policies
• Workers’ compensation policies and history

Legal

• Articles of incorporation/organization
• Business license
• Certificate of status/good standing from the secretary of state
• Copies of all licenses, permits, certificates, and registrations
• Copies of all key contracts
• Corporate/LLC by-laws or operating agreements
• Corporate/LLC minutes
• Description of environmental liabilities
• Fictitious business name statement (FBNS/DBA)
• Financing agreements
• Information for copyrights
• Information for patents
• Information for trademarks and service marks
• List of liens against the business
• Other third-party agreements or contracts
• Pending lawsuits
• Phase 1 and 2 environmental studies
• Preliminary UCC search results
• Previous purchase agreement and related business documents
• Resale permit
• Seller’s disclosure statement

Operations

• Advertising contracts
• Customer list
• Inventory count
• List of key competitors
• Marketing material
• Operations manual
• Preliminary equipment inspection 
• Premises lease
• Summary of key lease terms
• Supplier and vendor list
• Supplier and vendor contracts

Staff

• Benefit plans
• Compensation arrangements
• Detailed schedule of payroll expenses
• Employment, agency, and independent contractor agreements
• Job descriptions
• List of outside contractors
• Other employment-related agreements
• Overview of personnel turnover
• Schedule of owners, officers, employees, independent contractors, consultants, and their titles, length of service, and compensation benefits
• Summary biographies of key management

Accrual Basis: One of two primary accounting methods which recognizes income and expenses based on when they are “accrued” or when they actually occur. 

Add-Backs: An adjustment made to the income or expenses in a financial statement when calculating the cash flow of a business (i.e., SDE or EBITDA).

Add-On-Acquisition: The purchase or acquisition of a smaller company which is added on to a larger platform company by a corporate buyer to complement the acquirer’s business model.

Allocation of Purchase Price: The allocation of the purchase price of a business, for tax purposes, among various classes of assets which are defined by the Internal Revenue Service, such as inventory, goodwill, land, or buildings.

Asset Deal: One of three ways to structure an acquisition for legal purposes in which the buyer purchases the individual assets of the seller, as opposed to purchasing the seller’s stock or merging with the seller.

Basket: The minimum dollar threshold amount that must be met before a seller becomes liable for the buyer’s losses caused by the seller’s breach of representations and warranties. A basket functions similarly to an insurance deductible in which the seller is not liable for breaches until the threshold amount, or deductible, is exceeded.

Bill of Sale: The document with which ownership of the assets of a business are transferred from seller to buyer – if the sale is structured as an asset sale.

C Corporation: A corporation that has been elected to be taxed as an entity separate from its shareholders in accordance with Subchapter C of the Internal Revenue Code and may therefore be subject to double taxation if the sale is structured as an asset sale.

Capital Expenditures (CapEx): An investment made in the fixed or capital assets of a company that is expected to have a useful life longer than one year or that is not intended for resale. Examples of capital expenditures include software, office equipment, buildings, land, factories, and equipment. Capital assets are usually depreciated as opposed to being expensed. Inventory is not a capital asset.

Capitalization Rate (Cap Rate): The rate of return, expressed as a percentage, that is expected to be generated. The cap rate is calculated by dividing the income of the business by its purchase price. The cap rate is the inverse of the multiple. If the cap rate is 20%, the multiple is 5.0.

Cash Basis: One of two primary accounting methods which reports income when received and expenses when paid out.

Cash Flow: The amount of cash generated in a business after all expenses, inflows, and outflows of cash. This term is also loosely used to refer to EBITDA or other measures of cash flow. You should always ask for a definition if this term is used.

Confidential Information Memorandum (CIM): A document compiled by a business broker, M&A advisor, or investment banker that describes a company as a potential acquisition target and is used to generate interest in a company from prospective buyers. A typical CIM is 20- to 40-pages long and is only released to pre-screened buyers after they have signed a non-disclosure agreement.

Depreciation: An annual tax deduction that allows for the loss of value of a tangible capital asset, such as a business vehicle or real estate improvement, due to a decline in value over a period of years. Assets can either be expensed (written off in one year), depreciated (written off over a number of years), or amortized (for intangible assets).

Double Taxation: The taxation of income twice on the earnings of a C Corporation. Income is first taxed at the corporate (entity) level and then taxed again at the individual level when dividends are paid to shareholders. Double taxation is a concern when the owner of a C Corporation sells their business and structures the sale as an asset sale. The solution to avoid double taxation is to structure the sale as a stock sale or merger.

Due Diligence: The buyer’s thorough verification and investigation of a business after the seller accepts a letter of intent to determine if both parties wish to proceed with the transaction. Most due diligence periods range from 30 to 90 days, and some may be indefinite as long as the parties continue to negotiate in good faith.

Earnings Before Interest, Taxes, Depreciation, and Amortization (EBITDA): The most popular measurement of the cash flow of a middle-market company which includes earnings before interest, taxes, depreciation, and amortization.

Earnout: An agreement whereby the buyer pays part of the purchase price to the seller based on the future performance of the company or the fulfillment of some other specified event.

Entity: A separate, legal entity authorized to act separately from its owners, such as a C Corporation, S Corporation, or LLC.

Exclusivity: A provision in a term sheet or letter of intent in which the seller agrees not to solicit offers or negotiate with other potential buyers for a specific period of time.

Fair Market Value (FMV): The most common standard of value used in business appraisals. FMV is the amount at which property would change hands between a willing seller and a willing buyer when neither is acting under compulsion and when both have reasonable knowledge of the relevant facts.

Generally Accepted Accounting Principles (GAAP): The common set of principles, standards, and procedures established by the Financial Accounting Standards Board (FASB) that companies use to compile their financial statements.

Goodwill: An intangible asset associated with the acquisition of a company normally carried on the acquiring company’s balance sheet. It is the portion of the purchase price allocated to the value in excess of the tangible assets acquired.

Gross Profit: The total revenue minus the cost of goods sold, or the profit a company makes after deducting the direct costs related to manufacturing and selling products and services from the total revenue.

Holdback (a.k.a. Escrow): An amount of the purchase price that is withheld from the seller, typically by a neutral third party (i.e., escrow agent) in a separate account for a period of time after the closing to satisfy any of the seller’s indemnification obligations. The amount is paid to the seller after a specified amount of time following the closing, typically 6 to 18 months, if the buyer makes no indemnification claims.

Indemnification: A provision in the purchase agreement that allows a buyer to seek recourse against the seller for losses suffered due to breaches of representations and warranties.

Intellectual Property (IP): The legally protectable intangible assets of a business, which can include patents, copyrights, trade names, domain names, trade secrets, and trademarks or service marks. Intellectual property can be registered (e.g., trademarks, patents) or unregistered (e.g., trade secrets). 

Internal Rate of Return (IRR): The annual rate of growth an investment produces. The interest rate, applied to a stream of cash flows, causes the sum of the outflows and inflows to equal zero. IRR is one of the most comprehensive measures of calculating returns and accounts for both the impact of leverage and time. It is the most common measure of return used by private equity firms to measure the performance of their funds (i.e., acquisitions). IRR is heavily dependent on the amount of time an investment is held. IRR is most commonly used by private equity and venture capital groups when calculating returns. Other more advanced versions of IRR also exist, such as the modified internal rate of return, or MIRR.

Letter of Intent (LOI): A preliminary agreement that outlines the essential terms of an acquisition and signifies the parties’ commitment to start due diligence and begin working toward a purchase agreement. The letter of intent is replaced by a purchase agreement prior to or at the closing.

Main Street: The segment of the business landscape made up of small “mom-and-pop” businesses such as restaurants, coffee shops, landscaping companies, auto and truck service centers, convenience stores, most franchises, and small businesses that offer services. Main Street businesses are predominantly valued using a multiple of SDE and sold by business brokers.

Merger: One of the three primary methods of structuring a transaction for legal purposes. The combination of two or more companies into one with a single entity by filing a Certificate of Merger with the secretary of state. Transactions can be structured for legal purposes as an asset sale, stock sale, or merger.

Middle Market: The segment of the business landscape consisting of mid-sized businesses, such as manufacturing firms, distribution companies, wholesalers, and large service-based companies. The middle market is further divided into the lower, middle, and upper-middle markets and is primarily served by M&A advisors and investment bankers.

Non-Compete Agreement: A contract that limits the seller or key employees from competing with the business after the closing. Most non-competition agreements range from two to five years. A non-compete agreement is legal in all states in the sale of a business, whereas non-compete agreements in an employment context are illegal in some states.

Non-Disclosure Agreement (NDA): A legal contract between the buyer and seller that outlines confidential material, knowledge, or information that both parties want to share with each other for specific purposes, but with restricted access to or by third parties. The NDA is typically signed early in the transaction after the teaser profile is provided, but before the buyer is given access to the confidential information memorandum (CIM) or financial statements.

Non-Solicitation Agreement: An agreement signed by employees and management whereby they agree not to solicit customers or other employees of the company regarding job opportunities upon the termination of their employment agreement. Non-solicitation agreements are commonly used as an alternative to non-compete agreements because they are viewed as more enforceable.

Normalize (a.k.a. Adjust, Recast): The process of adjusting, normalizing, or recasting a business’s financial statements to determine the true earnings (i.e., EBITDA) of a company.

Normalized (Adjusted, Recasted) Financial Statements: Financial statements that have been adjusted to calculate a company’s SDE or EBITDA.

Net Income: The amount of money earned after deducting all expenses, including overhead, employee salaries and benefits, manufacturing costs, inventory costs, distribution costs, and marketing and advertising costs from a company’s gross revenue.

Platform Company: A large company that is the foundation to acquire and add smaller companies to, such as through an add-on or bolt-on acquisition, or by a financial or strategic buyer to complement the acquirer’s business model.

Private Equity Firm: A company that raises money from institutional investors (i.e., limited partners) and then invests these funds into private companies. A private equity firm normally has multiple funds, with each fund having a lifespan of 10 to 12 years. Private equity funds are often structured as a general partnership, or other similar entity, in which the private equity firm is the general partner, and the investors are limited partners.

Promissory Note: A document signed by a purchaser of a business that includes a written promise to pay the balance of the purchase price over an extended period of time.

Representations and Warranties: Statements and guarantees by a buyer or seller of a business relating to the assets, liabilities, and contacts of the business that are being acquired, or the business that is making the acquisition. Breaches of representations and warranties are addressed in the indemnification section of the purchase agreement. A percentage (usually 10%) of the purchase price is normally held back (known as a holdback) in an escrow account for 6 to 18 months following the closing to fund any indemnification claims. This amount is later released to the seller if no claims are made during this time period.

Re-Trading: The practice of renegotiating the price and terms of a company after the initial price and terms have been agreed to. This occurs when the buyer performs due diligence during negotiations and potential risks are uncovered during the process. While not as common as in the past, such actions by buyers definitely do occur and they not only aggravate sellers, but can also jeopardize the closing of a deal. There are times when buyers are justified in seeking an adjustment, as in the case of a discovery that certain deal fundamentals are not supportable under the scrutiny of the buyer’s due diligence.

Return on Investment (ROI): The return on an investment divided by the investment amount. Calculating ROI is quick and easy, enabling you to readily compare the potential returns on different investments. While calculating the ROI can be useful, the ROI has several shortcomings, such as not accounting for time or leverage. While ROI isn’t commonly used to value a business, it’s helpful to understand what impact ROI may have on the value of your business and how many different factors can impact returns. ROI is the inverse of a multiple. Common multiples for most small businesses are 2 to 4 times SDE. This equates to a 25% to 50% ROI. Common multiples for mid-sized businesses are 3 to 7 times EBITDA. This equates to a 16.6% to 33% ROI. The riskier your business, the higher the rate of return your buyer will require to compensate for the risk, and the lower the multiple you will receive. If your business is larger and less risky, an investor might decide they need only a 20% return, or a 5.0 multiple, to justify the risk. If your business is smaller, a 40% return, or a 2.5 multiple, may be required to justify the higher level of risk.

Return on Value Drivers: A proprietary model developed by Morgan & Westfield in which implementable strategic actions are prioritized based on which drivers will have the greatest impact on the value of a business in the shortest period of time and which also pose the lowest risks to implement. 

Roll-Up: The purchase or consolidation of smaller companies in an industry by a larger company in the same industry. The strategy is to create economies of scale and “roll-up” all the small companies into one big company to sell in the future with the hope of expanding the multiple (i.e., multiple expansion).

S Corporation: Short for “Subchapter S Corporation,” a state-incorporated business that elects to receive special tax treatment. An S Corporation is restricted to 100 shareholders, shareholders must be U.S. citizens/residents, and only one class of stock is permitted to be issued, although it can have both voting and non-voting shares. Most small and mid-sized companies are structured as an LLC or S Corporation, whereas most larger companies are structured as a C Corporation.

Search Fund (Independent Sponsor): An investment vehicle formed by individuals who deploy privately raised capital to search for and acquire privately held companies. Whereas an independent sponsor generally does not take on the day-to-day operations of a company, a search fund seeks to acquire a single business and then operate it. Independent sponsors come in all ranges and sizes, some have incredible relationships with family offices and private equity and the ability to quickly close deals, while others do not. A search fund has investors who have already committed search capital and thus have skin in the game.

Seller Financing: A loan which is payable (i.e., promissory note) from the buyer of a business to the seller or owner of a business, and is commonly used to acquire businesses as an alternative to third-party (i.e., bank) financing.

Stay (Retention) Bonus: A bonus given to employees, usually by the seller, to ensure they stay on board after the business is sold. A typical bonus ranges from 5% to 20% of the annual base salary and is released in multiple stages (i.e., ⅓ at closing, ⅓ at 6 months, and ⅓ at 12 months after the closing).

Stock Sale: One of the three primary methods of structuring a transaction for legal purposes whereby the buyer purchases the stock, or entity (a stock sale), of the seller, as opposed to purchasing the assets of the seller (an asset sale). Transactions can legally be structured as an asset sale, stock sale, or merger.

Strategic Buyer: A buyer or company that may provide similar or complementary products or services to the target and is often a competitor, supplier, or customer of the target, or one that brings other synergies to a potential acquisition.

Successor’s Liability: Liability that passes from the seller of a business to the buyer of a business by operation of law without an express contractual agreement for the buyer to assume the liabilities of the seller. Successor’s liability is most common in the areas of tax and environmental liabilities and can be imposed by governmental institutions. Successor’s liability is mitigated through extensive due diligence, representations and warranties, and escrowing a portion of the purchase price to fund indemnification claims.

Sweat Equity: An increase in value that is created as a direct result of hard work by the owners. Sweat equity is recognition of a partner’s contribution to a business in the form of effort while financial equity is the contribution in the form of capital.

Teaser Profile: A short summary of a business that doesn’t normally reveal the company’s identity. This is provided to prospective buyers before the buyer signs a non-disclosure agreement.

Term Sheet: A document that outlines the key terms of the purchase or sale of a business.

Trailing Twelve Months (TTM): A term used to describe the most recent 12 consecutive months of a company’s financial performance data, as opposed to a fiscal year.

Uniform Commercial Code (UCC): A standardized set of laws and regulations for transacting business with the aim to make business activities consistent across all states, and that has been adopted to some extent in all 50 states. 

Working Capital: The amount by which current assets exceed current liabilities in a business. Working capital is calculated as the value of accounts receivable, inventory, and prepaid expenses, less the value of accounts payable, short-term debt, and accrued expenses. Working capital is normally included in the purchase price of mid-sized businesses.

Thanks again for reading Acquired and for putting your trust in me. 

More information on the complex process of selling your business can be found in the Resources section of the Morgan & Westfield website at morganandwestfield.com/resources/. Here’s what’s included:

• Ask the Expert: Links to common M&A questions and answers. Ask any question related to buying, selling, or valuing a business. 
• Downloads: Links to forms and other useful resources for selling your business.
• Books: A complete list of my books on selling, valuing, or buying a business, and all other topics related to M&A.
• Glossary: A glossary of terms used throughout this book. Don’t be confused or intimidated by any terms or abbreviations in the M&A world – you’ll find answers here.
• M&A Encyclopedia: The most exhaustive encyclopedia in the industry with over 800 pages of insight on every step of the process of selling, buying, or valuing a business.
• M&A Talk: The #1 podcast on mergers and acquisitions, produced by Morgan & Westfield and hosted by Jacob Orosz. At M&A Talk, we bring you exclusive interviews with a wide variety of experts in mergers and acquisitions, private equity, investment banking, business valuations, law, finance, and all topics related to M&A, buying, selling, and valuing businesses. 
• M&A University: Complete courses related to buying, selling, or valuing a business. Courses are led by industry experts with decades of industry experience and are designed to give you in-depth knowledge regarding every aspect of the process of preparing your business for sale, valuing it, and closing your deal.

Thank you for turning to Morgan & Westfield for your M&A information needs. You made the right choice. 

“You are that which you are seeking.”

– Saint Frances of Assisi, Italian Friar

No one said this would be easy. After all, how many endeavors in life require expertise in sales, negotiation, accounting, finance, and lawyering – with a healthy dose of psychology to boot? You could build a rocket ship with less collective brain power than it can take to successfully pull off the sale of a $500 million business. Or a $5 million company, for that matter.

But by following the guidelines outlined in this book – advice based on personal experience and lessons learned from more than 20 years of selling mid-sized businesses – you will maximize your chances of scoring a timely transaction at top dollar.

If you’re one of those readers who jumps to the end to see how things turn out, you’re in luck. What follows is the CliffsNotes version of the measures you can take to help ensure the best possible outcome for you and your business.

First things first: Are you sure you want to do this?

Deciding to Sell

The decision to sell your company is a critical one. You’ve invested years or decades painstakingly building your business, and you’ve made countless sacrifices along the way. When contemplating such an important decision, there are four crucial factors to consider:

1. Your Goals, Including Personal, Financial, and Business: Start the process by writing down your goals – understanding what you want is the first step toward achieving your objectives. Only after you clarify your long-term goals can you examine how selling your business will move you closer to them. 
2. Internal Factors, Such as Emotions: Look at yourself and your business objectively and determine if a change would make you happier. At the same time, though, beware of trading one set of problems for another. 
3. External Factors, Including Timing and Competition: Timing the sale of your business is difficult, but you can come close to being spot on with the right intelligence. The ideal time to sell is when your business and industry are about to peak. Consult with industry veterans to obtain their opinion regarding the current market cycle of your industry. Consider both narrow industry cycles and broader macroeconomic cycles. But remember that, as with most important decisions, the timing will never be perfect. 
4. Your Business’s Value and Exit Options: Intelligent financial planning is difficult without having an accurate idea of the worth of your most valuable asset – your business. It makes sense to pay a professional to assess your business and get an idea of the steps you can take to increase its value.

Preparation vs. Execution

Most entrepreneurs have a strong bias toward action. Once they decide on a plan, they prefer to dive right in and figure things out later. But you must realize that a lack of preparation will extend the time frame of the sale, reduce the selling price of your business, put less cash in your pocket, and lower the overall chances of a successful sale. 

Proper preparation, on the other hand, will elicit the opposite outcomes – you’ll increase the chances of a successful sale, shorten the time frame, command a higher selling price, and put more cash in your pocket. As with most skilled endeavors, preparation makes execution look effortless.

No two exits are alike. Each exit must be deliberately planned. There’s no templated process you can follow to prepare your company for sale. Rather, the preparation stage involves creating a plan, prioritizing your plan, and then executing your plan. 

How Long It Takes To Sell a Business 

For all business sales since 2000, the average time on the market is 200 days or about 7.3 months. In recent years, however, the average time to sell a business increased to 10 months, from 6 months in the early 2000s. That timing, however, depends on several variables, namely:

1. Your industry
2. How attractive your business is to buyers
3. Your marketing strategy

Most of the factors that increase the value of a business will also have an impact on the amount of time it takes to sell the business. If you want to increase the value of your business or speed up the time frame, the steps you must take are often the same.

Why Some Businesses Don’t Sell

Most transactions die during one of the following stages:

• Marketing: Some transactions never get off the ground because the seller and their M&A advisor or investment banker can’t get the traction necessary to generate meaningful discussions with buyers.
• Letter of Intent: The seller has generated interest from a buyer, but they lose interest after taking a closer look at the business. 
• Due Diligence: The buyer makes an offer, but the transaction dies during due diligence for any number of reasons.
• Closing: The buyer successfully concludes due diligence, but then the deal dies sometime before the closing – again, for any number of reasons.

A variety of factors can cause a business to not sell. But you can dramatically improve your odds of success if you invest time to prepare for the sale well in advance. While some problems can’t be completely overcome, buyers often consider the totality of the circumstances. Still, the more risk the buyer perceives, the more likely they are to walk away and the less they’ll be likely to pay. 

However, even if a problem can’t be eliminated, it may still be possible to mitigate its effects to reduce the buyer’s perception of risk. The result of properly preparing your business for sale is that you dramatically tilt the odds of a successful transaction in your favor. 

Exploring Your Exit Options

All exit options can be broadly categorized into three groups:

• Involuntary: Involuntary exits can result from death, disability, divorce, or other unplanned events. Your plan should anticipate such occurrences, however unlikely they may seem, and include steps to avoid or mitigate potential adverse effects. 
• Inside: The buyer comes from within your company, such as your management team, or your family. Inside exits require a professional who has experience dealing with family businesses, as they often involve emotional elements that must be navigated and addressed discreetly, gracefully, and without bias. Inside exit options greatly benefit from tax planning because if the money used to buy the company is generated from the business, it may be taxed twice. Also, inside exits tend to realize a much lower valuation than outside exits. Due to these complexities, most business owners avoid inside exits and pursue an outside option instead. 
• Outside: The buyer comes from outside of your company or family. Outside exits tend to realize the most value. This is also the area where M&A advisors and investment bankers specialize. Outside exit options will nearly always yield you the highest price. If that’s your goal, focus on outside exit options and hire an M&A advisor or investment banker to conduct a private auction to sell your company.

Management buyouts (MBOs) are common in the middle market. Your current managers, or people in their networks, may have distinct insider knowledge that allows them to quickly make a decision. This can be one of the most efficient sales experiences any seller can hope for. Unfortunately, your management team may not have the financial resources necessary to buy your business and invest in its growth. To sell to a management team, be prepared to finance all or part of the sale or arrange for a bank to finance the transaction. Private equity firms also commonly back management teams that may be looking to acquire a business.

In addition to these three exit options, you can also sell a portion of your business. This would allow you to focus your talents on a division of your business with the most significant potential, or that you most enjoy, or that offers you the greatest opportunity for work-life balance. In deciding whether to sell your whole company or only a portion of it, first examine the overall value of your business and then determine the individual value of each division. Once you’ve performed this analysis, you may decide that it would be prudent to break your business in two to extract the most value.

Deciding to Double Down

One of the first things you should consider when deciding whether to sell your company is if suitable alternatives exist to an outright sale. Often, selling your business isn’t an all-or-nothing decision. Several potential options may exist. But before you explore those options, consider how committed you are to your business. Exploring your level of commitment requires being emotionally honest with yourself. If you decide you’re truly committed to your business and would like to double down, then do just that. But many entrepreneurs lack the capital to fuel the growth of their business. If this is you, growth equity from a private equity firm might be a suitable option. 

What Buyers Look For

When preparing your business, it’s important to understand the different buyer types and their criteria. That way, you can position your business to be as attractive as possible to the type of buyer who is most likely to acquire your company. Each type of buyer has a different set of preferences regarding the type of infrastructure, systems, and other elements they desire in a business. Many buyers will consider a profitable business that lacks infrastructure. But few buyers will consider an unprofitable business that has significant infrastructure in place. Always prioritize profitability over infrastructure until your EBITDA exceeds several million per year.

For most businesses, developing a management team is the most critical factor in building a salable business other than profitability. For other businesses, creating systems or increasing cash flow may create more value. There’s no cookie-cutter formula. Knowing the potential types of buyers for your business can help you maximize your sale price and properly market your business to the right audience when the time comes, setting it apart from others like it.

EBITDA

Before you value your business, you must ensure your financials accurately reflect its actual earning capacity. You do this by making numerous adjustments to your financial statements to calculate EBITDA. This process is called normalizing, recasting, or adjusting your financial statements. The resulting cash flow after the adjustments have been made is called earnings before interest, taxes, depreciation, and amortization (EBITDA).

Nearly all valuations in the middle market are based on EBITDA. But when it comes time to adjust your financial statements, there are several guidelines you should keep in mind. If you’re planning to sell your business soon, remember to:

• Minimize the number of adjustments several years before the sale.
• Ensure all adjustments are thoroughly documented.
• Be conservative when making adjustments.

The number one method for increasing the value of your business is to increase its EBITDA. The second method is to increase revenue. So if you want to increase the value of your business – focus first on increasing your EBITDA, then look at increasing your revenue.

Valuation Multiples

Buyers buy businesses so they can receive a return on their investment (ROI). ROI refers to the return on an investment divided by the investment amount. For example, a $100,000 return /$1,000,000 investment = 10% return on investment. 

In the real estate world, a capitalization rate is the rate of return a real estate investment generates. Typical cap rates for real estate range from 4% to 12%. This would correspond to an 8.3 to 25.0 multiple. In the business world, ROI is the inverse of a multiple. If the multiple is 4.0, then the ROI is 25%. Common multiples for most mid-sized businesses are 4 to 8 times EBITDA. This equates to a 12.5% to 25% ROI. Because returns are higher, it’s easier to calculate a multiple than a cap rate.

Multiples are the foundation of nearly every business valuation in the middle market. But while the math of calculating a multiple is simple, don’t let the apparent simplicity fool you. Just as a golf club is easy to swing, properly doing so is much more difficult. Understanding what multiples are and how they’re used is foundational to understanding how to value your business.

Valuation Theory

Valuing a business is a challenging task, even for the most seasoned advisor. The best you can hope to do is to make an educated guess about what the future will bring while trying to stay unbiased. While such an assessment of value may be tenuous, it’s nonetheless the starting point of the M&A process and a critical component of a successful exit strategy for any entrepreneur. A valuation of your business serves as a baseline from which to develop your exit strategy – the ultimate value can only be determined through a carefully executed sale. Remember these critical valuation concepts:

• Information Is Limited: The information available in transaction databases for mid-market transactions is often submitted without being verified, and only pieces of the story are provided, such as high-level financial information. 
• Predicting the Future Is Difficult: The essence of valuation is predicting how other investors will behave. Predicting the behavior of a single individual is difficult enough, let alone predicting the impact of fear, greed, and herd behavior. Changes in the macroeconomic environment can also have an enormous impact on the value of a business, and such changes have proven impossible to foresee.
• Buyers Have Different Criteria: The universe of potential buyers for a business is diverse, which greatly expands the possibility for a wide range of opinions.
• Valuation Methods Are Subjective: Be aware of the potential for biases to be built into any valuation and be cognizant of the impact such biases can have on the appraisal.
• Significant Time and Effort Is Required: Properly valuing a business takes a great deal of time and effort, especially when it comes to understanding and predicting future cash flows. The more sweat equity that’s invested in preparing the appraisal and predicting cash flows, the more accurate those predictions will likely be. 
• Fair Market Value vs. Strategic Value: Most business appraisals use fair market value (FMV) as the standard of value. This can limit the value of a business. The primary alternative is strategic value, but here’s the downside – you can’t measure strategic value until you know who the buyer is. That’s because every buyer can extract a different amount of value from your business based on the synergies they bring to the table.
• Business Valuation Is a Range Concept: Business valuation isn’t a hard science. Various buyers will value each business differently, and the same goes for appraisers. The value of a business should never be a single hard number, but rather a range of values. 
• Transaction Structure Affects Value: The terms of the sale – such as the amount of the down payment, the repayment period, and the interest rate – can all affect how much a buyer will be willing to pay. 
• Your Personal Needs Affect Value: Poor health or financial pressures may force you to sell. If for these or other understandable reasons you need to sell quickly, you’ll probably have to accept less than the optimal sale price.

Valuation Practice

Pricing a business is based primarily on its profitability. Profit is the #1 criteria buyers look for when acquiring a business, and the #1 factor that buyers use to value a business. There are other variables that buyers may consider, but the majority exclusively look for one thing – profit. Most valuation models are therefore based on some multiple of the profit a business generates.

Yes, a business’s potential can enhance its value – especially if that potential is close to being realized – but don’t expect the buyer to pay a lot for a promise that has yet to be entered into the ledger. The primary value driver of your business is historical profitability.

When considering whether you should have your business appraised, you have several options available to you. The various types of valuations don’t have standard definitions, but most reports fall into one of three main categories: 

1. Verbal Opinion of Value: These types of reports are useful if you’re in the exploratory stages of selling your business and would like a ballpark idea of what your business is worth before committing more time, money, and effort to the process. A formal report isn’t essential for most businesses.
2. Written Report for Non-Legal Purposes: These reports are useful for non-legal purposes such as a business sale, but they don’t comply with appraisal standards and can’t be used for legal purposes. These reports are most useful for business owners looking to sell a business. 
3. Self-Contained Appraisal: This type of report is also known as a “formal appraisal” and is required for any legal purpose such as a divorce, tax matters, or bankruptcy. While the price can fluctuate widely, these appraisals usually run at least $5,000 to $10,000. 

When choosing an appraiser, your options include M&A firms, CPAs, and business appraisers. M&A intermediaries with real-world experience selling companies are ideal when your objective is to sell your business or weigh your exit options. You don’t need an appraisal designed for legal purposes or one that can be used in court when you are selling your company. As a result, your advisor can produce a shorter report that’s limited to the valuation methods that buyers use in the real world, which will save you time and money.

Factors That Can Affect Value

Many of the factors that affect the value of your business can be boiled down to two simple elements – risk and return. The less risky your business, the greater its value. Likewise, the more potential your business represents, the higher the potential value. For most businesses, focusing on reducing risk is more prudent than focusing on maximizing potential. That’s because potential is usually limited by external factors, such as demographics and industry structure, which is less the case when it comes to reducing risk. 

The potential range and mix of factors that can affect the value of your business are more complex than a simple list of factors. Reality is more nuanced. When evaluating your business, buyers will initially consider a vast collection of issues, and then reduce this list down to just a few that represent the greatest risk. When selling your business, it’s wise to pay a professional to independently evaluate it to identify the factors that have the greatest impact on value and then develop a strategy to mitigate them.

Here is a summary of the factors that can affect the value of your business:

The Industry

• Barriers to entry
• Acquisition activity in your industry
• Industry trends
• Industry desirability
• Industry growth
• Scalability
• Industry stability
• Ability to replicate
• Regulations

Competition

• Degree of consolidation or fragmentation
• Degree of organic growth that’s possible
• Strength of competition
• Strength of your competitive advantage
• Threat of new entrants
• Threat of indirect competition and the effect of technology
• Brand awareness of your business vs. competition
• Reputation of your business vs. competition

Products and Services

• Ability to increase pricing
• Degree of product concentration
• New products in development
• Degree of specialization vs. commodity
• Outlook for your product category
• Overall demand for your product, such as if it is discretionary or cyclical
• Intellectual property rights
• Warranty obligations

Customers

• Mix and type of customer base
• Customer acquisition metrics
• Product fit with acquirer’s product line
• Customer database (CRM)
• Customer concentration
• Existence of close relationships with customers
• Degree of repeat or recurring customers
• Customer contracts

Operations

• Systems
• Attractiveness of location and facilities
• Ability to expand facilities and capacity utilization
• Ability to relocate the business
• Age and condition of equipment and other hard assets
• Age and condition of inventory, and turnover

Staff

• Degree of dependence on owners
• Number of active owners involved in business operations
• Compensation of owners
• Family members involved in business operations
• Strength of management team
• Dependence on key employees
• Compensation of staff compared to industry standards
• Average tenure and turnover rate of staff

Finance

• Overall financial performance vs. industry averages
• Revenue trends
• Growth prospects
• Gross margin trends
• Profitability trends
• Recurring revenue
• Cash flow cycle
• Working capital requirements
• Capital expenditures
• Quality of financial records

Legal

• Adequacy of insurance coverage
• Strength of intellectual property
• Pending litigation

Economic Factors

• Strength of national, regional, and local economies
• Inflation rates
• Unemployment rates
• Labor trends

Other Factors

• Negotiating skills and posture
• Overall marketability of your business, size of buyer pool, and financing available to acquire your business
• Factors that affect timing – price, region, financing, industry, attractiveness, marketing strategy

Improving Value

There are only two ways to directly increase the value of your business:

1. Increase EBITDA: This can be accomplished by reducing expenses or boosting revenue.
2. Increase the Multiple: Multiples are based on two factors – risk and return. Take steps to reduce risks associated with your business and improve its perceived growth potential.

At the same time, there are many areas in which you can indirectly create value, including:

• Business Model: The easier it is for a buyer to replicate your business’s offerings, the lower the price they’ll be willing to pay. By creating a business that’s difficult to replicate, you’re guaranteed to receive more for it.
• Financial Metrics: Two words: cash flow. Focus on maximizing cash flow over all other value drivers.
• Growth Plan: Develop an outline highlighting the major ways you can grow your business. Begin executing your growth plan before you put your business on the market.
• Operations: Take the time you need to ensure your operations are running as smoothly as possible. This minimizes risk for the buyer.
• Customers: Minimize customer concentration. Ensure customer contracts are assignable in the event of a sale. 
• Legal: Have your attorney identify any legal issues that need to be rectified before you begin the sales process. Legal issues generally don’t present an opportunity to create value, but they do present an opportunity to reduce perceived risk for the buyer. 
• Staff: Nearly every buyer will be concerned with the quality of your staff. Make sure there are minimal employee issues that can deter a buyer. Focus on building a strong management team with evenly distributed responsibilities. 
• Ownership: Make it easy for a successor to replace you. Don’t come across as being personally indispensable to the success of the company.

Prioritizing Your Value Drivers

Once you’ve identified your value drivers, prioritize and execute them based on their potential impact or return, and the risk, time, and investment required in achieving them. 

After you’ve educated yourself on the possible value drivers you can implement in your business, I recommend consulting with an experienced investment banker to help you prioritize them. A knowledgeable advisor can help you identify the value drivers that are most likely to generate the highest returns, that require the least amount of time and money to implement, and that represent the lowest associated risk. They can also help you identify which value drivers will appeal to all buyer types and which value drivers may only appeal to a specific buyer group. 

Team

Selling a business has become more complicated over time. Tools for financing, mitigating risk, and structuring the transaction can be complex but crucial to the sale of your business. Assembling a team of professionals who can give you the best advice specific to your business will help you navigate this complicated field. So, when considering advisors and professionals who might help you, understanding their fee structure, their specialty, and what they can bring to the table will help you assemble the most effective team to get your business sold.

• M&A Advisor: Think of your M&A advisor as your quarterback. They’ll play a key role throughout the transaction, from the opening kickoff until the final whistle blows. Your M&A advisor will initially assist in helping you package your company for sale, which will include valuing your company, identifying any issues that need to be addressed before putting your business on the market, and preparing key sales documents. Once the preparation is complete, they will put your business on the market, contact buyers, and manage your negotiations. They will also work closely with your M&A attorney in negotiating the letter of intent (LOI) and purchase agreement. Your M&A advisor will negotiate with the buyer regarding the high-level elements of the transaction and how the various components work together to form the overall deal structure, while your M&A attorney will negotiate the finer details of the agreements.
• Attorney: Your attorney will play the second-most critical role in the transaction and will negotiate the key agreements – primarily the non-disclosure agreement (NDA), the letter of intent, and the purchase agreement. In some cases, your M&A attorney may assist you in identifying legal issues that need to be resolved before you put your business on the market, so you can then delegate these matters to your commercial attorney to resolve.
• Accountant: Your accountant will assist you in preparing your company for sale from a financial perspective and make sure your financials are clean and consistent once your business is on the market. Accountants may also be involved in financial due diligence, as well as in examining the financial and tax implications of the purchase agreement. The role of an accountant is typically less involved than your M&A attorney, although the extent to which this is the case will vary based on the transaction.

Managing Employee’s Expectations

Employees are a key asset of any business. To maximize the value of your business, you must therefore protect the nature of your relationship with them. This is especially true in the event of a planned sale.

One of the most delicate decisions to make during a business sale is the timing of when to tell your employees. You need to determine the best way to approach this for your situation, and consider your relationship with your employees and personal advisors. Obviously, word will get out eventually, but if you maintain control of the timing and the process, you can use this critical stage to your advantage. Be prepared for the unexpected, consult with your advisors, and make plans to ensure the sale unfolds smoothly and successfully for everyone involved. 

If you have a trusting culture at your company, you may consider informing your employees of a pending sale early in the process. Your staff will most likely appreciate the vote of confidence you display by sharing with them news of such a monumental nature, and you’ll have time to build even more trust and prepare them for what’s to come. Furthermore, any apprehensions on the part of the buyer will likely be lessened if they know the staff is mentally and emotionally prepared for a change in ownership. If, on the other hand, you’re concerned that one or more key employees could sabotage or otherwise undermine a sale, it may be best to wait as late as possible before cluing them in – up to and including the day of the closing.

Non-competition agreements are another tool you can use with your staff to protect the value of your company. If a non-compete is illegal in your state, or if asking your employees to sign a non-compete is impractical, you have two sound alternatives – a non-solicitation agreement and a confidentiality agreement (CA). Both can be effective in helping to protect your business’s value.

Preparing the Information Memorandum

You may want to approach competitors or the market anonymously to start with. If this is the case, a two-to-three-page teaser profile can be written in a way that drums up interest in your business without divulging its identity. After the buyer signs an NDA comes the confidential information memorandum (CIM), a 20-to-40-page document that includes the name of the business along with more details about your company. The story of your business should be presented in a coherent, professional package. Your CIM should provide answers to the basic questions every buyer will ask and contain enough information for the buyer to decide if they’d like to invest time in meeting with you and learning more about your business. Questions with more nuanced answers should be reserved for a phone call or face-to-face meeting. Your CIM shouldn’t answer all the buyers’ questions, but it should provide enough information for the buyer to decide if they’d like to proceed to the next steps.

The CIM should present the key selling points of your business in a persuasive story. Remember, the purpose of the CIM is to sell. That said, readers of CIMs are sophisticated and won’t be keen to read a document filled with hyperbole, so strike a balance between presenting information and selling your company.

Maintaining Confidentiality

Understanding a few basic points about confidentiality agreements ensures they can protect you while selling your business. By examining their language and negotiating their terms, you can make sure they aren’t made obsolete by ambiguities or ignorance of the meaning of the terms used in the agreement.

Here are some ways you can help maintain confidentiality:

• Prepare for the Sale in Advance: An ounce of prevention is worth a pound of cure, and selling your business is no different. To preserve confidentiality, you should ideally prepare for the sale years in advance. 
• Draft a Non-Disclosure Agreement: While an NDA isn’t bulletproof, it does prevent leaks in most cases. Often, a leak is negligent, and the offending party isn’t intentionally trying to harm your business. The real purpose of a confidentiality agreement is leak-prevention, but it’s not the only tool you should use.
• Contact Buyers Based on Increasing Stages of Risk: When selling your business, contact buyers that represent the lowest risk to you and your company first in the process. Typically, this involves initially contacting private equity (PE) firms and indirect competitors.
• Thoroughly Screen Buyers: You should thoroughly screen all buyers before you provide them with sensitive information on your company. 
• Release Information in Phases: As the buyer demonstrates continued interest in your business, you can release more and more information. In this manner, you release more sensitive information as you come to know and trust the buyer over time. You should release highly confidential information, such as customer contracts, only at the later stages of due diligence. 
• Control How Information Is Released: Controlling how information is released is foundational to maintaining confidentiality. Here are several strategies for controlling what and when information is furnished to potential buyers:
  • Redact or aggregate information
  • Release information in phases 
  • Develop strategies for different types of information
  • Set up an electronic deal room
  • Email information to create a document trail
• Mark or Stamp Documents “Confidential”: Stamp or watermark all documents “Confidential” before releasing them to the buyer. 
• Handle Breaches Immediately: In the event of a breach, immediately call the offending party.

Maintaining confidentiality is essential when it comes to selling your business. Many critical issues are addressed in a properly drafted NDA, including non-solicitation and other “sales process” issues. It’s tempting to assume that all NDAs are boilerplate, but a mistake at the stages of negotiating and signing a non-disclosure agreement can close off critical options later in the process. In extreme cases, leaks can destroy your business. A CA is executed in nearly every M&A transaction but is only one of many tools in your toolkit to maintain confidentiality during the sales process.

Understanding and Finding Buyers

Knowing who your probable buyer is will help you figure out the steps you need to take to prepare your business for sale and determine the best marketing strategy to maximize your company’s value.

If you’re most likely to be approached by an individual buyer, for instance, you’ll want to focus on minimizing the perception of risk. If you expect to sell to a private equity firm, build a strong management team if you don’t already have one. If you’ll be looking for a corporate suitor to come knocking, build value in your company that can’t be easily replicated.

Then there’s the buyers’ list – a mini database assembled by you and your advisors of names, numbers, and background information of companies that might be interested in what you have to offer. The bigger the list, the better, as the idea here is to create a private auction. Once a potential buyer realizes they’ve got competition for something they want, they’ll likely be more willing to pay up. Keep in mind how the numbers shake out – a list of 100 to 200 buyers is necessary to produce the 30 to 40 conversations required to generate 5 to 10 letters of intent.

Screening Buyers

A major mistake entrepreneurs often make in the early phases of a transaction is wasting time on unqualified buyers. You can waste vast amounts of time weighing the merits of an offer if you don’t first obtain background information on the buyer. 

Just as buyers perform due diligence on you and your business, performing due diligence on buyers is paramount. Screening potential buyers is, in fact, one of the most critical first steps in the sale process. Its importance can’t be overstated.

Screening potential buyers will help ensure you’re dealing with serious buyers who have the means and determination to follow through on the purchase, saving you time and money in the long run. Understanding the differences between various buyer groups will help you determine how to best approach marketing your business while maintaining confidentiality. 

Meetings

Buyer meetings are far more than a forum for you to answer questions. With these meetings, you’re selling not only your business, but yourself. You want to assure your buyer that you’re prepared, honest, composed, and serious about selling. Working to foster a healthy relationship with your buyer will not only save you time and effort in the long run, it can increase the value of your business as a whole. It’s a key aspect of selling a business that’s often overlooked. Here’s how to do it right. 

When meeting with a potential buyer, remember the Golden Rule – treat others the way you want to be treated. Here’s what I mean:

• Be respectful of their time and needs when making the arrangements – send them the message that you’re professional and cooperative, but not a pushover.
• Be prepared. Be sure to have access to a computer and your confidential information memorandum (CIM) when you talk so you can easily answer their questions.
• If you talk with the buyer on the phone or via video meeting, do so in a quiet place. I’ve encountered far too many buyers that were annoyed because they talked with a seller who was on a cell phone driving in their car or in some other environment that wasn’t conducive to an important conversation.
• Schedule enough time so you can hold the meeting without any distractions.

Maximizing Negotiating Leverage

High-level negotiating skills aren’t as crucial as you might think, at least as they pertain to you as the seller. That’s because you can hire an M&A intermediary or investment banker to do the dirty work. But that doesn’t mean you’re off the hook. You’ll still need to:

• Conduct pre-sale due diligence.
• Hire a third party to perform due diligence.
• Reduce sunk costs.
• Create a strong position with many options.
• Maintain emotional objectivity.
• Focus on running your business.
• Beware of deal fatigue.
• Listen before speaking.
• Be honest and humble.

Negotiating the Letter of Intent

The LOI is the most significant document in an M&A transaction. With that in mind, here are the major terms and characteristics of an LOI and the impact they have on the negotiations:

• Preliminary Agreement: The LOI is a preliminary agreement that will be replaced by a purchase agreement and allows the parties to begin due diligence. Any terms of the transaction that aren’t defined in the LOI will be drafted to the buyer’s favor in the purchase agreement.
• Exclusivity: Most LOIs contain an exclusivity clause.
• Limited Information: The terms of the transaction and the content of the purchase agreement may change based on what the buyer discovers during due diligence. 
• Contingent: The LOI is contingent on the buyer’s successful completion of due diligence. 
• Momentum: The LOI presents an opportunity for each party because it enables them to resolve problems before becoming too deeply entrenched in a position.
• Highlights Unresolved Issues: The LOI highlights any potential undefined issues.
• Non-Binding Except for These Provisions: Most of the terms in the majority of LOIs are non-binding. However, the following provisions are typically drafted to be binding – exclusivity, confidentiality, due diligence access, earnest money deposit, and expenses.

There are many problems that can arise as a result of signing an LOI. Here’s a list of the most common ones and a solution for each:

• Terms Degrade During Due Diligence: The terms of an LOI will never improve for you after you’ve signed it.
  • Solution: Define as many terms as possible before signing the LOI, when you have the maximum amount of leverage. But remember that doing so is a balancing act because buyers have access to a limited amount of information at this stage.
• Undefined Terms: Undefined terms will always be slanted in the buyer’s favor.
  • Solution: Define terms in as much detail as possible in the LOI.
• Long Exclusivity Periods: The longer the exclusivity period, the lower your negotiating leverage. Most exclusivity periods range from one to three months, while some buyers propose an open-ended exclusivity period.
  • Solution: Keep exclusivity periods as short as possible. Include milestones in the LOI for the buyer to continue to be granted exclusivity.
• Losing Negotiating Leverage: Signing the LOI disarms you. You give up nearly all your bargaining power the moment you sign the LOI.
  • Solution: Take your time negotiating the LOI. Rush to close the transaction once you’ve signed the LOI.
• Due Diligence Problems: Problems the buyer discovers during due diligence will result in less favorable terms and price.
  • Solution: Prepare for due diligence to minimize the number of problems the buyer discovers during due diligence that can be used to renegotiate the price or terms. 

 Here are the most important tips to bear in mind when negotiating the LOI:

• Remember the Balance of Power: The balance of power changes the moment you grant the buyer exclusivity. Due to this dramatic shift in the balance of power, take your time to ensure the LOI is as specific as possible. 
• Take Your Time Before Signing: Regardless of what the buyer says and how urgent they appear to be, move slowly when negotiating the LOI.
• Move Fast After Signing: Take your time negotiating the LOI but get hopping the moment it’s signed.
• Prevent Re-trading: Do the following:
  • Take your time negotiating the LOI – it should be as specific as possible.
  • Include milestones and deadlines in the LOI.
  • Commit to the shortest possible exclusivity period. 
  • Move as fast as possible once you have accepted the LOI.
  • Prepare for due diligence. Doing so will speed up the process and reduce the possibility of re-trading.
• Focus on Running Your Business: Once you’ve signed the LOI, continue to focus on running your business as if you weren’t going to sell it. Your top priorities should be maintaining profitability and keeping your sales pipeline full.
• Read the Buyer: There’s no standard LOI. If you suspect the buyer will be particularly picky about certain issues, such as the reps and warranties or access to employees during due diligence, be sure to address those matters in the LOI. It’s much better for the deal to blow up at this point than for you to take your company off the market for three months and then spend tens of thousands of dollars conducting due diligence, only for the deal to derail later because you failed to address sensitive issues up front.
• Prepare for Due Diligence: Preparing for due diligence can dramatically speed up the process. The main documents most buyers will request should be ready and available to pass along the moment you’ve accepted the LOI. They should be highly organized and uploaded to a virtual data room or other location that can be easily accessed by third parties. 
• Maintain Confidentiality: Confidentiality agreements aren’t bulletproof. Avoid sharing some sensitive information during the due diligence process even if you have a signed CA in place, especially if the buyer is a direct competitor. If you must disclose sensitive information, wait until the end of the due diligence process to do so.
• Disclose Beforehand: Disclose all problems about your business before the buyer makes an offer. If you disclose new, negative information after you accept the LOI, the terms of your deal will change.
• Be Thorough: The LOI should ideally encapsulate all the major terms of the transaction and not leave any significant provisions to be negotiated later in the process. 
• Define Working Capital: If you want to avoid the working capital adjustment time bomb, the language in the LOI regarding how working capital is to be calculated should be as specific as possible. 

Deal Structure

Bear in mind, a $20 million all-cash offer isn’t the same as a $20 million offer with $1 million down and a $19 million earnout. When receiving an offer, you should evaluate the various financial and legal components to determine how favorable the offer is compared with others on the table.

You should first evaluate the form of consideration. How is the purchase price being paid? The purchase price can be paid as follows:

• Cash: This can be from cash the buyer has on hand or third-party financing, which will be delivered to you in cash at closing.
• Seller Financing: The terms of the seller note and the creditworthiness of the buyer should be considered, in addition to the seniority of your note relative to any other lenders.
• Stock: The health of the acquirer and liquidity of the stock should both be carefully considered.
• Earnouts: Earnouts are a complex matter and should be carefully considered before you commit to one.
• Employment or Consulting Agreements: These are normally guaranteed payments, but are taxed at ordinary income tax rates to you.
• Holdback/Escrow: Most transactions include a holdback, although the terms of the holdback should be analyzed to ensure it’s reasonable.
• Royalties and Licensing Fees: Licensing fees are less commonly used and are designed to compensate you for new product launches.

You should next evaluate the legal structure of the transactions. Most small and mid-sized transactions will be structured as asset sales. If that’s the case, how the purchase price will be allocated is critical and will have a tremendous impact on your taxes. The allocation of the purchase price should be carefully analyzed by your accountant to determine if it’s reasonable and to evaluate the extent to which your tax burden can be mitigated.

Due Diligence

After you accept an LOI on your business, the buyer will begin confirmatory due diligence, as opposed to preliminary due diligence that occurs before the LOI is signed. Due diligence normally lasts 30 to 60 days, but can be extended if both parties agree. In most circumstances, the buyer can walk away from the transaction if they’re unsatisfied for any reason during the due diligence period.

I strongly recommend that you invest the time necessary to prepare your business for due diligence. Most business owners skip this step altogether. By preparing for this process, you’ll significantly improve the chances of a successful sale. Additionally, demonstrating to the buyer that you’ve prepared for due diligence increases the buyer’s confidence in your business and reduces their perception of fear and risk. 

Due diligence can be heaven or hell. If you have your financials in order, and all is well from an operational and legal standpoint, chances are due diligence will be uneventful, and your deal will take flight, bringing you one step closer to the closing of your dreams. If you’re unprepared and the buyer finds things amiss during due diligence, you’ll find yourself on the horns of a dilemma. Being prepared can go a long way in facilitating the outcome you want.

Purchase Agreement

Negotiating any component of the purchase agreement can’t be done in isolation since there are many interconnected components that constitute the overall transaction structure. All these components should be taken into consideration on a collective basis during negotiations. 

For example, if the buyer proposes a lower purchase price, you may concede but may request more cash down at closing or that the size of the earnout be reduced. Or, if you insist on providing minimal representations to a buyer, the buyer may concede but may tighten up other elements of the deal structure, such as escrows, knowledge qualifiers, or thresholds.

The trade-offs and tensions can be summarized as follows:

Seller’s Objectives:

• Maximize the purchase price.
• Receive maximum cash down at closing.
• Pay minimum taxes.
• Reduce earnouts, escrows, and other contingent payments.
• Reduce the scope and breadth of reps and warranties.
• Reduce the strength of indemnification via baskets, caps, and survival periods.

Buyer’s Objectives:

• Minimize the purchase price.
• Put minimum cash down at closing.
• Maximize the tax-deductibility of assets acquired by increasing the tax basis in these assets.
• Increase earnouts and escrows.
• Increase the scope and breadth of reps and warranties.
• Increase the strength of indemnification via baskets, caps, and survival periods.

The purchase agreement is a tool for allocating risk. As the seller, the more assurances you’re willing to provide the buyer in the purchase agreement, the lower the risk for the buyer and the higher the purchase price they can potentially afford to pay given the amount of risk they’re assuming. Risk and return are directly related. The higher the risk, the lower the return – and vice versa. By lowering the risk for the buyer by offering a collection of protections in the purchase agreement, you can potentially realize a higher purchase price. 

The most fiercely debated elements of the transaction are as follows:

• Price and Terms:
  • Purchase price
  • Terms of the seller note
  • Post-closing purchase price adjustments, such as working capital adjustment
  • Size and length of escrow
  • Contingent payments, such as earnouts and escrows
  • Specific terms of employment and consulting agreements
• Deal Structure:
  • Allocation of the purchase price, which affects the tax implications of the transaction
• Protective Mechanisms:
  • Survival period, knowledge, and materiality qualifiers of reps and warranties
  • Caps, baskets, and survival period of indemnification
• Miscellaneous:
  • Conditions to closing, such as material adverse change (MAC) clause

Closing

On the closing date, you and the buyer may physically meet around a table, where the buyer delivers the final payment and you sign and deliver the closing documents. Alternatively, they may sign the documents electronically or via FedEx. These days, most closings are virtual closings where documents are sent electronically or via next-day delivery. 

And Finally … 

“It’s always best to start at the beginning.”

– Glinda the Good Witch in The Wizard of Oz

The conclusion to the conclusion might seem like a strange place to invoke Glinda the Good Witch’s advice about starting at the beginning. But think back to the beginning of this book – the introduction, to be precise.

That’s where I first emphasized the importance of preparation in getting your business – and you – ready to be put on the market. And I kept mentioning it – the word “prepare” or one of its derivatives appears nearly 350 times throughout these chapters.

That’s the theme that ties everything together. Whether you’re getting ready to hit the Yellow Brick Road or about to sell your business, you’re going to face challenges virtually every step of the way – challenges that can be met and mitigated or overcome with preparation – challenges that are cataloged and discussed throughout this book, based on my years of experience actually selling businesses.

Consider this – what if, well into the sales process, you suddenly discover new information about your industry or new truths about yourself? Be ready to switch gears or strategies, if necessary, at a moment’s notice. The number one deal-killer of business sales is incomplete or inaccurate financial records – are your financial statements up to date and well organized? What if the buyer discovers a material fact they can use against you? How do you answer the question, “Why are you selling?” When and what do you tell your employees?

Preparation is key, whether you’re rehearsing how you’ll announce a sale to your staff or making sure your financials are in order. Being fully prepared will not only ensure you maximize your price, it will also ensure the process unfolds as smoothly and quickly as possible.

Whether you’ve already put your pending sale in motion or are getting ready for an exit a couple of years down the road, Acquired is a useful tool to keep at the ready – every step of the way.

Thanks for reading Acquired. Best of luck with the business. You’ll find links to more resources in the next section. And stay in touch. If you’ve had any unique challenges in getting your business ready for sale or you’re in the market for a consultation, drop me a line at [email protected]. And, if you’ve enjoyed this book, please leave a review on Amazon – I’d really appreciate it. 

The buyer has done their due diligence, and you’ve done yours. All the terms of the transaction have been agreed to. The purchase agreement is ready to be signed. 

Next up: The closing. 

You’ve gotten this far, so what could go wrong? Hold my beer … 

There’s no such thing as a perfect closing, but we can come close. This chapter addresses some of the potential landmines that can detonate in the final stages of a transaction and how to mitigate them – for both you and the buyer. 

Before the Closing

Here is a summary of essential actions that both you and the buyer should take before the closing:

• Allocate the Purchase Price: The parties should agree on the allocation of the purchase price as early in the process as possible to eliminate any delays due to disagreements.
• Calculate Net Working Capital (NWC): The parties should prepare a spreadsheet to track any changes in net working capital.
• Inspect Equipment: The parties should inspect the equipment well before the closing to eliminate last-minute surprises and allow you ample time to repair or replace any equipment, if necessary.
• Do a Preliminary Inventory Count: The parties should conduct a preliminary inventory count as early in the process as possible to prevent any surprises. 
• Check Seller’s Entity: You should check the status of your entity to ensure it’s in good standing. The closing can’t occur if your entity isn’t in good standing, and the closing can be significantly delayed as a result.
• Obtain Tax Clearances: The parties should obtain the following tax clearances before the closing. Note that these can be obtained by an escrow agent if they are coordinating the closing:
  • Payroll Tax Clearance: This ensures your payroll taxes are paid and current before closing.
  • Sales Tax Clearance: If your business collects sales tax, you must obtain a clearance certificate prior to the closing. Failure to do so could expose the buyer to unpaid taxes.
  • Other Tax Clearance Certificates: Clearances may often be required from other state agencies for other taxes.
• Coordinate With Third Parties: You and the buyer must coordinate with third parties regarding the following:
  • Financing Documents: If third-party financing is involved, multiple additional documents must often be completed, such as business plans, projections, and others. Many third-party lenders also require that an escrow agent conduct the closing.
  • Lease Assignment: If the landlord must approve a transfer of the lease, I recommend contacting the landlord as early in the process as possible to eliminate potential surprises.

Escrow and the Closing Process

An escrow agent is a third party charged with the responsibility of holding all monies and papers until all conditions of the escrow are observed. 

Multiple adjustments and prorations must often be made to various bills at the closing to account for timing differences between when bills are paid and when a change of possession occurs. For example, lease payments, utilities, property taxes, and accounts receivables may all be impacted due to their billing cycles. Escrow can assist in making these closing adjustments and prorations.

Escrow is often required if bank or other third-party financing is involved. Escrow serves several important functions in the sale of a business. The primary duties of the escrow agent include:

• Ensuring clear title of assets is transferred at closing by performing UCC and other searches
• Filing a notice to creditors, which is required in a minority of states
• Prorating expenses, such as property taxes and other expenses
• Acting as a third-party clearinghouse for payment of liens, debts, or other bills
• Holding and releasing funds

Days Before the Closing

You and the buyer should do the following several days before the closing:

• Final Inventory Count: If your business has a substantial amount of inventory, an inventory count should be performed on the day before closing by both you and the buyer, or by an inventory-valuation service. You may liquidate or dispose of any obsolete inventory if you obtain the buyer’s approval. 
• Final Walk-Through: You and the buyer should perform a final walk-through of the business to ensure there are no surprises at closing.
• Transfer Funds to Escrow: There are often delays with wire transfers, which can impede a sale if a wire is made on the day of closing. To prevent problems, I suggest the buyer wire the money to escrow at least three days before closing. The buyer should check with their bank beforehand to ensure no daily wire transfer limits exist since banks sometimes maintain restrictions on the amount of wire transfers that can be made per day. Cashier’s checks usually aren’t accepted by most escrow companies due to numerous recent fraudulent issues. If the parties aren’t using escrow, the buyer can wire funds the day before or the day of closing.

Signing and the Official Closing

Here are some common questions about the closing:

How are most closings handled? 

The parties may conduct the closing virtually or meet around a table on the closing date. Most closings today occur virtually. In this situation, the closing documents are often mailed to the parties via courier for signatures and then sent back to the escrow agent for release on the closing date, or the documents are signed electronically. A virtual closing is uneventful for most and is becoming more common with advancements in technology.

Who needs to sign? 

All owners don’t need to sign the purchase agreement and all exhibits and schedules, but they should sign a consent authorizing the “signer” to sign on their behalf. If the business is solely owned by a married person and is in a state or jurisdiction that follows community property laws, both spouses should sign all closing documents. 

Are hard copies required? 

The Uniform Commercial Code (UCC) used to require that a security agreement be in writing and signed, which was usually interpreted to mean that a hard copy was involved. Now, the UCC merely requires the security agreement to be a “record,” which is interpreted to allow electronic documents. However, individual county clerks or secretaries of state offices may maintain the traditional hard-copy requirement. It’s important to confirm in advance with lenders, escrow agents, and other parties to the closing if hard copies are required or if a secure electronic signature is acceptable.

When does the actual closing occur? 

The purchase agreement represents the parties’ binding commitment to the sale. Closing occurs when the sale takes effect, or in other words, when the business transfers ownership from the seller to the buyer. This happens when these two actions take place:

1. The seller and buyer sign the bill of sale – in the case of an asset sale, or the stock certificates – in the case of a stock sale. 
2. The buyer wires or transfers payment to the seller. 

Only when both have occurred can the sale be said to have officially closed. If payment and the signing of the bill of sale occur on different days, the sale will close on the day of the later action.

When does the actual transfer of possession occur? 

In an asset sale, the signing of the bill of sale by both parties, not the bill’s delivery, constitutes the passing of the title. When the bill of sale is signed, the parties have, by mutual consent, transferred ownership, even if the bill of sale is not yet delivered or handed over to one of the parties. 

How are vehicles transferred? 

The parties should include any vehicles and titled property in the asset list, which will be attached to the purchase agreement. When the parties sign the bill of sale, legal ownership of all property in the asset list – including any vehicles listed – transfers from you to the buyer. It’s important to note that while the buyer gains legal ownership of the vehicle at the moment of signing the bill of sale, the parties must still arrange for the registration of the transfer with the DMV, which may happen days or weeks later. In certain instances, the law may provide that if the sale hasn’t been registered, third parties can continue to treat you as the owner with respect to the vehicle. In this regard, the purchase agreement’s “beneficial ownership clause” addresses this situation. According to this clause, if for any reason third parties continue to treat you as the owner, you must give any resulting benefit to the buyer.

Which documents are signed at closing?

The following documents must be signed before or at the closing:

• Purchase Agreement: The purchase agreement can be signed before closing or at closing. The purchase agreement and schedules become effective and binding when signed, but the business’s legal ownership will transfer only upon signing of the bill of sale – if the sale is structured as an asset sale, or upon signing the stock certificates – if the sale is structured as a stock sale. 
• Schedules: These are signed at the same time as the purchase agreement. The purchase agreement and schedules become effective and binding when signed, but the business’s legal ownership will transfer only upon the signing of the bill of sale. 
• Exhibits or Bill of Sale: The bill of sale and assignment of the lease, if applicable, are attached to the purchase agreement and signed only at closing. Legal ownership and possession of the business transfer to the buyer only when the bill of sale is signed. Typically, you will sign the bill of sale only after the buyer has transmitted payment as agreed upon, and if any contingencies have been fulfilled or waived to the parties’ satisfaction. You remain the owner of your business and are entirely responsible for the company until the closing. 

Immediately After Signing

You and the buyer should do the following immediately after the closing:

• Provide a Client List: You should provide the buyer with a list of your customers or clients and assist with the transition of these relationships.
• Inform Employees: You and the buyer should meet to inform employees regarding the change in ownership, if they haven’t already been informed. The meeting should be positive, upbeat, and reassure all employees of their futures. The guidelines for telling employees vary widely and largely revolve around the dynamics of your relationship with employees. I recommend that the buyer present a solid and persuasive vision of the company moving forward and ensure employees of their continued employment. 

After Closing

You should transfer the following after the closing:

• Key Assets: At closing, you should provide the buyer with these important items:
  • Computer access codes, safe combinations, and alarm codes
  • Keys to file cabinets, premises, and vehicles 
  • Owner’s manuals, instruction manuals, and information on any warranties
• Equipment Leases: Any equipment leases that are to be assumed must be properly transferred from you to the buyer.
• Any Third-Party Contracts: These include advertising contracts, equipment leases, and others.
• Key Customers and Other Relationships: You and the buyer should jointly meet with all important relationships following the closing and assure them that the transition will be a smooth, seamless process.
• Telephone Service: An arrangement should be made to transfer telephone services at the closing.
• Utilities: The parties should contact the utility providers to transfer the utilities to the buyer.
• Vendor and Supplier Accounts: You and the buyer should contact all vendors and suppliers after the closing to notify them of the ownership change.
• Websites, Domain Names, Phone Numbers, and Other Assets: You and the buyer should work together to transfer all technology to the buyer.
• Uniform Commercial Code (UCC) Financing Statement: You should file a notice or a lien with the appropriate filing office if there is a seller note.

Months After the Closing

You and the buyer should address the following in the months following the closing:

• Allocation of Purchase Price: The parties must file IRS Form 8594 at the end of the tax year. 
• IRS Checklist: You should contact your accountant to assist in closing your entity sometime after the sale.

Conclusion

Selling a company sends emotional shockwaves through many business owners, ranking right up there with stressors such as the death of a loved one, divorce, and going to jail. Okay, well, maybe not jail.

But the reality is that most entrepreneurs are lifelong “go-getters” who feel empty when there’s nothing more to “get.” To say, “I will be retired” isn’t enough for these business owners. As a wanna-be ex-owner, you’ll likely need to direct your energy toward a new passion. After all, grandkids don’t stay little and cute forever. 

The trick, of course, is to keep anxiety and stress to a minimum before and after the sale. You don’t necessarily need to have a detailed Plan B in place before you sell your business. But you should at least address the question of what you hope to be doing in 5 years, 10 years, and beyond.

And then there’s the sales process itself. As you’ve seen, it can be complex and time-consuming.

But if you’ve made it this far, to the doorstep of the closing, congratulations – the end is in sight. By following the suggestions in this chapter – including maintaining a good relationship with the buyer, keeping the agreements simple, and doing the necessary prep work – you’ll be cashing in or out with confidence and peace of mind.

When selling your business, it’s important to prepare emotionally for the closing. This life-changing period may produce feelings of anxiety beyond the expected stress you anticipate from the sales process. 

You’ve heard of buyer’s remorse – that feeling of regret after making a purchase – and have maybe even experienced it. It only stands to reason that seller’s remorse is a thing, too.

Some business owners become stressed before the closing as the personal implications of the sale of their business start to sink in. They often delay the sale or even back out entirely. This may be due to anxiety at the thought of having to make major life changes after devoting so much time to their business.

After being business owners for years, many entrepreneurs are initially relieved to retire. They may have dreams of traveling, spending time with grandchildren, fishing, reading, taking up a new hobby, and every other kind of cliché retirement activity you can imagine. And, in theory, this is a great plan. You’ve worked hard all your life – now it’s time to slow down and relax.

However, a year or less into retirement, most entrepreneurs end up looking for something else to do with their time. Many sellers even return with a desire to play a role in their former business, which can present an ideal opportunity for the buyer, who can tap into your previous expertise in the business. 

As the seller, your emotional needs are often just as important as your financial needs. Keep this in mind during the transaction. You may experience periods of last-minute anxiety. Addressing these needs helps ensure a smoother sale and often garners more cooperation from the buyer, both during the transition and after.

I can’t write prescriptions for Valium, but I can offer sound and drug-free advice on how to deal with the anxieties associated with selling your business.

A year or less into retirement, most entrepreneurs end up looking for something else to do with their time. 

Find a New Passion

As we discuss the details of finalizing the sale, I’ve had many clients ask, “Now, what?” When the sale is complete, and they’re officially “retired,” they set off to do all the glorious things they imagined. The hitch is that most won’t spend the rest of their lives traveling or playing with the grandkids.

Most entrepreneurs are go-getters. They need something to do with their time, be it a hobby, a new job, a role in a charitable organization, or something that will give them a sense of purpose. Once they sell their business, some entrepreneurs find that what they once thought would be their dream of retirement turns out to be the very thing they resent. 

Luckily, there are ways to calm your nerves when selling your business. You must realize that what happens after you sell your business needs to be planned just as much as the sale itself. You wouldn’t sell your house without knowing where you’d be moving next. The same principle applies here – why would you sell your business without having a detailed plan about what you’ll do next? Answering “I will be retired” isn’t enough. As a driven entrepreneur, you will likely find that you need to direct your energy toward a new passion.

If you’re preparing to sell your business and aren’t sure what you’ll do next, or if you plan to just retire, I challenge you to spend some time answering this question: “What do I want to accomplish over the next 5, 10, or 15 years?”

The more detailed your plan, the better. Writing down your short-term goals, such as traveling or visiting family, as well as your long-term goals, like learning a new language or starting a not-for-profit undertaking, will help you feel less overwhelmed by the potential loss in meaning a sale may represent for you as you get closer to closing day. You can even gather information now about the different things you’d like to accomplish once you do sell your business. You’ll find that a little preparation now will save you stress and anxiety about your future as you navigate the complex process of selling your business.

Aligning the Seller’s and Buyer’s Interests

The sale or purchase of a business never goes as smoothly as expected. Problems often remain, even after the closing. It’s best that you and the buyer maintain an excellent working relationship, so you can easily cooperate to solve such issues.

After the sale, your interests and skills may also provide enormous ongoing value to the business, such as in recruiting, sales, marketing, or establishing key alliances. These are often difficult roles to play or positions to fill. As the previous owner, you may be talented at one or more of these functions and may be willing to perform them at a salary below market value if your other needs are met. 

Maybe you’ll consider working in these positions if the role is structured to align with the flexibility you desire in your new lifestyle. The buyer can develop a win-win situation in which they retain valuable talent while you meet your lifestyle needs. Structuring an arrangement like this can also assist in retaining key customers or employees. Key partners will feel more valued if they observe your ongoing participation in the business.

Carefully considering your next move and emotionally preparing yourself will help set you up for the final steps – the closing.

“Are we there yet?”

– Anonymous Six-Year-Old

On the closing date, you and the buyer may physically meet around a table, where the buyer delivers the final payment, and you sign and deliver the closing documents. Alternatively, you may sign the documents electronically or via FedEx. These days, most closings are virtual, where documents are signed and sent electronically or via next-day delivery. 

Here I’ll explain how the process unfolds.

If a Representation or Warranty Is Breached or Inaccurate

The indemnification section requires the parties to indemnify one another for breaches of representations, warranties and covenants, and other types of claims that may arise after the closing, such as those related to tax, environmental, or employee issues. The indemnification clause, which is sometimes called a “hold harmless” clause, functions similarly to an insurance policy and requires the breaching party to reimburse the other party for all expenses resulting from a breach. 

The value of the indemnification depends on the financial strength and creditworthiness of the party providing the indemnification. In most M&A transactions, 10% to 20% of the purchase price is withheld by a third party in an escrow account to fulfill any post-closing indemnification obligations, which mitigates the risk of the seller sailing off to the Bahamas.

The indemnification section of the purchase agreement addresses what will happen if a representation or warranty is breached. In most cases, an indemnity offers a party the right to recover losses and legal expenses. Indemnification is a hotly negotiated component of the purchase agreement.

Indemnification rights are much more specific than the general legal rights included in most contracts. The indemnification provisions include specific rules governing the level of involvement the parties may have in defending suits or other claims, and other options that are rarely afforded to the parties under other general legal rights in most purchase agreements. 

The indemnification is normally subject to limitations such as the minimum thresholds that must be triggered (i.e., the basket) and the maximum limit of indemnification (i.e., the cap). Indemnification can also be limited by knowledge qualifiers, materiality qualifiers, and survival periods. These collectively serve to limit your exposure level and further serve to allocate risk between the parties beyond the specific language provided in each individual representation. 

Reps and warranties work similarly to an insurance policy. There are exclusions or events that the policy doesn’t cover. There’s also a deductible, or basket, and a maximum payout amount, or cap. Your goal is to limit your exposure by doing the following:

• Tighten the Language:
  • Limit the language of each representation individually.
  • Limit “joint and several” liability.
  • Add knowledge qualifiers such as “to the best of Seller’s knowledge.”
  • Limit the indemnification to actual losses, as opposed to other types of damages, such as punitive or speculative damages.
• Reduce Financial Exposure – Money:
  • Increase the basket or deductible that must be met before a claim is paid.
  • Reduce the maximum payout through a cap. 
  • Reduce the amount of the escrow.
• Limit the Length of Exposure – Time:
  • Decrease the survival period.
  • Reduce the length of the escrow.
• Other:
  • Require the buyer to self-insure against certain risks.

The specifics of how a dispute is handled are addressed in the purchase agreement, usually in a section called “Disputes.” For example, the agreement may require arbitration, or it may require litigation. In some cases, a breach of reps and warranties may be handled differently than any other breach. One of the most common disputes concerns errors in financial statements. Any representations made regarding the condition or accuracy of your financial statements should be carefully reviewed by your CPA. Examples of potential disputes include:

• Inaccurate financial statements 
• Violations of post-closing covenants, such as non-competes or non-disclosure agreements
• Tax claims
• Loss of key employees
• Loss of key customers
• Working capital calculations
• Undisclosed pending litigation
• Undisclosed material liabilities, such as unpaid bills 
• Undocumented employees

The buyer also normally agrees to indemnify you. Common areas include the buyer’s covenant, or promise, to offer employment and certain benefits to your key people. The buyer may also indemnify you regarding environmental liabilities or accounts payable.

The following remedies are available to the buyer of a mid-sized business: 

• Holdback: The primary method involves holding back 10% to 20% of the purchase price. This is when a portion of the purchase price is held in escrow for a period after closing for the sole purpose of being made available to the buyer in the event of a breach of a representation or warranty. Most holdbacks range from 6 to 18 months. 
• Right of Setoff: Alternatively, some parties use a right of setoff against any future payments, such as an earnout or a promissory note. In some states, there’s a statutory right of offset for specific claims. 
• Litigation: Finally, the parties may litigate. 

Nothing in M&A is simple – the parties can negotiate varying baskets and caps for different types of losses, so it’s wise to hire an experienced M&A attorney to review your exposure. Note that losses occurring because of fraud may not be subject to a basket or cap.

When a problem arises after the closing, the parties look to the “Indemnification” and “General” sections of the purchase agreement to determine how the dispute will be handled.

The Indemnification section usually addresses the following questions:

• Parties: Who exactly is providing the indemnification? Is the indemnification solely limited to one shareholder or are all shareholders indemnifying the buyer? If multiple shareholders are indemnifying the buyer, are they jointly and severally responsible? Is the buyer also indemnifying you?
• Scope: What specifically does the indemnification cover? What’s the scope of the indemnification? Most typically cover breaches of reps and warranties, breaches of covenants, non-compliance with laws, liabilities arising from the assets, and the like. Is the indemnification limited to the four corners of the agreement, or are ancillary documents – such as those provided to the buyer during due diligence – subject to indemnification? The precise scope of the indemnification is often subject to intense negotiation. Some agreements also contain separate remedies that aren’t covered by the indemnification section in the purchase agreement. This could include a non-compete agreement, for example, and those agreements will be governed by the provisions outlined within the agreement.
• Remedies: Is the indemnification the parties’ exclusive remedy, or are other remedies available to the parties?
• Survival: How long will the representations, warranties, covenants, and other obligations in the agreement remain in place?
• Limitations: What are the financial limits, such as baskets and caps, of the indemnification obligations?
• Escrow: Will a portion of the purchase price be held in escrow? If so, how much, for how long, and what are the terms of the escrow?
• Right of Offset: Does the buyer have a right of offset against the promissory note, consulting agreement, or other obligations?
• Indemnification Process: How are indemnification claims handled? What role does the indemnifying party have in the role of the defense of the claim?

The indemnification clause should also address the following questions:

• What recovery is available to the party in the event of a breach?
• What’s the process for resolving a dispute? Most agreements require an initial complaint in writing. If the parties can’t resolve the issue, the agreement determines how the parties must resolve the dispute.
• What are the procedural aspects of indemnity claims?
• What are the rights of the parties to take part in any legal proceedings?
• What notice requirements exist?
• Who controls the defense of a claim from third parties?
• How will a party collect on an indemnification claim? Is collection limited to the amount in escrow?
• What rights do both parties have to access information?
• What rights of subrogation do the parties have?
• How do insurance proceeds affect the parties’ indemnification obligations?
• Does a failure to act on a breach constitute a waiver?
• How do the parties choose counsel to defend a claim? Who has control over the defense and the fees?

The General Provisions section of the purchase agreement usually addresses the following:

• Dispute Related
  • Jurisdiction: Addresses dispute resolution options, such as litigation, arbitration, mediation, jury trials and forum, selection of mediators or arbitrators, rules for mediation or arbitration, who pays expenses, remedies, and to what extent the decision is final.
  • Enforcement: This may provide the parties additional remedies, such as specific performance or injunctive relief.
  • Waiver: May state that rights are cumulative, and a failure to exercise a right doesn’t constitute a waiver.
  • Governing Law: Specifies which state’s law governs the agreement. 
• Non-Dispute Related
  • Expenses: How are transaction-related expenses allocated between the parties?
  • Notices: Who are notices sent to, and when are they deemed received?
  • Entire Agreement: This clause usually states that the purchase agreement constitutes the entire agreement and supersedes all previous written or oral agreements. 
  • Severability: Severability states that if any provision is determined to be invalid by a court, the remaining provisions will remain in effect. 
  • Assignment: This prohibits the purchase agreement from being assigned to third parties and provides that the agreement doesn’t create any rights for third parties.
  • Time of Essence: A clause explicitly stating that time is of the essence, which enables the parties to enforce deadlines, such as drop-dead and other dates.
  • Execution: The agreement can be executed in counterparts or electronically. 

Notice that there’s some overlap between the indemnification provisions and the general provisions in the purchase agreement. In some purchase agreements, these sections may be combined. Other times, they remain separate. This underscores the need for you and the buyer to hire experienced attorneys to represent you and the need to rely on their guidance in negotiating the terms of the reps and warranties, related indemnification, and other clauses that govern how disputes will be handled.

Tips for Negotiating Indemnification

Custom-Tailor the Language: The indemnification language should be custom-tailored to the unique characteristics and circumstances of your business and the specific risks identified during due diligence. The relationship between time and dollar limits should also be taken into consideration. Businesses in certain industries may be better served by higher dollar limits and shorter time limits, and vice versa. 

Limit Who Provides Indemnification: It’s important to consider who, specifically, is providing the indemnification. If there are multiple shareholders of your company, will all shareholders indemnify the buyer, or only the majority shareholders? Or will your entity indemnify the buyer? In most cases, the majority selling shareholders are required to personally indemnify the buyer. To be obligated under the indemnification clause, a selling shareholder must sign the purchase agreement directly or through a “joinder.” This is often the case because your entity normally ceases to exist after the closing date. If it does exist, the proceeds from the sale are usually distributed to the shareholders, and your entity is left with few assets to fund a potential indemnification claim. It’s difficult for the buyer to have to chase down multiple shareholders, which is why escrows are so prevalent. If there are multiple selling shareholders, they should also attempt to limit their liability to “several” (separate) liability, as opposed to “joint and several” liability.

Conclusion

American baseball legend Yogi Berra coined the phrase, “It ain’t over till it’s over.” To which I would add, “But even then, it may not be over.” That’s certainly the case with reps and warranties, one of the few elements of a purchase agreement that survive the closing and which can come back to bite you if you’re not careful.

The antidote? Be careful. Pay attention.

As a seller, it’s wise to meticulously read the representations before you sign them. Don’t assume anything is boilerplate language. In fact, a breach of a rep or warranty – unwitting or not – can kill a deal at worst or lighten your bank account in less extreme circumstances. Obviously, neither outcome is desirable. 

The information in this chapter will help you avoid the snafus that can arise from a lack of preparation when it comes to dealing with reps and warranties – one of the most important and often overlooked aspects of a deal.

Let’s switch gears for a moment. The scene is like a living, breathing postcard from paradise – clear skies, white-sand beaches, warm ocean breezes. And look! There’s you – tanned and rested, a John Grisham legal thriller in one hand and a pina colada in the other.

In one sense, it took a lifetime to get here. You spent decades building your company and a grueling 12 months to get it sold. But you did it, and now you’re reaping the rewards. You’ve heard about former life-long business owners who found it impossible to relax after successfully exiting the fray. But that’s not you. There are going to be plenty more postcards like this one. Life is good.

But then the phone rings, and life is about to get a little less good. It seems there’s a problem with your former company’s financial statements. The buyer of your business discovered that the numbers aren’t compliant with generally accepted accounting principles (GAAP), and as a result, EBITDA was overstated. It’s not a big deal, you think – your deal closed six months ago, and it’s the buyer’s problem now. The buyer is demanding a reduction in the $2 million purchase price. But, hey, the deal is already closed!

You call your attorney in a fit of fury. Your attorney asks if you remember signing a representation or warranty stating that your financials were prepared in accordance with GAAP. Your response: “What’s a representation or warranty?”

Welcome to the world of reps and warranties, where in extreme instances, a misrepresentation – inadvertent or otherwise – about the company you’re selling could put the kibosh on the deal or a major drain on your bank account. Let the headaches and lawsuits commence.

Reps and warranties typically make up the bulk of the content in a purchase agreement and are one of the most hotly negotiated components of the transaction. That’s why I’ve devoted more than half of this chapter to the topic here, and that’s why you should pay attention.

Reps and warranties typically make up the bulk of the content in a purchase agreement and are one of the most hotly negotiated components.

The Basics 

Reps and warranties are legal promises made by both you and the buyer. Reps and warranties are a foundational component of any purchase agreement, whether a stock purchase agreement or an asset purchase agreement. 

Reps and warranties survive the closing and serve as the buyer’s basis for future lawsuits under the “Indemnification” clause. Reps and warranties typically comprise most of the content in a purchase agreement and are heavily negotiated components, along with the price and terms. Reps and warranties serve to allocate the risk between you and the buyer and are one of the last major negotiations to take place before the closing can occur.

Definition: A representation is technically the statement of a fact, such as “The corporation is duly authorized …”, and a warranty is a promise that a fact will remain true, as in “The Seller warrants that the business has operated in compliance with all laws … .” However, this distinction has proven unimportant in recent years. Reps and warranties are not listed separately in the purchase agreement but are rather grouped together in one section called “Representations and Warranties.” 

For example, most agreements state, “The Seller represents and warrants that … .”

With minor exceptions, the other elements of the purchase agreement, such as price, terms, conditions, and covenants, have no further implications after the closing has taken place. On the other hand, the reps and warranties and related indemnification clauses “survive” the closing and can have implications for both parties for years thereafter. As a result, the reps and warranties are often heavily negotiated, especially when you wish to retire and avoid any lingering obligations that may conflict with your peace of mind. Most entrepreneurs want to sell their business so they can fully let go. If you’re meticulous in negotiating the reps and warranties, you’ll be able to do just that; otherwise the potential liability that can linger from poorly drafted representations can come back to haunt you during what should be the most relaxing stage of your life.

Most reps and warranties are worded similarly from deal to deal, and exclusions are then documented in the disclosure schedules for your business based on the following factors:

• Size of your business
• Complexity and type of business
• Structure of the transaction – asset, stock deal, or merger
• Specific risks that may be present in your business 

In practice, this means that the buyer’s attorney usually prepares the purchase agreement, which includes a standard list of reps and warranties, and your attorney is then obligated to list any exceptions in the disclosure schedules.

For example, a manufacturing company may have more representations concerning environmental and employee concerns, such as unions and benefits, while a technology company may have more representations regarding intellectual property.

Reps and warranties may address any of the following topics, as well as others not mentioned here: 

• Corporate authority
• Investment banker fees 
• Insurance 
• Compliance with laws 
• Employee benefits
• Product liability and warranties 
• Material contracts 
• Capitalization 
• Intellectual property 
• Title to assets
• Taxes
• Real property
• Personal property 
• Financial statements
• Inventory
• Customer agreements 
• Environmental issues

The Importance of Reps and Warranties

Many sellers think they can run off into the sunset after closing, free of all future obligations related to the sale of their business once the check clears. Not true. 

Reps and warranties are one of a few protections that are instituted in most transactions to protect the buyer from material misrepresentations or fraud. These protections include:

• Reps and warranties
• Indemnification
• Escrows or holdbacks

The reps and warranties that are signed in the purchase agreement survive the closing when you sell your business. In most purchase agreements, you indemnify the buyer, and a breach of a representation would be subject to indemnification. 

In other words, if a statement you make later proves to be untrue, the buyer may offset a portion of the purchase price via a setoff, withhold funds from escrow, or sue you to make themselves whole again. 

For example, if you claim your equipment is in operable condition and the buyer later proves this to be untrue, the buyer can seek damages from you, even after the closing. 

You’ll remain liable for a significant period after the closing if any of the reps or warranties are breached or found to be inaccurate. The time period ranges from 12 to 24 months, although in some cases it can be indefinite. For this reason, a significant amount of time is spent negotiating the reps and warranties. 

If a statement you make later proves to be untrue, the buyer may offset a portion of the purchase price, withhold funds from escrow, or sue you to make themselves whole again. 

Reps and Warranties Can Speed Up Due Diligence

Due diligence can expose problems in your business that will subsequently be addressed through drafting tighter representations based on what was uncovered during the process. However, due diligence is unlikely to reveal every problem concerning your business. 

In other words, reps and warranties are drafted to protect the buyer from what they may have missed during due diligence and what a seller may have intentionally withheld or simply forgot to disclose. The buyer’s decision to acquire the business is based on a combination of the due diligence they performed and the extent of the protections afforded to them through the reps and warranties.

Purposes

Reps and warranties serve many purposes within a transaction. Following is a detailed explanation of their primary objectives.

Encourage Full Disclosure

Representations are engineered to compel you to provide full disclosure to the buyer – in other words, they force you to disclose material issues regarding your business. 

Allocate Risk

They also serve as a mechanism for allocating risk between the parties for events that are uncovered after the closing. 

For example, if a customer sues the business for an event that happened prior to closing, the reps and warranties would serve to allocate the risk of such events between the buyer and you. The reps and warranties would define who would be responsible for such an event, for how long, and to what extent.

Unknown risks are inherent in any business, and the reps and warranties seek to allocate both known and unknown risks between the parties. In a buyers’ market, the role of reps and warranties in risk allocation strongly favors buyers, and vice versa in a sellers’ market. Reps and warranties also serve as a condition to closing – if the reps and warranties aren’t true as of the closing date, the buyer may refuse to close. 

Flush Out Material Facts During Due Diligence

The representations serve as a method for encouraging disclosure of material facts during due diligence. Without reps and warranties, buyers would need to verify every statement you make. This would make for an inefficient process, and the cost of completing an acquisition would skyrocket. As a result, purchase prices would decline to offset the increased risk and higher professional fees would be required to perform more thorough due diligence.

How do buyers use reps and warranties to flush out the facts? It’s simple – the buyer includes a set of comprehensive reps and warranties, then uses your response as a device for ferreting out areas of concern. 

For example, the buyer may ask you to represent that your financial statements were prepared in accordance with GAAP. If you know this to be untrue, you’ll refuse to sign such a representation, and your attorney will either strike or heavily modify the clause. Your response will signal to the buyer that they need to perform more thorough financial due diligence. This may lengthen the due diligence period for selling your business and possibly result in a purchase price reduction if the buyer finds there are significant deviations from GAAP.

Buyers often include a set of comprehensive reps and warranties, then use your response as a device for ferreting out areas of concern. 

Function as Termination Rights or Closing Conditions

You may warrant that your business will operate in the normal course of events until the closing. If you decide to liquidate any assets, terminate any contracts, revise your product warranty, or make other material changes to your business outside the ordinary course of events, the buyer may have the right to terminate the transaction before the closing. Note that this may serve a similar purpose to pre-closing covenants if the purchase agreement is signed prior to the closing.

Encourage Precise Language

The language used to draft the reps and warranties plays a critical role in allocating risk between the parties. If, for example, you warrant that all your equipment is in good repair, you’ll bear more risk than if you simply warrant that “all equipment is operational to the Seller’s knowledge.” The phrase “all equipment is in good repair” is an absolute statement and is more restrictive than “all equipment is operational to Seller’s knowledge,” which includes a modifier (i.e., to Seller’s knowledge). 

Seller’s vs. Buyer’s Representations

The purchase agreement contains significantly more representations concerning you because the buyer has much more to lose than you do. You’re primarily concerned about receiving payment – therefore, the buyer’s representations are primarily about access to capital and authority to complete the acquisition. 

On the other hand, the buyer is concerned about dozens of aspects of the business and its operations. Here’s a list of sample representations you might be asked to make. Note that these should be subject to a knowledge qualifier, such as “to the best of seller’s knowledge”:

• You aren’t delinquent regarding the payment of taxes.
• There are no judgments, claims, liens, or proceedings against you or your business.
• The information you’ve given the buyer, including financial information, is accurate.
• Your corporation is in good standing and has the authority to enter the transaction.
• The assets being sold constitute all the assets of the business, are in good repair, and are free and clear from liens, encumbrances, pledges, or claims.
• You’re in compliance with all laws, including licensing, permits, zoning, environmental regulations, and more.
• The inventory is sufficient, unused, and salable.
• You aren’t in default on any obligations or contracts.
• There are no hazardous substances used in the business.
• All accounts receivable are bona fide, have arisen in the ordinary course of business, and are not subject to offset.
• There are no undisclosed liabilities, legal proceedings, orders, or judgments.
• There are no undisclosed employment, consulting, bonus, or other agreements with employees or any third parties.
• You’ve disclosed all material facts that would affect the buyer’s decision to purchase the business.

Covered Parties

Normally, the buyer seeks to obtain protection from as many parties as possible in the purchase agreement, such as all shareholders, key managers, and others. They’ll also seek protection that’s as broad as possible, such as requiring you to represent that all information you’ve provided is accurate. When attempting to expand the scope to third parties, negotiations may become contentious as a breach can have major financial implications for such a party. 

The Process of Negotiating Reps and Warranties

Negotiating the reps and warranties can occur throughout the process of due diligence until the closing, in conjunction with negotiating the purchase agreement. Here’s a detailed description of the process of when and how the reps and warranties are customarily negotiated.

The Letter of Intent

Unfortunately, the full reps and warranties are only documented in the purchase agreement, not the LOI. As a result, you won’t have the opportunity to see the reps and warranties that a buyer may be proposing in the LOI. But you can counter this by asking the buyer to mark up a draft purchase agreement when evaluating a buyer’s LOI. However, this is customarily only done in larger transactions. The breadth and depth of the reps and warranties are also based on facts discovered during due diligence, and their substance may change based on what the buyer uncovers during the course of due diligence. 

As a result, the reps and warranties aren’t drafted until much later in the process. In effect, this results in two stages of negotiations – once when the LOI is hammered out, and again when the purchase agreement is negotiated. This is why reps and warranties are so hotly negotiated – the parties have already struck a deal, but now they must negotiate a second time.

The Purchase Agreement

In most transactions, the buyer’s attorney prepares the purchase agreement, and your counsel responds by marking up the agreement. When drafting the reps and warranties, the buyer’s attorney normally focuses on the likelihood and amount of potential exposure. 

The scope of negotiations is based on the first draft of the purchase agreement from the buyer’s attorney, taking into consideration how aggressive their initial draft is and the bargaining positions of each party. That’s why buyers aim for a long exclusivity period – to reduce your bargaining power later in the process when the purchase agreement and reps and warranties are being negotiated. 

Consider a scenario in which you take your business off the market before the sale is complete. You’ll have spent tens of thousands of dollars conducting due diligence through fees paid to attorneys and accountants, made a significant emotional investment in your transaction, and put all other potential buyers on hold for several months. As a consequence, you’ll be in a weaker negotiating position, and the buyer may be able to negotiate much more stringent terms in the purchase agreement.

You should carefully read through the representations and not blindly sign them as if they were boilerplate – they’re not. If you’re not 100% certain regarding a representation, that representation should contain a knowledge qualifier, such as “to the best of the Seller’s knowledge” or “to Seller’s knowledge.” At the same time, exclusions can be documented in the disclosure schedules. 

But, remember that the purchase agreement is essentially a tool for allocating risk. Even though you may not have knowledge of something, you may still be asked to make a representation regarding that fact, which in essence is transferring the risk to you, despite your lack of knowledge.

Breaching a rep or warranty can have disastrous effects on either party and shouldn’t be taken lightly. 

You can minimize the potential scope of reps and warranties by:

• Hiring an experienced negotiator, such as an investment banker or M&A advisor, to manage negotiations.
• Holding an auction to improve your negotiating posture – the more buyers you’re negotiating with, the stronger your position will be.
• Doing pre-sale due diligence to identify and address problems before beginning the sales process. 
• Conducting yourself in a trustworthy manner at all times. Always be on time, always do what you say you will do, maintain your composure during negotiations, make conservative estimates, and perform other trustworthy actions.

If you operate a simple business, the reps and warranties likely won’t be extensive in scope. However, if you own a risky or complicated business, you can expect the buyer to demand far more stringent reps and warranties. 

For example, if your business handles hazardous materials, the buyer will request stringent representations addressing potential environmental concerns, workers’ compensation claims from the workers handling the hazardous materials, and a lot more. 

The scope of negotiations is based on the first draft of the purchase agreement from the buyer’s attorney, considering how aggressive it is and the bargaining positions of each party.

Tips for Negotiating Reps and Warranties

Here are some tips for negotiating reps and warranties:

Past Events Only: Representations should primarily cover past events. They aren’t designed to provide the buyer with assurance regarding the future. Operating a business involves numerous risks, so the buyer should assume normal business risks and not attempt to mitigate future risks that occur in the ordinary course of business. 

Analyze Indemnity Provisions: Use a chart to analyze indemnification provisions. These provisions can be complex, and it’s best to separate the legal language from the economic parameters. Extract the economic parameters of the provision and map it out on a spreadsheet like the one below. This helps organize and analyze the terms of indemnification and facilitates making tradeoffs. 

Beware of Financial Representations: Be careful when making a financial representation, such as: “Purchase Price is based on EBITDA for the most current year of $5.2 million … continued to a separate representation … and the financial statements have been prepared in accordance with Generally Accepted Accounting Principles.” This is a potential landmine and is tantamount to giving the buyer a blank check. If your financial statements aren’t prepared in accordance with GAAP – and most aren’t, you’ve essentially given the buyer carte blanche to later negotiate the purchase price. Before signing representations concerning accounting or financial matters, have a CPA review them to ensure they’re accurate. 

Reducing Exposure

Here are some ways you can reduce your potential exposure to the reps and warranties:

• Reps and Warranties Insurance: Insurance is available to minimize the potential liability of breaches. The price is normally 4% to 8% of the coverage amount – not the purchase price – and depends on the scope of the reps and warranties, the industry your business operates in, the deductible, and the term of the coverage. For a $50 million transaction, with a 10% cap ($5 million cap), this would equate to a one-time premium of $200,000 to $400,000. This type of insurance has become commonplace in private middle-market M&A transactions but doesn’t cover fraud or gross negligence. This is a wise investment for any middle-market business owner who plans on retiring and would like to fully let go after the sale. 
• Knowledge Qualifiers: Limiting the reps and warranties based on your knowledge is an effective strategy for reducing your exposure and can place the burden of proof on the buyer to prove that you did have knowledge of the information. Knowledge qualifiers can also be limited to certain parties. For example, a representation can be limited exclusively to your knowledge, or it could also apply to your management team. You should attempt to limit knowledge solely to your own knowledge, as broadening the scope of liabilities of knowledge to third parties can increase the amount of risk. For more on this, including examples of knowledge qualifiers, see the “Limitations to Reps and Warranties” section below.
• Materiality Qualifiers: Materiality can be addressed either in individual reps and warranties or collectively in the indemnification section. More commonly, materiality is addressed in the indemnification section by the use of baskets and other thresholds. Most agreements specify that only material breaches will be subject to indemnification. The level of materiality is usually defined by providing a specified basket, or deductible. In most transactions, the amount of the basket is 0.50% to 0.75% of the purchase price. For example, in a $10 million transaction, a claim must exceed $50,000 to $75,000 before it’s subject to an indemnification claim.
• Survival Periods: Reps and warranties are almost always limited to a specified time period, also called a survival period. Survival periods may differ depending on the type of representation being made. For example, reps and warranties regarding tax and environmental concerns may be for longer periods or may even be perpetual, with no time limit, in certain cases. Nonetheless, survival periods can also serve to limit your level of exposure.
• Right of Offset: Indemnification claims can also be offset by unpaid amounts of the purchase price. For example, indemnification claims could be subtracted from the outstanding balance of a seller note.
• Insurance: You can insure against any risks that are potentially insurable by purchasing tail coverage for your existing insurance policies, in addition to reps and warranties insurance. You can also maintain your existing policies if the policies are made on a claims basis vs. an occurrence basis. The indemnification should be net of any insurance reimbursements. You should be sure to request that the insurer waive any subrogation rights they may have if they aren’t the named party in the policy. This prevents the insurer from coming after you in the event of a loss since you aren’t the named policyholder. 
• Indemnification Caps: You can cap your total exposure to breaches of reps and warranties. Caps, or limits, are generally 10% to 20% of the purchase price, but may be higher for specific types of claims, such as environmental claims. 
• Shareholder Liability: The parties to the indemnification can either be your entity or the individual shareholders. In most cases, the selling entity ceases to exist, and the buyer requests that all operating shareholders sign the purchase agreement. A selling shareholder must personally sign the purchase agreement in order to be subject to being required to indemnify the buyer. If multiple shareholders exist, they shouldn’t agree to “joint and several liability.” If joint (together as a whole) and several (individual) liability exists, the shareholders can be held liable either together as a whole (joint) or individually (several).
  • In other words, a 10% minority partner could be potentially liable for the entire amount of the claim. Or a 60% majority partner could be liable for the entire claim, and the 60% partner would then have to chase down the minority partners for reimbursement. If you have multiple partners, you should attempt to limit indemnification on a pro-rata basis where each partner pays their share of the award, as opposed to “joint and several.”

Limitations to Reps and Warranties

Limitations to reps and warranties can be further broken down into the following four categories:

1. Knowledge Qualifiers: These limit reps and warranties based on a definition of your knowledge of the representation or warranty being made.
2. Survival Periods: Reps and warranties expire after a period of time known as a “survival period.”
3. Baskets – Minimums: You aren’t liable for claims until the basket amount is exceeded. This functions similarly to an insurance deductible.
4. Caps – Maximums: You are only liable up to a maximum amount, also called a cap.

Here’s a closer look at each of these categories.

Knowledge Qualifiers

One of the simplest ways to limit the scope of a representation or warranty is through a knowledge qualifier. A knowledge qualifier limits your exposure based on your, or one of your executives’ (e.g., CFO), “knowledge” of a representation. For example, if you state that your accounts receivables are collectible, and the buyer later determines that you loosened your credit policies before the sale, you may be held liable. But the degree to which you’re held liable depends on the parties’ exact definition of “knowledge.”

You may not have knowledge regarding every aspect of your business. This can be especially the case if you’re an absentee owner. This means you may rightfully become nervous if you’re required to make representations regarding aspects of your business of which you may be unaware. For example, an absentee owner may not be aware if all equipment is operational. Therefore, reps and warranties are often limited based on your knowledge.

Sample in-line knowledge qualifiers include:

• “To the best of Seller’s knowledge”
• “To Seller’s actual knowledge”
• “To Seller’s knowledge”

These statements may precede the reps and warranties section in a purchase agreement. For example, “To the best of Seller’s knowledge, the Seller represents and warrants that …”. In this case, the definition of knowledge is included in the statement itself, as opposed to being defined separately in the Definitions section.

The precise definition of knowledge, as defined in the agreement, will have significant implications for both parties. In the absence of any knowledge qualifier, you could be 100% responsible for any reps and warranties in the purchase agreement, regardless of whether you knew it was true or not. Limiting the definition of knowledge can dramatically alter the dynamics and can force the onus on the buyer to prove that you knew your representation was false at the time it was made. It can also significantly limit the buyer’s indemnification rights by shifting unknown risks to the buyer. 

The buyer will attempt to expand the definition of knowledge to include “constructive” knowledge, which includes information that should have been known after reasonable or due inquiry, or that should be known based on your role in your business. For example, a CEO will be presumed to have a different level of knowledge than a CTO or CMO.

Both parties should remember that uncertainty will always be present, regardless of the parties’ desires. Reps and warranties aren’t solely a test of integrity but are primarily a legal mechanism for allocating risk. 

Careful consideration should be given if you’re an absentee owner with little knowledge of your business. In such cases, the definition of knowledge should suit the circumstances, but bear in mind that knowledge qualifiers are also a risk-allocation tool, and you may be required to make representations regarding areas of the business of which you’re not knowledgeable. 

Finally, the agreement should specify to whose knowledge the reps and warranties are subject. Are the reps and warranties based solely on your knowledge, or is the knowledge of your officers and other executives also included in the definition? If third parties are to be included in the definition, you must be willing to bear the risk of depending on the knowledge of those third parties. In some circumstances, officers or key employees are asked to sign a certificate in which they individually certify knowledge of reps and warranties that are applicable to their roles. For example, a CFO may be required to sign a certificate relating to any financial representations.

Reps and warranties aren’t solely a test of integrity but are primarily a legal mechanism for allocating risk. 

Survival

Reps and warranties are also commonly limited in time. Once the time period elapses, you may no longer be held liable to the buyer for a breach, except in certain circumstances, such as an intentional or willful breach or fraud. Most buyers prefer to operate the business for at least a full year or business cycle to identify any potential breaches before the reps and warranties expire. As a result, the average life of representations ranges from 12 to 24 months. 

Survival periods may also differ, depending on the type and nature of the representation. For example:

• Intellectual Property: Can often be as long as 36 months. 
• Environmental: Can be unlimited.
• Tax: Unlimited, or the full period of limitation under local, state, or federal law.
• Employment: ERISA and employment matters can range from two years to unlimited.
• Organizational and Title: Can be unlimited.
• Compliance with Laws: Can be unlimited.

Baskets, or Minimums

Reps and warranties are almost always subject to a basket, or a minimum threshold that must be met before you become liable. This operates similarly to an insurance deductible. You aren’t liable for claims until the basket, or deductible, is exceeded. The basket sets the minimum loss the buyer must bear before you can be held liable. Most M&A transactions include a basket of 0.75% of the purchase price. In a $10 million transaction, a 0.75% basket would be $75,000. You wouldn’t be liable to the buyer until the cumulative amount of the claims exceeds $75,000.

The basket serves several purposes, such as:

• It incentivizes the buyer to bear some of the risk, like an insurance deductible. If the basket, or deductible, were zero, the buyer would have nothing to lose by submitting numerous frivolous claims.
• It acknowledges that no transaction is perfect. With a basket, the parties accept that problems will arise, and they agree to not submit claims until a material threshold is exceeded. This simplifies the transaction by requiring the parties to submit only material claims.
• It improves the efficiency of the transaction by eliminating immaterial claims.
• It encourages the buyer to be more thorough in their due diligence.

Baskets can be tipping or non-tipping:

• Tipping Basket: With a tipping basket, you must reimburse the buyer for 100% of the losses once the basket is exceeded. For example, if the basket is $100,000 and there’s a $101,000 claim, you must reimburse the buyer $101,000.
• Non-Tipping: With a deductible, or non-tipping basket, you only reimburse the buyer for amounts that exceed the basket amount. In the case above, with a $100,000 basket and a $101,000 claim, you would only reimburse the buyer $1,000.

Some agreements require the parties to split losses up to the deductible amount. For example, if there were a $100,000 deductible and a $101,000 loss, the buyer would be required to pay $50,000 and the seller $51,000. This provision requires the buyer to absorb a significant portion of any losses and therefore motivates the buyer to be thorough in their due diligence to mitigate potential losses. This also motivates you to help mitigate smaller losses on behalf of the buyer. This mitigates, to some extent, the motivation of a buyer to “tip” a tipping basket, so they’re reimbursed for the “deductible.”

Buyers will obviously argue for the lowest basket possible, while sellers will seek a higher basket amount. Certain reps and warranties are often not subject to the basket, such as those relating to employees, environmental, organizational, title to assets, or tax issues. The basket may also be voided if you commit a willful breach, or it may be limited based on your knowledge, as it’s defined in the agreement. However, most sellers contest this language since determining “willful” is subjective and subject to costly disputes.

Caps, or Maximums

A cap is the maximum amount of liability you can incur to the buyer. Caps average 10% to 20% of the purchase price of the business for most transactions. Once the cap is exceeded, you’re no longer liable to the buyer for damages, with minor exceptions such as fraud. Caps can be higher, or even unlimited, for the following reps and warranties:

• Intellectual property
• Title to assets
• Employee matters
• Employee benefits, ERISA
• Environmental issues
• Tax issues
• Organizational issues

General Guidelines

Here’s a chart of general guidelines for baskets, caps, and survival periods.

Sample Representations, Warranties, and Covenants

Seller Reps and Warranties

Here’s a general summary, though not a complete list, of typical reps and warranties you may be asked to provide. Note that the majority of the reps and warranties would be subject to a knowledge qualifier, and any exceptions would be listed in the Disclosure Schedules to the purchase agreement:

• Approvals:
  • No approval or notice is required to do the deal, except as scheduled. 
• Assets – Title to Assets, Ownership, Condition, Encumbrances, and Others: 
  • There are no judgments, claims, liens, or proceedings pending against the Seller, the business, or the assets being sold, and none will be pending at closing, except as disclosed to the bank or permitted pursuant to the loan agreement.
  • The entity being sold owns all the assets needed to operate the entity’s business. At closing, the assets will be free from any claims of others.
  • The business and financial information Seller has given the Buyer is accurate.
  • Tangible assets are in good working order, ordinary wear and tear excluded, except as scheduled. 
• Authority:
  • Seller is in good standing and duly organized and qualified in their legal jurisdiction to conduct business. 
• Brokers and Agents:
  • Seller has no finders’ or brokers’ fees, except as scheduled. 
• Claims – Judgments, Claims, Liens, and Proceedings:
  • There are no judgments, claims, liens, or proceedings pending against the entity or its assets, and none will be pending at closing.
• Contracts:
  • Seller is not in default under any contract assigned to Buyer.
  • The entity is not in default on any contracts.
• Corporation:
  • The Seller is a corporation duly organized and existing in good standing under the laws of the state in which it is operating and has all requisite power and authority to carry on its business, to own or lease its properties and assets, to enter into this Agreement, and to carry out its terms. Copies of the Certificate of Incorporation and Bylaws of the Company that have been delivered to Buyer prior to the execution of this Agreement are true and complete and have not since been amended or repealed. The Seller has no subsidiaries or direct or indirect interest in any corporation, limited liability company, or partnership.
  •  The shares constitute all the issued shares of the entity. No additional shares will be issued before the closing. At closing, the shares will be free from any claims of any persons or entities other than Seller(s).
• Customers:
  • Seller has not received any written notice from its largest customers of intention to discontinue or substantially reduce business.
• Employees:
  • The borrower has no exposure under the Employee Retirement Income Security Act (ERISA). 
  • There is no union strike pending or underway or charges pending before the Equal Employment Opportunity Commission (EEOC). 
• Environmental:
  • The entity is in compliance with all environmental laws. There are no hazardous materials on the business premises that may be a source of future liability under the environmental laws.
  • Seller’s operating sites are free of any environmental contamination, or order to remediate, or penalty from any authority. Seller has all environmental permits required to operate its sites, except as scheduled. 
• Financials:
  • Seller’s financial statements are prepared per GAAP, are complete, and fairly present, in all material respects, the financial position of the business. 
• Inventory:
  • Inventories are of a type and quality salable in the ordinary course and are valued at lower cost or marketed on a first in, first out (FIFO) basis net of appropriate reserves for obsolescence, except as scheduled. Buyers seek “quality and fit-for-purpose” assurances. 
• Intellectual Property – Trademarks, Patents, and More: 
  • Seller’s IP does not infringe the IP of others. No outstanding claims against the company for infringing the IP of others exist pre-closing, nor do infringements of Seller’s IP exist pre-closing, except as scheduled. 
• Laws – Compliance, Permits, and Licenses:
  • Seller is in full compliance with all laws, ordinances, or regulations applicable to the operation of the business.
  • Seller has all material approvals and permits for conducting the business, and all are in full force and effect. 
  • No government agency is investigating, threatening to investigate, or has filed or threatened to file a claim against the Seller or target business.
• Liabilities – Absence of Undisclosed Liabilities and No Undisclosed Liabilities:
  • There are no undisclosed liabilities for which Seller is liable. 
• Litigation:
  • There are no lawsuits pending or threatened against the borrower that are likely to have a material adverse effect on it if decided against the borrower, except as disclosed to the bank. 
  • There is no action or suit or governmental investigation to the knowledge of Seller pending or threatened with respect to the business that may affect the deal, except as scheduled. 
• Material Adverse Change/Effect (MAC/MAE):
  • There has not been any material adverse change in the business or financial condition of the business as a whole since a certain date, except as scheduled. 
• Operations:
  • The current uses of the Seller’s business premises are permitted under the applicable zoning laws. The business premises presently meet all applicable health, safety, and disabled access requirements and are in good repair.
• Taxes:
  • At closing, Seller will have paid all taxes that have then come due and that affect the business and its assets.
• Catch-All:
  • The information provided by the Seller and the Shareholders with respect to the Seller, the Assets, and the Business, including the representations and warranties made in this Agreement and the Schedules attached hereto, and all other information provided to the Buyer in connection with their investigation of the Seller, does not contain any untrue statement of a material fact and does not omit to state any material fact necessary to make the statements or facts contained herein or therein not misleading.

Buyer Reps and Warranties

Here is a summary of typical reps and warranties provided by a buyer. Note that most will be subject to a knowledge qualifier, and any exceptions will be listed in the Disclosure Schedules to the purchase agreement:

• Buyer represents that its company is a duly organized entity, qualified in its legal jurisdiction to conduct business, and is in good standing. In other words, Buyer promises that its company is a going concern.
• The business and financial information that Buyer has given Seller is accurate.
• Buyer has the authority and legal right to execute the purchase agreement. 
• Buyer is not in violation of its corporate governing documents and will not cause any liens or defaults, except as scheduled.
• Buyer has no finders’ or brokers’ fees, except as scheduled. 
• Due Diligence:
  • Buyer has had the opportunity to visit with the Seller to discuss the target business.
  • All materials and information requested by Buyer have been provided to the Buyer to their reasonable satisfaction.
  • Buyer has made their own independent examination, investigation, analysis, and evaluation of the purchased assets and the target business, including Buyer’s own estimate of the value of the purchased assets and the target business. 
• Buyer has inspected the tangible assets that Buyer is purchasing and the leased premises and has carefully reviewed Seller’s representations regarding them. Buyer is satisfied with the physical condition of the tangible assets and the premises.

When a business changes hands, most buyers expect you to sign a non-competition agreement, or non-compete for short, at closing. Few buyers will purchase a business without a commitment from you to not compete with them after the business is sold. Determining the terms of a non-compete is an integral part of the process of buying or selling a business, especially if you don’t plan on fully retiring and would like to avoid closing off any options. 

Non-competes are more heavily negotiated in certain industries, such as professional practices or service-based businesses, where you may retain a strong ability to compete with the buyer after the sale. They aren’t as important in other industries where replicating the business would be difficult for you after the sale, such as industries involving a large investment in infrastructure – storage facilities and hotels, for example.

Few buyers will purchase a business without a commitment from the seller to not compete with them after the business is sold. 

Scope

The time frame for most non-competes usually varies from three to five years. The geographical area covered by the non-compete typically coincides with the market area served by the business. For example, if a business’s customers come from a 50-to-100-mile radius, most parties will negotiate a 100-mile non-compete.

Often, the seller has no intention of re-entering the business. In these cases, most sellers offer a liberal non-compete, such as for five or more years, and covering entire counties or states. Some sellers tell me they’re willing to offer the buyer a 100-year non-compete.

Staying Involved

What if you want to stay involved in your business?

If you’re selling your company and want to remain in your business or industry, it’s best to express your intentions to the buyer clearly. Discuss your plans with the buyer and the role you would prefer to play after the sale. An experienced attorney can then draft a non-compete that expresses your mutual agreement. Your attorney will help you prepare a definition of a competitive business that carves out any activities you hope to engage in the future.

A non-compete should be specific as to what activities are permitted. A well-drafted agreement will clearly define a “competitive business” and define the capacity in which you can be involved, for example, as an employee, owner, or other position. Competition can be either direct, as in an owner, or indirect, as in a passive investor, and can come in many other forms. This definition can also be inclusive – for instance, “The seller is allowed to…” or exclusive, as in, “The seller is prohibited from…”. Again, an experienced attorney will ensure your agreement meets both parties’ needs.

Enforceability 

Some experts believe a shorter non-compete is more enforceable, although the degree to which this may be true varies from state to state. Most experienced attorneys agree that a three-year non-compete is enforceable. In some states, such as California, non-compete agreements are illegal in certain situations, such as an employer-employee context. A non-compete in the sale of a business is legal in all 50 states. Most states also develop parameters of reasonableness that can be researched in both statutes and case law. 

Other Considerations 

The buyer and seller should also ask themselves the following questions regarding the non-compete:

• Am I the only one obligated to sign the non-compete, or is my spouse also asked to sign? 
• Is the non-compete assignable if the buyer sells the business later? 
• Is the non-compete revocable if I finance a portion of the sale and then the buyer later defaults? 
• What are the methods of enforcement and remedies for violation? 
• Can I work as an employee for another company after the sale? 
• What types of businesses can I engage in after the sale? 
• Does the non-compete restrict solicitation of the employees, customers, and vendors?

Supporting documents are attached to the purchase agreement as schedules or exhibits. The range of schedules and exhibits required will heavily depend on whether the sale is structured as an asset or stock sale. Certain schedules or exhibits may not be necessary for stock sales, as some agreements are transferable despite a significant change in the entity’s ownership. If the third-party agreement, such as the lease, contains a change of control provision, then they will need to be individually transferred and will not automatically transfer in a stock sale. Typical supporting documents include:

• For Asset Sales
  • Bill of Sale: This document is used for asset sales and transfers your company’s individual assets to the buyer via a bill of sale. The bill of sale may list both tangible and intangible assets included in the sale. Some advisors list intangible assets separately and transfer them using a separate set of exhibits.
• For Stock Sales
  • Assignment of Shares: This document transfers shares of your entity and is only used for stock sales. The shareholders of the selling entity will individually sign over their stock certificates to the buyer at closing.
• Reps and Warranties and Indemnification
  • Disclosure Schedules: Any exceptions to the reps and warranties are listed in the disclosure schedules.
  • Escrow or Holdback Agreement: Holdbacks are common in middle market transactions and require a third-party escrow agent to hold back a portion of the purchase price to reimburse the buyer for any covered items until the holdback period has expired.
• Tax
  • Allocation of Purchase Price: This breaks down the purchase price into separate asset classes for tax purposes and is recommended for both asset and stock sales.
• Security for the Seller Note
  • Promissory Note and Security Agreement: This document is recommended if a seller note is involved. The promissory note outlines the terms of repayment, and the security agreement enables you to place a UCC lien on the assets of the business until the buyer pays the note in full. A Uniform Commercial Code-1 (UCC-1) statement also needs to be filed to perfect the lien. Your lien may be in a junior position if the buyer obtains third-party financing to complete the acquisition.
  • Share Pledge Agreement: For stock sales, shares of your entity can be held in trust or escrow until the buyer pays the note in full. A buyer would likely only agree to this if a significant seller note was involved.
• List of Assets Included in the Purchase Price
  • List of Tangible Assets: This is a detailed list of all tangible assets that are being sold. This list isn’t necessary for stock sales, although it doesn’t hurt to be clear on which assets are owned by your entity and which assets are owned by you personally. Keeping an accurate list of assets can help prevent future litigation regarding which assets were meant to be included in the sale.
  • List of Intangible Assets and Intellectual Property: This exhibit includes a list of intangible assets included in the sale, such as phone numbers, websites, and other intangible assets.
  • List of Titled Property: A list of titled property included, such as real estate or vehicles. Titled assets require a separate set of transfer procedures. For example, vehicles may need to be transferred through the Department of Motor Vehicles in your home state.
• Assignments
  • Assignment of Contracts: This document transfers third-party contracts, such as equipment leases, from you to the buyer at closing.
  • Assignment of Intellectual Property: This exhibit transfers any intellectual property (IP), such as patents, trademarks, or other registered IPs, from you to the buyer. It can also transfer non-registered IPs, such as phone numbers, websites, and other forms of content.
• Miscellaneous
  • Employment/Consulting Agreement: This is necessary if you’ll continue working for the buyer in some capacity, although it can also take the form of an employment or consulting agreement.
  • Non-Competition Agreement: The non-competition agreement contains a description of what you may and may not do and for what period you’re restricted from competing. Almost all M&A transactions include a non-compete agreement. Sometimes this agreement is included as a clause in the purchase agreement, and sometimes it’s listed separately as an exhibit. The non-compete agreement should be voided if the buyer defaults on payments to you.
  • Corporate Resolution: A corporate resolution is required by the seller in an asset sale if the seller is an entity. Technically, the seller in an asset sale is the entity, such as a corporation or LLC, and a corporate resolution is required in most corporate bylaws when taking major actions, such as selling all assets of the company. A corporate resolution isn’t required if you’re selling your entity, such as in a stock sale. A corporate resolution may be required by the buyer whether an asset or stock sale.

The transaction can take three general legal forms:

1. Asset Purchase Agreement (APA): An APA transfers the individual assets from you to the buyer through a bill of sale, which is signed at closing. You retain ownership of your entity while the buyer forms a new entity or uses an existing entity they own to purchase the assets of your business.
2. Stock Purchase Agreement (SPA): An SPA transfers the shares of your entity, such as your corporation or LLC, that owns the assets of your business. By purchasing the shares of your entity, the buyer becomes the owner of your entity’s assets. Shares in an LLC are called “membership interests,” but for the sake of simplicity, most parties refer to the transaction as a stock sale.
3. Merger Agreement: A merger happens when two entities merge into one another, with one entity surviving. Mergers are rare in the middle market.

The Definitive Purchase Agreement (DPA)

The DPA is called “definitive” because it’s the final or definitive agreement signed between the parties. This replaces any previous agreements, such as an LOI or offer to purchase. A definitive purchase agreement can take any form – asset, stock purchase, or merger. The term DPA is often used when the parties don’t know what form the transaction will take.

When the Purchase Agreement Is Signed

The purchase agreement is rarely signed before the closing when the change of possession occurs. That’s when the bill of sale is signed and delivered to the buyer in an asset sale, or when the stock certificates are signed in a stock sale. If the DPA is signed prior to closing, contingencies will usually remain, such as approval by key third parties, including the lender, lessor, franchisor, or licensor. The sale is canceled if these contingencies aren’t satisfied before the scheduled closing date or before the DPA expires. If the purchase agreement is signed before closing, the purchase agreement must also contain pre-closing covenants that govern how the business will operate before the closing, and termination rights, such as a material adverse change (MAC) clause. Both clauses are heavily negotiated and present a tremendous amount of risk to both parties, which is why the purchase agreement isn’t normally signed until closing.

There are many schools of thought when it comes to negotiating the purchase agreement. In this section, I’ll describe the factors that affect the negotiations, what the negotiation process looks like, and offer tips to ensure you receive the best deal possible. 

Scope of Negotiations

These are some of the factors that can affect the scope of the purchase agreement negotiations:

• Negotiating Skills and Posture: The negotiating skills of each party can make a difference, as can the negotiating posture and bargaining strength of each party.
• Legal Structure: Whether the deal is structured as an asset sale, stock sale, or merger will also affect the scope. The purchase agreement usually offers more protections to the buyer in a stock sale than in an asset deal.
• Financial Strength and Credibility of Seller: You can expect more favorable terms if the buyer has a positive perception and assessment of your character. If the selling shareholder group is dispersed and the selling entity will cease to exist after the closing, the buyer will seek other protective deal measures such as escrow.
• Industry: Businesses with more operational risks will be subject to more stringent reps and warranties. Impacting this factor will be the level of the buyer’s knowledge of your business and industry, and their perception of your business’s threats.
• Due Diligence: The more thorough the due diligence, the weaker the protections in the purchase agreement can be, at least in theory. That’s why the buyer’s ability to conduct thorough due diligence comes into play, as does the extent of the issues discovered during due diligence. 

The scope of negotiations regarding the purchase agreement varies significantly from transaction to transaction. For example, a stock sale may require more comprehensive protections than an asset sale. Likewise, a buyer who is intimately familiar with an industry and is, therefore, more confident in their ability to conduct due diligence may demand fewer protections than a buyer who isn’t familiar with the industry. No two negotiations are alike.

Impact of Market Conditions on Negotiations

The current state of M&A activity and the extent to which it’s a seller’s or buyer’s market heavily influence the scope of negotiations over the purchase agreement. Market conditions not only impact the price and terms of the transaction but may also dictate the prevailing definition or notion of what may be considered reasonable or fair.

For example, in a seller’s market, you can expect to sign reps and warranties that are far less broad in scope than in a buyer’s market. In recessionary periods, sellers must often have to agree to extremely restrictive language in both the letter of intent and the purchase agreement. Once the market gains traction, the scope of these restrictions loosens up. 

Current market conditions can influence the following:

• Price and Terms
  • EBITDA multiples
  • The amount of cash down and amount of equity purchased vs. rolled over
  • Amount of contingent payments, such as earnouts 
• LOI Terms
  • Exclusivity periods, which are less restrictive in a seller’s market
• Protective Mechanisms
  • Scope of indemnification
  • Size of escrow or holdback
  • Indemnification limitations, including baskets and caps

Market conditions not only impact the price and terms of transactions but may also dictate the prevailing definition or notion of what may be considered reasonable or fair.

Negotiating Tips

Here are tips for negotiating the purchase agreement.

Make Concessions Known

Never make a silent concession. In other words, never give the buyer something without the buyer becoming aware of it. 

Be Prepared To Give In at Times

Be prepared to negotiate and occasionally give in on some points. You must weigh the cost of a dispute vs. the potential benefits to be gained. Disputes are expensive and time-consuming, and even if you win, you lose. No deal is perfect, and you can reasonably expect to encounter at least one substantial dispute in nearly every transaction. For immaterial matters, it may be most prudent to simply split the difference. 

Understand the Purpose of the Protections in the Purchase Agreement

Both parties must recognize that no business is perfect. There are bound to be a variety of problems in any company, no matter how meticulously it has been operated. For example, few businesses comply with literally every law. The purchase agreement can’t insulate the buyer from every imaginable problem that can arise. The purpose of the protections in the purchase agreement is to protect the buyer from undisclosed, material risks that occur outside the ordinary course of running the business. 

Maintain an Excellent Relationship

A Japanese proverb holds, “One kind word can warm three winter months.” 

You should attempt to maintain a strong working relationship with the buyer after the closing. The transaction must be a win-win for both parties. If the buyer later suffers from buyer’s remorse, they’ll have sufficient opportunities to obtain revenge through numerous protections afforded to them in the purchase agreement. Such protections include escrows, post-closing purchase price adjustments such as working capital adjustments, inventory adjustments, collection of accounts receivable, reps and warranties, earnouts, bonuses, and the like.

The best antidote for disputes is prevention. How does that work? Maintain an excellent working relationship with the buyer – not just professionally but personally, as well. It’s much easier to work out problems with a friend than a foe, and given the complexity of businesses there are guaranteed to be problems after every closing. 

Understand Underlying Motivations

Buyers propose language in a purchase agreement for specific reasons. You, as the seller, need to find out these reasons and address the buyer’s concerns directly. Often, the problem can be resolved through other creative measures, or the buyer may have a misunderstanding of the underlying risk the representation is intended to address. This can open a dialogue to educate the buyer on the risk and other methods for mitigating it.

Negotiating Process

Here’s a summary of the negotiation process of the purchase agreement:

• Due Diligence: The breadth and depth of the protections offered in the purchase agreement are based on facts discovered during due diligence. The purchase agreement should be prepared in tandem with the due diligence process so the parties can negotiate the language as soon as possible in the transaction.
• Buyer’s Attorney: The buyer’s attorney prepares the purchase agreement, which includes a standard list of protections focused on the likelihood and amount of potential exposure. 
• Seller’s Attorney: Your attorney lists any exceptions to the reps and warranties in the disclosure schedules.
• Negotiations: Reps and warranties are one of the most hotly negotiated components of the purchase agreement, other than price and terms, especially when the seller wishes to retire and avoid lingering obligations. The scope of negotiations is based on the aggressiveness of the buyer’s initial draft and the bargaining positions or alternatives for each party. The current state of the market impacts not only the price of companies but also the terms of the transactions. Buyers aim for a long exclusivity period to reduce your bargaining power later in the process when the purchase agreement is being negotiated. Your leverage vanishes once the LOI is signed.
• LOI vs. Purchase Agreement: When negotiating an LOI, the buyer hasn’t yet performed due diligence and has limited information on your business; therefore, the buyer is unable to know exactly what protections they’ll request from you. This results in two negotiations – the LOI and the purchase agreement. This is why protections such as the reps and warranties are so hotly negotiated – you have already struck a deal, but now you must negotiate a second time. 
• Content: The purchase agreement contains more representations concerning you because the buyer has much more to lose. 
• Survival: Reps and warranties almost always survive the closing and can have implications for both parties for years thereafter. The other elements of the purchase agreement, such as the price and terms, conditions, and covenants, have no further implications after closing has taken place. Transactions involving publicly traded companies include reps and warranties, but they don’t survive the closing.
• Closing: For you, the seller, the “real closing” hasn’t occurred until the following has transpired:
  • You’ve fulfilled your transition obligations.
  • Post-closing adjustments have been made, such as working capital adjustments.
  • You’ve received all the money due.
  • Earnout periods have expired.
  • You’ve satisfied the terms of employment and consulting agreements.
  • The indemnification period has elapsed.

Following is a summary of the key elements of a purchase agreement. I’ll cover each in greater detail later in the chapter. 

General Clauses

• Definitions: Any well-written purchase agreement contains definitions of the key terms used throughout the document. It can clarify the differences between closing, change of possession and change of possession date, and other important terms. Thoroughly documented definitions help avoid potential issues stemming from questions related to any key terms.

Price and Terms

• Purchase Price: This defines the amount of the purchase price and the form of consideration (i.e., how the purchase price will be paid), such as the cash down payment, stock, debt or liabilities assumed, amount of seller financing, third-party financing, earnouts, and how much of the purchase price will be heldback in escrow. 
• Allocation of Purchase Price: This includes how the purchase price will be allocated for tax purposes.
• Working Capital: This section contains a description or definition of net working capital (NWC). This may also specify who will count the inventory – the buyer, the seller, or an inventory valuation service. It also provides adjustments to the purchase price based on differences in the value of working capital between signing and closing, and a representation of the condition and salability of the inventory.
• Closing Costs and Prorations: This area of the agreement explains who will pay which closing costs. Most closing costs are split equally between you and the buyer, with each party paying their own advisors.
• Transition Period: This section outlines the length and form of the transition agreement. Being highly specific regarding the length of the transition agreement – including how many hours and on what terms – is a good practice. Not being specific can lead to post-sale disagreements and helps prevent the buyer from suing you for failure to properly transition the business.

Reps and Warranties, Indemnification, and Escrow

• Reps and Warranties: Reps and warranties are promises and disclosures made by each party that serve as “insurance” if a representation later proves to be untrue. For example, you will warrant that you’ve paid all taxes due and there’s no outstanding litigation. Reps and warranties comprise most of the content in a purchase agreement and vary significantly based on the type of business. Manufacturing businesses, for example, will primarily have environmental and employee concerns, while technology companies will have IP concerns.
  • Knowledge and Materiality Qualifiers: If you aren’t 100% sure regarding a representation, that representation should contain a knowledge qualifier such as “to the best of Seller’s knowledge” or “to Seller’s knowledge.” 
  • Exclusions: Reps and warranties are worded in the affirmative, and your attorney will list any exceptions in disclosure schedules.
  • Survival Periods: The reps and warranties normally expire after 12 to 24 months. Some, such as those related to tax matters, survive indefinitely.
• Indemnification: This section governs how disputes will be handled and includes an obligation to reimburse the other party for breaches of contract. Indemnification is usually covered by holding 10% to 15% of the purchase price in an escrow account for 18 to 24 months following the closing. The amount of indemnification is limited by baskets, or minimums, and caps, or maximums.
  • Basket – Minimum: A basket operates like an insurance deductible and is a minimum threshold that must be exceeded before indemnification is triggered. The average size of a basket is 0.75% of the purchase price. Baskets can be tipping, in which the liability starts from $0, or non-tipping, in which the liability starts from the amount exceeding the deductible.
  • Cap – Maximum: A cap is the maximum limit of indemnification. The average cap is 10% to 20% of the purchase price.
  • Parties: The buyer will often seek to obtain protection, or indemnification, from as many parties as possible, such as all shareholders and key managers. If multiple shareholders exist, ideally they should avoid agreeing to “joint and several liability.” 
  • Remedies: The purchase agreement should also address if indemnification is the exclusive remedy for the parties.
  • Indemnification Process: The purchase agreement will also address how indemnification claims are handled.
• Escrow Account: The escrow amount usually ranges from 10% to 20% of the purchase price. The size of the escrow is based on the likelihood and magnitude of potential risks.
  • Time Period: Most escrows range from 12 to 24 months. 
  • Conditions: The purchase agreement should also address who controls its release and how disputes are handled. 

Miscellaneous Legal Provisions

• Form of Transaction: The legal form of the transaction – asset sale, stock sale, or merger.
• Conditions and Covenants:
  • Contingencies and Conditions: The purchase agreement contains contingencies if signed before closing. Contingencies are events that must occur before a closing can take place, such as financing or landlord approval. A common condition for closing is also that the reps and warranties must be true as of the closing date – called a “bring-down.” 
  • Covenants: Covenants are responsibilities of the parties during the period between signing the purchase agreement and the closing. For example, you will agree to operate the business as normal and agree to fulfill outstanding purchase orders, and so on. Covenants are rarely negotiated.
• Default and Remedies: This includes conditions for canceling the agreement and penalties for defaulting, such as a break-up fee.
• Miscellaneous Legal Provisions: This section contains miscellaneous legal provisions, such as those related to attorney fees, mediation, indemnification, entire agreement, severability, assignment, waivers, governing law, notices, risk of loss, and other provisions that generally apply to all legal agreements.

Here is a high-level overview of the process from signing the letter of intent (LOI) to the closing:

• Letter of Intent: You and the buyer sign the LOI, which is usually non-binding. The purchase agreement replaces the LOI once it’s signed. 
• Due Diligence: Due diligence begins when the LOI is accepted. Due diligence typically lasts 30 to 60 days. 
• Purchase Agreement: The buyer’s attorney normally drafts the purchase agreement. The parties go through several rounds of negotiations until the purchase agreement is finalized.
• Closing: The closing is normally conducted remotely or virtually. The purchase agreement is normally signed at the closing.

“The superfluous is very necessary.” – Voltaire, French Essayist and Philosopher

Negotiating individual components of the purchase agreement can’t be done in isolation because there are many interconnected parts of a transaction that constitute its overall structure. All these components should be taken into consideration on a collective basis during negotiations. 

For example, if the buyer proposes a lower purchase price, you may concede but may request more cash down at closing or reduce the size of the earnout. Or, if you insist on providing minimal representations to a buyer, the buyer may concede but may tighten up other elements of the transaction structure, such as escrows, knowledge qualifiers, or thresholds.

The purchase agreement is a tool for allocating risk. As the seller, the more assurances you’re willing to provide the buyer in the purchase agreement, the lower the risk for the buyer and the higher the purchase price they can potentially afford to pay given the amount of risk they’re assuming. 

Risk and return are directly related. The higher the risk, the lower the return – and vice versa. By lowering the risk for the buyer by offering a collection of protections in the purchase agreement, you can potentially realize a higher purchase price. 

The reverse is also true – if you fail to offer the buyer significant protections in the purchase agreement, this increases their risk and they may attempt to negotiate a lower purchase price as a result. To maximize the purchase price, you must therefore be prepared to offer the buyer an adequate level of protection in the purchase agreement.

When it comes to deal structure, the objectives of the parties can be summarized as follows:

As you can see, when negotiating the deal structure, the parties objectives are at odds with one another. The most fiercely debated elements of the transaction are as follows:

• Price and Terms:
  • Purchase price
  • Terms of the seller note
  • Post-closing purchase price adjustments, such as a net working capital (NWC) adjustment
  • Size and length of escrow
  • Contingent payments, such as earnouts and escrows
  • Specific terms of employment and consulting agreements
• Deal Structure:
  • Allocation of the purchase price, which determines the tax implications of the transaction for both parties
• Protective Mechanisms:
  • Reps and warranties
  • Survival period, knowledge, and materiality qualifiers of reps and warranties
  • Caps, baskets, and survival period of indemnification
• Miscellaneous:
  • Conditions to closing, such as a material adverse change (MAC) clause

Due diligence is a complicated, taxing ordeal. The more you can do to prepare for it, understand it, and remain emotionally objective, the better you’ll fare and the more you’re likely to receive for your business. Having tools, such as checklists to track documents, requests, problems, and any of the many other aspects you must remain on top of will help you immensely. Here’s a sample due diligence checklist to give you an idea of what to expect.

Sample Due Diligence Checklist:

Operations:

• Advertising contracts
• Customer list
• Inventory count
• List of key competitors
• Marketing material
• Operations manual
• Preliminary equipment inspection 
• Premises lease
• Summary of key lease terms
• Supplier and vendor list
• Supplier and vendor contracts

Insurance:

• Health insurance policies
• Liability insurance policies
• Workers’ compensation policies and history

Assets:

• Description of any real estate owned
• Equipment inspection reports
• Equipment leases
• Equipment list 
• List of all assets included in price
• Inventory list

Staff:

• Meetings with management 
• Benefit plans
• Compensation arrangements
• Detailed schedule of payroll expenses
• Employment, agency, and independent contractor agreements
• Job descriptions
• List of outside contractors
• Other employment-related agreements
• Overview of personnel turnover
• Schedule of owners, officers, employees, independent contractors, consultants and their titles, length of service, and compensation benefits
• Summary biographies of key management

Legal: 

• Articles of incorporation and organization
• Business license
• Certificate of status and good standing from the applicable secretary of state
• Copies of licenses, permits, certificates, registrations, and other documents from all governmental authorities
• Copies of all key contracts
• Corporate or LLC by-laws or operating agreements
• Corporate or LLC minutes
• Description of environmental liabilities
• Fictitious business name statement (FBNS or DBA)
• Financing agreements
• Information for copyrights
• Information for patents
• Information for trademarks and service marks
• List of liens against the business
• Other third-party agreements or contracts
• Pending lawsuits
• Phase 1 and 2 environmental studies
• Preliminary UCC search results
• Previous purchase agreement and related documents for business
• Resale permit
• Seller’s disclosure statement

For a downloadable version of this due diligence checklist, visit the Resources page of our website at morganandwestfield.com/resources/downloads/.

Conclusion

I strongly recommend you invest the time necessary to prepare your business for due diligence. Most business owners skip this step altogether. By preparing for this process, you’ll significantly improve the chances of a successful sale. Additionally, demonstrating to the buyer that you’ve prepared for due diligence increases the buyer’s confidence in your business and reduces their perception of fear and risk. 

Due diligence can be heaven or hell. If you have your financials in order and all is well from an operational and legal standpoint, chances are due diligence will be uneventful, and your deal will take flight, bringing you one step closer to the closing of your dreams. If you’re unprepared and the buyer finds things amiss during due diligence, you’ll find yourself on the horns of a dilemma. Being prepared can go a long way in facilitating the outcome you want.

Here are tips to consider to prepare for the due diligence process:

• Be Emotionally Prepared: Due diligence can be a grueling undertaking if you’re unprepared. You must be prepared to commit a substantial amount of time and energy to the process. The objective of some buyers is to wear you down, discover problems, and then attempt to renegotiate the terms of the deal. Anticipate this possibility by preparing for due diligence and resolving issues long before a buyer discovers them. You should also attempt to remain emotionally unattached to the process so you can negotiate from a detached, objective perspective. 
• Stay Focused: By the time you reach the due diligence stage, you may feel as if you’re almost done, but this is a critical stage where the sale can still be made or lost. You’re only on the 50-yard line at this point – if you lose focus, your deal can die. There is still a lot of work to be done before the sale is complete. It’s vital that you stay engaged and actively involved in due diligence to reach your goal of a smooth closing. 
• Prepare a Due Diligence Checklist: The best way to keep the complicated process of due diligence straight is to put it to paper. Prepare a checklist to help you stay organized and focused.
• Buyer Type Determines Thoroughness: Individuals are generally less thorough than companies when conducting due diligence. However, some individuals can be especially comprehensive if they’re detail-oriented, risk-averse, or have a CPA or attorney advising them behind the scenes. Most companies are thorough, especially if they’ve completed multiple acquisitions in the past. 
• Exclusivity: Keep your business on the market even after you’ve received an offer unless you have negotiated an exclusivity period with the buyer. 
• Involve Your Accountant: Much of the documentation needed for due diligence is financial in nature. Therefore, including your accountant or CFO in your plans as early as possible will help you prepare for due diligence. The more cooperation you have from your team, the smoother the process will go. 
• Designate a Point Person: The point person should be the quarterback during the transaction. They should review all information before you release it to the buyer, as well as orchestrate communication with all parties involved. Many professional advisors will lose you as a client if the transaction is successful, so they may not be inclined to conclude the transaction quickly due to their hourly-rate fee structure. Being the point person yourself, or appointing someone within the company, will help simplify the due diligence process. 
• Contact the Landlord Early: The lease is one of the most critical elements of the process and needs to be carefully orchestrated. Issues around the transfer of a lease are common, so the process must be handled with care. Landlords can’t be compelled to approve the lease transfer, but delaying the landlord’s involvement can slow the closing or prevent it altogether. I recommend involving the landlord as early as possible in the process. 
• Prequalify the Buyer: Be sure you’ve prequalified the buyer before negotiating and accepting an offer. You want to ensure that you’re negotiating with a buyer who has the financial capacity to close the transaction. 
• Tell the Buyer You Are Prepared: If you’ve prepared your business for sale and organized all the documents, make sure to mention this in early conversations with buyers. You could say something like this:

“I’m a motivated, serious seller who has prepared my business for sale with the help of a CPA. I have all the necessary documents ready for due diligence, including tax returns, leases, equipment lists, financial statements, and more.”

Common Mistakes Sellers Make

By far, the biggest mistake sellers make is not being prepared for how grueling the diligence typically is. A common example of this is when a seller simply tells the buyer to come to the business to look for themselves to see all the money they’re making. Many sellers misunderstand the purpose of due diligence, so they view the buyer’s document requests and thorough diligence as a form of unwarranted suspicion.

A seller’s misunderstanding of due diligence is a red flag to a buyer. It’s a sign that conducting diligence will be time-consuming and difficult. Such a statement only heightens a buyer’s level of concern, and the response is often to conduct more thorough diligence and demand more thorough protections in the purchase agreement. 

Many sellers fear what may happen if the deal doesn’t close – that the company will become tarnished and difficult to sell. Sellers are often uncommitted at this stage, and instead of sprinting to the end-zone, they hee-haw and tiptoe. This lengthens the time it takes to reach the closing, which, as a result, increases risk.

A major element of due diligence is gathering all the information. To expedite this process, you can prepare and arrange in advance the common documents most buyers will request. Any additional documents the buyer requests should be quickly and accurately gathered and assembled for their review. The quicker you organize the documents, the quicker the closing will occur.

Common Mistakes Buyers Make

The biggest mistake buyers make is sending a templated due diligence checklist to the seller and then failing to communicate with them – which results in a lack of trust between the parties and increases the time and difficulty of performing due diligence. Sellers often become defensive and unmotivated to follow through if they see unreasonable requests for information or requests for information they deem irrelevant.

The buyer should understand the impact that performing diligence can have on the target company. The buyer should also be interested in maintaining the financial performance of the company – since they’ll assume ownership if diligence goes as planned.

If you receive what appears to be a templated due diligence list with requests for irrelevant information, it may be wise to have a talk with the buyer.

Due diligence is conducted primarily in four areas – financial, operations, legal, and HR.

Financial Due Diligence

In most transactions, the review of the financial statements is the most important part of due diligence. Before the buyer conducts due diligence, they may have already seen summary or normalized P&L and balance sheet statements. After you accept an offer, the buyer will finally get to see beyond these summaries to the financial details of your business. 

The importance of financial diligence depends on the legal form of the transaction and whether it’s structured as an asset or stock sale. In a stock sale, more emphasis will be placed on examining the debts and liabilities of your company because these will be assumed by the buyer. In an asset sale, less emphasis will be placed on the balance sheet.

The purpose of financial due diligence varies from buyer to buyer. Some buyers primarily use financial due diligence to value the business. Others simply want to verify that the numbers presented to them are accurate. The extent to which either is the case depends on the buyer’s purpose for making the acquisition. In industries where valuations are fairly stable, and the buyer is purchasing a book of business, the potential range of values is more narrow, and they may simply be seeking to verify the numbers. In high-growth industries, such as software, the buyer may use the due diligence process to value the business to help determine if the price they’re offering is reasonable.

Here’s a general description of some of the primary objectives of financial due diligence:

• Financial Controls: Assess the strength of your company’s financial controls. The stronger your financial controls, the more trust the buyer will place in your financial statements.
• Financial Statements: Determine the extent to which your financial statements comply with generally accepted accounting principles (GAAP). If the LOI contains language that specifies that your financial statements comply with GAAP, this can become a pitfall for you if your financial statements don’t comply.
• Working Capital: Examine the level of working capital to determine if it’s sufficient. The buyer will estimate the amount of working capital required to operate your business, and then this number will be verified sometime after the closing, typically 90 to 120 days following the closing. 
• EBITDA: Ensure the stated EBITDA is accurate. Many buyers will place a heavy emphasis on this verification. They’ll also spend time ensuring any adjustments to the financial statements are accurate.
• Financial Ratios: Compare your company to others in your industry by examining industry benchmarks to ensure financial ratios are reasonable. The buyer will pay particular attention to any ratios that have improved in recent years, such as gross profit margins, to ensure that no financial gimmicks were employed to massage the numbers.
• Due Diligence: The buyer will also be on the lookout for any of the following:
  • Inflating revenue or hiding or deferring expenses.
  • Timing of inventory purchases, which will affect the cost of goods and the gross profit.
  • Any indication that revenue may have been booked early.
  • Significant changes in the balance sheet trends from year to year, such as an increase in accounts receivable.
  • The extent to which your accounting policies differ from industry norms.

The following is a list of financial documents commonly requested during due diligence:

• Accounts payable schedule
• Accounts receivable aging schedule
• Annual personal property tax certificate
• Backup data of adjustments to financials
• Bank statements
• Breakdown of sales by customer
• Breakdown of sales by product type
• Copies of existing loan or financing agreements
• Customer or client agreements
• Documentation for add-backs to financial statements
• Federal income tax returns
• Financial budgets and projections
• Full QuickBooks or accounting software files
• General ledger or detailed list of all transactions and expenses
• List of monthly sales since inception
• Merchant account statements
• Payroll tax reports
• Profit and loss statements
• Sales and use tax reports
• Utility bills

Operations Due Diligence

The buyer must understand your business’s operations as a whole to make sense of its parts. By understanding how your business operates at a fundamental level, they will be better equipped to comprehend the other areas of due diligence, including legal, financial, tech, and HR. Operations due diligence may be further broken down into the following categories, depending on the industry:

• Financial Services and Healthcare: Financial services and healthcare are highly regulated, and much of due diligence will be focused on compliance with existing laws.
• Professional Services: Professional services are relatively low risk, and one of the primary concerns will be customer retention.
• Manufacturing: Manufacturing is considered medium to high risk with common issues related to staff experience and adequacy, ownership of intellectual property, and product liability.
• Tech: Tech is considered medium risk with issues related to ownership of intellectual property and new competitive threats.
• Retail and Wholesale: Retail and wholesale are considered low to medium risk with threats from mismanagement of costs.
• Construction: Construction is considered medium risk with potential threats related to compliance with regulations and issues with contracts and work in progress.

Face-to-face interviews are common when assessing the operations – they may be used to corroborate what’s in writing, fill in knowledge gaps, or uncover new areas of risk not previously identified. The interviews may be with third parties, customers, suppliers, or key employees. Many private equity firms also employ the use of experts, especially in highly specialized industries. 

Here’s a summary of common topics covered during operational due diligence:

• Operations
  • Strength and adequacy of internal controls
  • Efficiency of operations
  • Capabilities of the management team
  • Potential issues related to integration 
  • Adequacy of the facilities, and condition and age of your equipment
  • Current lease terms and degree to which these align with present-day market conditions
  • Your company’s reputation in the marketplace
  • Performance or operational standards
  • Product or service methods of operations
  • Revenue projections and assumptions
  • Warranty claims
  • Capital expenditures
  • Revenue trends
  • Supply chain dependencies
  • Cost of goods trends
  • Seasonality trends
  • Variations in revenue or income
  • Industry trends
  • IT due diligence, including an analysis of current software and integration
• Marketing Due Diligence
  • Analysis of any marketing and advertising methods 
  • Advertising and marketing concentration issues, such as salespeople or marketing concentration
  • Competition, leadership, and position in the market
• Cultural Due Diligence
  • Issues with integration
  • Attitudes, norms, hierarchy, how decisions are made, and ethics
  • Corporate communication styles and preferences
• Threats
  • Competition, whether direct and indirect, or from new products, or new competitors
  • Raw material and labor shortages
  • New or proposed regulation changes
  • Changes in economic conditions, such as an increase in interest rates
  • Lawsuits, typically from customers, employees, competitors, or suppliers
• Environmental: Environmental laws consist of a patchwork of federal and state regulations that cover the land, water, and air and are enforced by numerous agencies. The two primary agencies are the U.S. Environmental Protection Agency (EPA) and the U.S. Occupational Safety and Health Administration (OSHA). There are two main concerns – ongoing environmental compliance and cleanup that may be required. In most cases, a preliminary assessment will first be conducted. A full site investigation will be conducted only if necessary. Problems can stem from ongoing compliance or from violations committed in the past, which can lead to successor liability.
  • The cost of cleanup is expensive. As a result, environmental due diligence can be thorough for any businesses that handle materials that may lead to environmental violations. Officers, directors, and stockholders can also be held personally liable. The U.S. Federal Superfund Law can pierce the corporate veil, and as a result, cleanup costs can be enormous. The extent of liability depends on the legal form of the transaction and the extent to which the seller provides reps and warranties to the buyer. Any environmental concerns will require significant indemnification, and reps and warranties may survive a long time or even indefinitely, in some cases.

Legal Due Diligence

Legal due diligence is normally conducted by the buyer’s legal team.

The form of the transaction – asset vs. stock sale – will greatly impact the level of legal due diligence conducted. In a stock sale, the buyer will assume your liabilities and must make sure your company is free from all illegal activity. The reverse may also be true – legal due diligence may determine the form of the transaction. If significant liabilities are discovered, the buyer may elect to structure the transaction as a stock sale instead of an asset sale.

One of the most common issues is pending, threatened, or potential litigation. The buyer will research litigation trends in your industry to determine points of potential risk. The buyer will also examine any existing claims to determine the extent to which they may be valid and their potential impact. Note that immaterial litigation can start with a small claim that can roil the industry. For example, the asbestos debacle began with one small claim. Industries with the highest average number of proceedings are health care, manufacturing, and energy. As a result, you can expect businesses in these industries to be subject to greater legal due diligence requirements. 

If you’re involved in litigation, you should consider expediting it by settling out of court or through an alternative dispute resolution. The buyer may also examine litigation involving other companies since litigation within your industry could pose a potential source of risk through changes to industry structure and practices. Anyone can file a lawsuit – employees, unions, shareholders, customers, suppliers, competitors, contractors, governmental agencies – so the buyer must often cover a lot of ground to discover potential risks.

The findings will also impact the strength of the reps and warranties proposed in the purchase agreement. The purchase agreement can also state that the risk of undisclosed liabilities will remain with you after the closing.

Here’s a summary of the major areas addressed by legal due diligence:

• General legal compliance
• Agreements with customers, suppliers, landlords, lenders, taxing authorities, employees, subcontractors, and others
• Insurance coverage – including issues such as deductibles, adequacy of coverage, if premiums will rise when claims are made, and more. It should also address whether the policy is claims-incurred, such as coverage that continues after termination, or claims-made, like covering claims made during the term of the policy. If you have a claims-made policy, you should purchase a tail to ensure you’re protected after the closing.
• Intellectual property ownership and protection – for example, checking actual ownership and infringement
• Confirmation of the legal formation and existence of the corporation, including a review of the articles, amendments, bylaws, and minutes
• Qualifications to do business in all jurisdictions the business operates in
• Tax certificates
• Liens on assets
• Title to all assets
• Potential successor liability, which can arise from unpaid taxes, environmental violations, or product liability claims
• Copies of correspondence with all governmental agencies 
• Debts and liabilities – the buyer will generally not be liable if the transaction is structured as an asset sale
• Collective bargaining agreements and unions – the buyer will generally be required to recognize unions

The form of the transaction – asset vs. stock sale – will greatly impact the level of legal due diligence conducted. 

HR Due Diligence

Employees are one of a business’s most valuable assets. They’re also one of the biggest sources of liability. Issues with employees are a common source of litigation. Employment law is complex and consists of thousands of federal and state laws, administrative regulations, and judicial decisions. The statute of limitations isn’t always clear when it comes to employee liability – there are no clear rules on when liability may start and stop. The result is that buyers spend a significant amount of time and effort ensuring your business is in compliance with all employment laws.

Common issues related to compliance with employment laws include:

• Equal Opportunity: This will cover potential discrimination issues such as race, disability, age, gender, religion, drug use, sexual harassment, and other topics. 
• Health and Safety: OSHA
• Wages and Hours: This includes minimum wage, family or medical leave, workers’ compensation, unemployment insurance, health insurance, overtime pay, ERISA (pensions), and more, including:
  • The buyer will also determine whether the plan is underfunded, whether to terminate or merge plans, and the impact of severance agreements.
  • Treatment of pensioners when a business is sold is a common area of litigation.
  • Merging of plans is best handled on a case-by-case basis.
• Collective Bargaining (Unions): The buyer will check if you’re in compliance with collective bargaining regulations, which is a source of potential successor liability.
• Workforce Reduction: Considerations include layoffs, avoidance of discrimination in layoffs, and the WARN Act, which applies to companies with 100 or more employees to provide 60 days of advance notice of a plant closing.
• Illegal Aliens (Non-Citizen): Companies may not employ non-U.S. citizens. 

Here’s a summary of the major areas reviewed during HR due diligence:

• Organization chart, including lines of reporting and authority
• Recruiting practices
• Retention, including average tenure and attrition rates
• Performance awards
• Benefits
• Whether salaries are in line with the current market
• HR policies
• Workers’ compensation claims

Conducting due diligence requires the buyer to understand both the whole of your business and its individual parts. Because buyers often employ a variety of experts to handle due diligence on their behalf, they might struggle to understand a business in its entirety. This highlights one of the biggest challenges for buyers – focus. Many buyers have a difficult time maintaining their focus when conducting diligence. It’s easy for a buyer to become lost in the details and to simply “check off the boxes” without appreciating how the various parts comprise the whole and how they work together.

For the buyer, due diligence can make the difference between success and failure. What may initially look like an attractive acquisition may later prove to be unattractive after the due diligence review is completed. Acquirers use due diligence in conjunction with other activities such as strategic planning and valuation to determine whether to proceed with the transaction. At a high level, the buyer is assessing whether the acquisition is a strategic fit – assuming the buyer is a strategic buyer – and the risks and opportunities your company presents. 

How thoroughly the buyer performs due diligence may depend on the following factors:

• Degree and Likelihood of Potential Risk: The buyer will conduct more thorough due diligence if the sale is structured as a stock purchase or if they expect to assume pending litigation with a sizable potential outcome. The buyer is expected to do everything reasonable, not just possible, to assess the transaction’s level of risk. The performance of due diligence shouldn’t require an unusual amount of effort, just a reasonable effort given the level of risk that the transaction represents. Buyers should never expect to uncover every possible risk in a business. 
• Time and Money Available: The extent of due diligence also depends on how much time and money the buyer is willing to spend on the process. The amount of resources invested in performing due diligence often depends on the degree of risk present in the transaction, the size of the transaction, the form of the transaction, and the buyer’s familiarity with the target business’s industry. It’s worth noting that a higher percentage of the purchase price is spent conducting due diligence for smaller transactions.
• Operations of the Business: Operations include how many years the business has been in existence, whether the financial statements have been audited, the degree of turnover among the staff and management, customer turnover, and any other factors that may affect the stability and perceived level of risk in the business. The more complex the operations, the more thorough due diligence usually is.
• Complexity of the Business: More complex businesses with multiple product lines and locations that operate in multiple international jurisdictions and across several industry sectors require a greater degree of diligence than a simple business with one product line in one location that operates in an unregulated industry.
• Public vs. Private Companies: Publicly held companies are subjected to a greater degree of scrutiny by the underwriters, the advisors servicing those firms, and the investor base both during the initial diligence in the underwriting process and throughout ongoing due diligence. They also have ongoing disclosure obligations that help reduce risk for the buyer. Public firms generally have more thorough controls in place, and purchasers often expect public firms to present less risk than private firms. On the other hand, the acquisition of public companies doesn’t often include thorough representations and warranties because pursuing indemnification from such a dispersed shareholder base would be difficult. 
• Scope of Reps and Warranties: The degree of protection you’re willing to offer the buyer in the purchase agreement can also affect the level of diligence performed. In theory, the more protections you’re willing to offer, the less thorough diligence can be. But, in practice, few buyers are willing to forego conducting a reasonable level of due diligence, even if you’re willing to offer a thorough set of reps and warranties, unless there’s an external reason for doing so, such as the need to close by December 31 for tax reasons.
• Form of Transaction: Whether the transaction is structured as an asset or stock transaction will also impact the level of diligence required. An asset purchase may require the buyer to perform less thorough diligence than if the transaction were structured as a stock purchase. That’s because the buyer would generally not assume liabilities unless they expressly agree to do so – the major exception being successor liability. The successor is generally not liable for the debts and legal obligations of the predecessor unless they contractually agree to assume such liability.
• Third-Party Financing: Additional diligence may be required by the buyer’s financing sources. An example of this would be environmental risks, when, in some cases, the lender may assume successor liability related to environmental contamination.
• Ability to Verify: Buyers prefer not to rely on your oral representations if the information can be reasonably verified. The more information that can be verified through documentation, as opposed to management interviews, the more documents will be requested. This allows buyers to see your business for themselves, understand that you’re telling the truth, and view your business as less risky. 
• Red Flags: The more red flags the buyer perceives as due diligence unfolds, the more likely they’ll conduct more thorough diligence.
• Controls in the Business: The more controls present in your business, such as financial controls and management reports, the more trust the buyer will have in your company, and the less thoroughly they’ll perform diligence.

How Due Diligence Fits Into the Overall Process

Due diligence is normally driven by the head of M&A or corporate development, or the legal counsel of the buyer. Here’s a summary of how due diligence fits into the sales process:

• Letter of Intent: The parties negotiate and accept the LOI.
• Due Diligence: The due diligence period begins immediately after the LOI is accepted by the parties. 
• Purchase Agreement: Due diligence is usually conducted simultaneously with the drafting of the purchase agreement. Whatever findings arise from due diligence are incorporated into the purchase agreement or listed as exclusions in the disclosure schedules.
• Contingencies That Survive Due Diligence: Often, contingencies survive due diligence, such as bank financing, lease assignment, or license transfers. These contingencies are resolved between the conclusion of due diligence and the closing. The buyer may cancel the transaction if these contingencies aren’t resolved.
• Closing: Once the contingencies are resolved, the closing may occur. In most cases, the purchase agreement is signed at closing, but it may be signed prior to closing in a minority of cases.

The Appropriate Level of Diligence

Traditional due diligence checklists imply that the selling company is a landmine of potential problems. The implication is “buyer beware.” But the level of diligence required should be proportional to the size and complexity of the transaction. Ronald Reagan put it best when he said, “Trust but verify.” 

The goal of the buyer is to first predict potential risks and then find a way to mitigate those risks. But even the best strategy for due diligence can only be so comprehensive.

Reasons for Being Diligent

If the buyer is a public company, making the wrong move can tarnish its reputation and negatively impact the value of its share price. In a study of over 1,200 transactions conducted by Mark Sirower, co-author of The Synergy Solution (Harvard Business Review Press, 2022), whom I had the pleasure of interviewing on my M&A Talk podcast, Sirower determined that the market’s initial reaction to an acquisition is surprisingly accurate. Yes, the market is smarter than you think and has little patience for anything less than due diligence. If you would like to learn more, check out the M&A Talk episode Why Half of Acquisitions Fail with Mark Sirower at morganandwestfield.com/resources/podcast. 

Mistakes can put a company out of business nearly overnight, whether the company is public or private. In other cases, the participants can be held personally liable for failing to exercise “due” diligence. Congress has also passed numerous pieces of legislation that have required companies to exercise an even greater degree of due diligence. The problem is compounded by the limited time available to conduct it.

How careful do buyers need to be? Do they need to consider every imaginable risk, those that are most likely, or only those that can have the greatest impact? 

The level of due diligence ultimately required is subjective.

Let’s break down the meaning of “due diligence.” Here’s the definition according to the Merriam-Webster Dictionary:

• Due: Required or expected in the prescribed, normal, or logical course of events.
• Diligence: Steady, earnest, and energetic effort: devoted and painstaking work and application to accomplish an undertaking. The attention and care legally expected or required of a person, such as a party to a contract.

Common sense and judgment are required when exercising diligence. In most cases, you can easily see what went wrong in retrospect. The trite adage holds true – hindsight is 20/20. But predicting a specific problem within a company that may potentially have hundreds of problems is difficult. 

To illustrate the complexities of due diligence, consider the failures of “Big Five” accounting firm Arthur Andersen in 2002 and the energy company Enron in 2007. They underscore the fact that judgment can’t simply be delegated to a third party – all parties involved in the diligence process must exercise care and perseverance. Both of these catastrophic collapses were due to a lack of diligence. These are the stakes of the due diligence process. In fact, participants may expose themselves to personal liability even if they had no intent to defraud but simply failed to exercise due diligence. The scandals that enveloped the corporate world even before Arthur Andersen and Enron in the 1990s and 2000s changed the way business is conducted. The result was increased legislation requiring anyone involved in the due diligence process to ensure that diligence – for lack of a better word – is conducted diligently. 

The best acquirers now integrate due diligence into the entire acquisition process – from early valuation modeling to integration planning. Integration is no longer an afterthought but a critical component of the process for every acquirer.

The level of diligence required should be proportional to the transaction. 

Due Diligence and Small Private Enterprises

It’s becoming more likely, even for small, privately held companies, that the buyer of your company will be an institutional investor, such as a private equity firm or a strategic acquirer. Institutional investors have multiple stakeholders to please, and a failure to exercise diligence can expose them to liability.

What does this mean for you, the seller?

It’s simple – expect that diligence will be conducted diligently.

Any skeletons in the closet will likely be discovered. A thorough diligence process also highlights the importance of preparing for due diligence in advance by identifying and eliminating as many problems as you can. 

Assessing Problems Before a Sale

While preparing for due diligence, you may come across problems that can’t be feasibly solved before the sale. How should you go about addressing them? Here are my rules of thumb. 

Degree vs. Likelihood

When assessing risk, you should consider both the potential impact and the likelihood of the risk. A hurricane can be deadly, for instance, whereas an alien invasion is unlikely. For another example, in a retail business, theft is likely but not material. In a manufacturing business, liability may be unlikely but could be significant. 

By weighing both the likelihood of the problem occurring and the degree to which it may impact your business, you can decide how to move forward. Should you mitigate the problem so you can convince the buyer it isn’t important, or should you simply be upfront about the problem in an effort to build goodwill? The answer, of course, depends on the specifics of the problem itself, but using these two variables can help you decide which action to take. 

Due Diligence and Timing

Due diligence may be conducted sequentially or iteratively. If sequential, it’s common for the most accessible information to be reviewed first, such as financial statements, or to first review those areas that present the most risk. In most cases, due diligence is performed in an iterative fashion that’s driven by the pace of information you provide to the purchaser.

In addition, due diligence doesn’t have a definite start and end date. Diligence often begins when the buyer first receives information on the target company and doesn’t end until sometime after the closing date. Diligence may extend beyond the closing because the purchaser is afforded protections through the reps and warranties provided in the purchase agreement. Due diligence is an imperfect process that’s highly iterative, subjective, and dependent on the unique circumstances of the transaction.

Typically, due diligence takes 30 to 45 days, but the time frame is heavily dependent on how thoroughly you’ve prepared. The more prepared you are, the quicker the time frame can be. The converse is also true – the less prepared you are, the longer the process will take.

The length of due diligence should be based on the following:

• Availability of Information: If you respond promptly to the buyer’s document requests, the due diligence period can be shorter.
• Turnaround Time: By providing concise, organized, and clear information, you make it easier for the buyer to review the information quickly, speeding up the process.
• Communication: If you’re more available to the buyer, this may also shorten the due diligence period.

Due diligence is an imperfect process that is highly iterative, subjective, and dependent on the unique circumstances of the transaction.

Mutual Due Diligence

As the seller, you may also conduct due diligence on the buyer if:

• You’ll play an ongoing role in the business.
• You’ll carry a note or finance a portion of the purchase price.
• The buyer holds back a portion of the purchase price outside of escrow.
• You’re receiving stock in the purchaser’s entity as a form of consideration.
• The buyer is seeking third-party financing, and you aren’t sure of their financial qualifications.
• You own the real property and will be leasing the property to the buyer.

What Can Go Wrong

When determining what can go wrong, you can look to the providers of reps and warranties insurance. In an episode of my podcast, M&A Talk, I interviewed TJ Noonan, Managing Director of M&A Transaction Solutions Practice with Hyland. He provided the following statistics based on the number of claims under reps and warranties insurance policies for M&A transactions regarding these common problems: 

• Financial statement accuracy: 20%
• Tax liabilities, such as income and payroll taxes: 18%
• Compliance with laws, such as minimum wage laws: 15%
• Material contracts, such as all customer contracts being in good standing: 13%
• Miscellaneous, such as IP, litigation, operations, environmental, and more: 34%

Learn More

To listen to the full interview, check out the M&A Talk episode Reps and Warranties Insurance with TJ Noonan at morganandwestfield.com/resources/podcast. 

List of Documents and When They’re Shared

Every transaction is different, but here are my general guidelines.

Here’s what to share before you accept an LOI:

• Confidential information memorandum (CIM)
• Profit and loss statements (P&Ls)
• Balance sheets
• Summary or abstract of your lease
• List of assets included in the purchase price
• Sales literature and brochures

Before accepting an offer, you should be cautious regarding what information you disclose to a buyer. You should come across as motivated and cooperative, but you shouldn’t comply with every request they make. At some point, you should politely and tactfully ask the buyer to make an offer.

Here’s a partial list of what to share after you accept an LOI:

• Federal income tax returns
• Bank statements
• Invoices and receipts
• Full copy of the lease for the premises
• Equipment leases
• Third-party contracts, such as supplier or vendor contracts
• Sales and use tax reports
• Staffing and payroll-related documents, including job descriptions and employment contracts
• Insurance-related documents like workers’ compensation, as well as health and liability insurance
• Equipment inspection reports
• Licenses and permits
• Marketing, advertising, and promotional documents
• Environmental documents and inspections

The list above isn’t typical for every business. Each business will have a unique due diligence structure. Most due diligence requests are more extensive than the list above, but this gives you a general idea of what documents are shared before and after you accept a letter of intent.

Handling Buyers Who Request Too Much Information

How should you handle a buyer who’s requesting too much information, such as bank statements and tax returns, before submitting an offer? 

While this is uncommon with seasoned buyers, you may experience these types of requests from smaller corporate buyers or from those who may have ill intentions. If so, explain to the buyer that a thorough investigation can only be conducted after you accept an offer. Tactfully point out that once an offer is accepted, they’ll have plenty of time to perform their due diligence and verify the accuracy of your representations. Let the buyer know that you’re making representations that will be verified during due diligence. 

The Importance of “Representations” and “Warranties”

Due diligence is never perfect – it can never uncover every potential problem with a business. The buyer can never be absolutely assured that your business is without problems. In fact, there’s no such thing as a “perfect” business. 

If a buyer can’t ensure your business is problem-free by performing due diligence, what can they do?

Reps and warranties are statements and guarantees by you, the seller, relating to the assets, liabilities, and other elements of the business you’re selling. You’ll be required to make factual statements in the purchase agreement regarding the condition of your business, covering nearly all aspects of your company. 

Essentially, you’re assuring the buyer that your representations are true, and if proven to be otherwise, the buyer will be entitled to seek legal remedies, which could result in you having to reimburse the buyer for damages. Reps and warranties collectively serve to mitigate the risk of any material defects that weren’t discovered, or disclosed during due diligence.

• A representation is a statement of fact. If a representation is untrue, it’s “inaccurate.”
  • As the seller, you may represent that the assets of your business are in good repair, that all inventory is salable, that there are no hazardous substances used in the business, that it’s operated in compliance with all laws, or that you have the legal capacity to sign the purchase agreement. 
• A warranty is an assurance. If a warranty is untrue, it’s “breached.”
  • You may warrant that you’ll operate the business in a regular and normal manner and will comply with all laws until closing, or you’ll pay all payroll taxes that will come due from past operations up to the time of closing. 

Reps and warranties in the purchase agreement assure the buyer that legal remedies will be available if you fail to disclose any material facts regarding your business that aren’t subsequently discovered during due diligence. Reps and warranties assure potential acquirers that additional protection is available if you aren’t fully forthcoming during due diligence. It covers any gaps that are naturally present within any due diligence process.

Due diligence is never perfect – it can never uncover every potential problem with a business. 

Due diligence is the buyer’s investigation of every aspect of your business and is conducted in four primary areas:

1. Operational due diligence
2. Financial due diligence
3. Legal due diligence
4. HR due diligence

Each of these areas can benefit from proper preparation. Here’s why you should prepare for due diligence, the benefits it can provide, and how to go about preparing your business for the grueling process of due diligence. 

The Importance of Preparing for Due Diligence

If you don’t prepare for due diligence, it can turn into an expensive and time-consuming undertaking. Therefore, preparation is a crucial step in selling your business quickly and for maximum value.

The primary purpose of preparing for due diligence is to address potential problems before they’re discovered by buyers. To attract a sophisticated buyer to your company, you want to make sure your business is in the best condition possible. Preparing your business for sale dramatically increases your chances of success. Laying the groundwork for due diligence decreases the buyer’s perception of risk in your business and may even convince them to agree to a shorter due diligence period and less restrictive protections in the purchase agreement.

When selling a business, time is your greatest enemy. Time kills all deals – eventually. By organizing documents so they’re ready for review, you’ll shortcut the process. You may also increase the chances of receiving an offer since buyers are often reluctant to make an offer on a business they may have concerns about. 

Buyers don’t want to risk the time and financial investment in performing due diligence only to find an undisclosed problem. Preparing for due diligence mitigates these concerns for buyers. It also means you’re ready for the buyer to start reviewing documents immediately after you accept an offer, which can potentially speed up the process and dramatically improve your chances of closing the deal.

I highly recommend you prepare for due diligence as early as possible. This is where your accountant or CFO can really help with gathering the documents you need. 

In one transaction I worked on, due diligence was significantly delayed because the seller didn’t have copies of bank statements on hand, and it took several weeks to obtain the original documents from the bank. This delay ended up resulting in a price concession because the economy showed signs of weakening during this period. If the seller had prepared for due diligence in advance, this likely would not have happened and the seller would have put an additional $3 million in their pockets at the closing table.

By taking the time and effort to prepare your business for sale, you also demonstrate to the buyer that you’re serious about exiting your business. Buyers prefer to deal with sellers who are both motivated and prepared, and are reluctant to invest time with any sellers who they believe are anything less than committed to the process.

Benefits of Preparing for Due Diligence

By properly preparing for due diligence, you will:

Resolve Issues Before They Become Dealbreakers: When a buyer decides to pursue the acquisition of your business, they’ll conduct thorough due diligence before they commit to the transaction. Unexpected issues that arise during the buyer’s investigation may potentially kill your deal. You can resolve many of the issues before a buyer ever learns of them with advanced warning of any unsettled problems. Further, a problem identified in advance that can be explained will keep your credibility intact. Preparing for due diligence enables you to work out problems before a buyer even comes into the picture. 

For example, issues with financial records, if not addressed beforehand, usually trigger demands for a lower price, more restrictive terms, or may cause the buyer to walk away from the sale entirely.

Improve the Odds of a Successful Transaction: Preparing for due diligence allows your advisor team to correct potential problems in advance and helps avoid pitfalls to a sale before you expose your business to buyers. With inaccurate financial records, you run the risk of losing a buyer because once the buyer discovers the defects during due diligence, the sale must be delayed to address the problems. After spending many months finding a buyer, losing them over something that could have been corrected from the outset is a disappointment and a waste of valuable time, money, and resources. This scenario plays out more often than sellers realize because, despite working in their business full-time, owners are often unaware of seemingly simple issues. But those simple issues can have a material effect on a buyer’s perception of the relative risk of a company if they aren’t resolved in advance. 

Retain a third party to examine your financials – profit and loss statements, balance sheets, and federal income tax returns – and scrutinize key ratios, trends, and other data, and then provide you with a report of their findings. This helps spot potential issues a buyer may find with your financial records and allows you to address these issues before you ever receive an offer.

Speed Up the Due Diligence Process: Having your financial records in order before selling your business can speed up the due diligence process once you accept a letter of intent, resulting in a higher chance of closing the deal. This is because a buyer who finds issues with your financial records will most certainly conduct due diligence more thoroughly, looking for problems in other areas as well. Shoring up problems before due diligence shows buyers that you and your business are trustworthy. As a result, they may review your records with less scrutiny or curtail due diligence altogether, thus making it more likely your deal will close. 

Maximize Your Sale Price: Conducting pre-sale due diligence maximizes the value of your business by identifying issues early on to avoid complications that can affect the transaction. Simply put, the more organized your business’s financial records appear, the more likely you’ll sell your business quickly and receive top dollar for it. A thoughtful evaluation of your business before the sale process begins will make the undertaking much more manageable, efficient, and cost-effective for you.

Increase the Strategic Knowledge of Your Business: Through the process of preparing for due diligence, members of your advisor team will come to know and understand your company as well as you do – and far better than a potential buyer. This understanding enables your transaction advisor to prepare a confidential information memorandum (CIM) and other marketing materials that fully describe and highlight the strengths of your business. Highlighting your business’s strong points and being fully prepared to explain its intricacies will put you in the best possible position to sell your business for top dollar.

How To Prepare for Due Diligence 

Getting your business ready for due diligence is a relatively straightforward endeavor. It involves assembling and organizing the documents that most buyers request and review during the due diligence period. It may also involve retaining a third-party expert to review these documents and uncover any issues the buyer may discover during due diligence. You should then address any problems once they’re uncovered before you go to market. 

Preparing for financial due diligence is one of the most important parts of successfully closing the sale of your business. The number one deal-killer of business sales is incomplete or inaccurate financial records. This should prompt you to ensure that your financials are in order beforehand. It’s far easier to address potential obstacles to a successful negotiation on your own time without the added stress of the transaction being dependent on its outcome. Otherwise, you risk losing the buyer since financial inaccuracies will most likely be discovered during due diligence. 

No business owner wants to invest enormous amounts of time with a buyer only to lose them to something that could have been prevented. Pre-sale financial due diligence should be conducted by a third party, preferably a CPA with experience in conducting a quality-of-earnings analysis (Q of E). A third-party professional will be able to look objectively at your business and spot mistakes you might otherwise miss. Ideally, this should be performed at least three to six months before beginning the sale process. This will give you ample time to resolve any issues before the buyer even sees them.

Preparing for financial due diligence is one of the most important parts of successfully closing the sale of your business. 

“Knowledge is a process of piling up facts; wisdom lies in their simplification.” – Martin H. Fisher, American Physician and Author

After you accept a letter of intent (LOI) for your business, the buyer will begin confirmatory due diligence, as opposed to preliminary due diligence, which occurs before the LOI is signed. Due diligence is the process of gathering and analyzing information to help the buyer determine whether to proceed with the transaction. 

Due diligence normally lasts 30 to 60 days but can be extended if both parties agree. In most circumstances, the buyer can walk away from the transaction if they’re unsatisfied for any reason during the due diligence period.

So, what’s a seller to do? Start by conjuring up your best Boy Scout. Start by being prepared. Doing proper due diligence on your own business before going to market will uncover any problems and give you a chance to resolve them before a buyer discovers them. 

The Purpose of Due Diligence

Businesses are complicated – there are hundreds of factors buyers must take into consideration when deciding if they would like to move forward with the transaction. Due diligence is the process of verifying facts about your business’s financials, operations, and myriad other details.

When evaluating a home for sale, buyers can quickly form an opinion on its value and suitability, even before hiring someone to conduct an inspection of the property. Homes and other tangible purchases often require little to no due diligence. However, buying a business involves assessing many intangible factors that aren’t readily apparent and are more difficult to evaluate. 

As a result of this increased complexity, buyers of businesses go through a lengthy and thorough due diligence process before completing the transaction. 

When Due Diligence Is Conducted

Due diligence begins the moment you accept a letter of intent. Only after that point are your representations verified during due diligence. This is important because if all buyers conducted their due diligence before you accepted an offer, you’d spend a tremendous amount of time with many buyers and risk a leak in confidentiality. Conducting due diligence with multiple parties simultaneously may also lead you to lose focus on your business, causing its value to decline. That potential loss of value is why the buyer must accept your initial representations at face value before they make an offer – only after you accept their offer can the buyer have the opportunity to verify your representations.

While considering the sale of your company, selling only a portion of your business may cross your mind. Many business owners have all their wealth tied up in their company, even though doing so may be considered risky. Selling a piece of your company allows you to create liquidity while still maintaining control of the remainder of your business. It also allows you to focus your talents on the division you think has the greatest potential. It’s important to remember that selling a business is not always an all-or-nothing proposition. Just ask Jack Welch.

General Electric CEO Jack Welch was well-known for divesting businesses as a way of “pruning” the company to give way to the growth of the remaining business units within GE. In his first four years as GE’s CEO, he divested over a hundred business units accounting for about 20% of GE’s assets. Welch eliminated over 100,000 jobs through layoffs, forced retirements, and divestitures. During Welch’s 20-year reign, GE’s profits grew to $15 billion from $1.5 billion, as market valuation increased to $400 billion from $14 billion. 

Publicly owned companies, which are usually under intense pressure to meet projected quarterly earnings, commonly sell non-core divisions. And so can you, even if you’re no Jack Welch. 

Selling a piece of your company allows you to create liquidity while still maintaining control of the remainder of your business. 

Why Businesses Sell Part of Their Companies

The sale of a portion of a business is called divestiture. This typically happens when a company’s management decides they no longer want to operate a business unit or asset. 

So, why do businesses sell part of their companies? Here’s why: 

• A divestiture is often a means of focusing on the core competencies of the company by spinning off non-core divisions. In other words, a business may divest divisions that aren’t part of its core operations to allow the entire company to focus on what it does best. A company’s strategic development plan may involve divesting or spinning off non-core businesses while strengthening core operations through a series of disciplined acquisitions.
• Companies sometimes make bad acquisitions and later divest those divisions to correct their mistakes. The buyer may be too large, and the new company may suffer from a lack of attention after the acquisition. Sometimes, poor management decisions lead to a need to divest non-performing business units. Selling a weak division is a straightforward management decision.
• Selling non-core divisions could also be a way to raise funds. A divestiture generates cash at the sale, with that cash being invested in more promising opportunities that can yield higher returns. Also, a company’s individual components are sometimes worth more than the company as a whole. Therefore, breaking up the company and selling its pieces can yield more than if the business were sold in its entirety.

Deciding to Sell a Portion of Your Business

As a business owner, you don’t need to sell your entire company should you decide to retire or cash out. With proper strategic planning, you can often sell just a piece of your company, allowing you to generate additional funds for your retirement or provide you with growth capital to invest back into your business.

As the owner of a mid-sized company, the decision you face may not be as straightforward as it is for the management of large companies like General Electric.

When deciding whether to sell the whole company or only a portion of it, first examine the overall value of your business and then the individual value of each division. It may be possible to sell your business in pieces to extract the most value.

You have two main options in selling a portion of your business:

1. Sell a Percentage: Selling a certain percentage of your entire company is usually structured as a percentage of your stock. This type of sale is often called a recapitalization and is commonly used by business owners looking to retire in stages. These business owners may just want to take some cash off the table. 
2. Sell a Division or Unit: Many companies are acquired for strategic purposes. A buyer may see tremendous value in one division of your company while seeing little value in your other divisions. If this happens, you may consider a spin-off of one division. 

Selling a Division Is a Strategic Decision

The cost of keeping a non-performing or non-core division could be much higher than the returns that could be generated by selling that division. This strategic decision could free up your time and energy, allowing you to focus on your core operations, potentially dramatically increasing its value as well.

A common example I encounter is a business that originally started as a single retail location and gradually evolved into a business with multiple retail outlets and significant online sales. Splitting the business into two divisions – an online division and a retail division – may make the company easier to sell and potentially maximize its value. Many buyers have a strong preference for online-based businesses and a strong aversion to retail businesses, or vice versa. Selling the divisions separately solves this problem.

Splitting your company in two may make it easier to sell, boost its value, and ultimately increase the final selling price. Value is directly related to risk. The higher the risk, the lower the value. By splitting the business into two, you potentially reduce the level of risk for the buyer. Why? Because few buyers possess the skills and knowledge necessary to be successful in multiple domains, such as in both the retail and online realms.

If your business consists of two segments but can only be sold as a whole, the buyer may view one segment of your business as excessively risky if they lack experience in that segment, and the valuation will therefore be lower. Most buyers’ skill sets are concentrated in one domain. Therefore, to use the example above, if both the online and retail divisions can be sold separately to buyers who have a strong background and experience in each domain, the risk will be lower for each buyer, and you will potentially receive a higher purchase price because of the reduced risk.

Many companies develop additional product lines as a part of their overall corporate growth strategy. In the process, many business owners create product lines they later regret pursuing. The product line may not fit in with the overall operations or may make the business owner lose focus on their core business. In that case, selling the product line can make sense.

Additionally, many buyers search for strategic acquisitions and have specific criteria regarding which businesses they’ll consider. They may be interested in just one component of your business and may not pursue your business as a whole because your other divisions don’t align with their strategy.

Popular divestitures include the decision of former Hewlett-Packard CEO Meg Whitman to spin off and merge the company’s non-core software assets with Micro Focus, a British company. This transaction was valued at about $8.8 billion, significantly less than the $11 billion it spent to acquire the division five years earlier. 

Even smaller companies can benefit from splitting their businesses into separate divisions and selling them individually. For instance, some businesses require special licensing, so breaking the business into two divisions may be prudent, as some companies may only be interested in the divisions that don’t require the licensing.

Regardless, the decision should first be considered from a strategic standpoint, so you should ask yourself if selling a division will help you accomplish your long-term objectives. Only after you’ve considered the strategic elements of the decision should you consider the tactical components, or the “how to’s,” which I’ll address next.

Consider the Operational and Legal Implications

After you’ve decided that selling only a portion of your business aligns with your long-term objectives, you’ll be confronted with the operational realities of doing so. Navigating the legal structures while managing your business is no easy task. The following explains how to handle some of those challenges. 

Operational Implications

You must first be sure your division can be segregated from an operational standpoint before considering the legal implications. Some divisions are so intertwined that it’s impossible to separate them, or doing so could prove too costly. 

Do you have a separate website, phone number, and facility for each division? Can costs be accurately allocated between divisions? Do you have employees who share duties for each division? If so, which division would they remain with? The answers to these questions should be considered as early as possible to determine how practical it is to separate the divisions from an operational standpoint. In many cases, significant work needs to be done to separate divisions on an operational basis.

Few buyers want to take the risk of creating a separate website, hiring new employees, and completing the dozens of other tasks involved in establishing a new division unless you’re selling a unit, such as a product line that can be easily integrated into another company. 

If the division is likely to be run as a stand-alone entity by the buyer, you should run it as a stand-alone business with a separate P&L for as long as possible before putting it on the market. Doing so will make the business easier to sell and will simplify the process of valuing each division separately. This will also increase the chances of the buyer being able to obtain third-party financing for the transaction. Running a division independently prior to beginning the sales process will make it notably easier to sell. Hawking an integrated division as a divestiture will make it much more difficult to sell.

Legal Implications

When selling a division, there are two main methods for structuring the deal from a legal perspective – asset sale or stock sale: 

• One Entity: If your business is one entity – such as a corporation or LLC – with two segments, your only option is to structure the sale of one of the divisions as an asset sale. In an asset sale, your entity sells the individual assets of the division to the buyer via an asset purchase agreement (APA), and the assets are listed and transferred separately in a bill of sale. The APA is sometimes called the definitive purchase agreement – the name simply indicates that the agreement is definitive or is the final agreement signed at closing.
• Separate Entities: If each division is a separate entity, the sale can be structured either as an asset sale or a stock sale. A stock purchase agreement (SPA) is used for a stock sale, and an asset purchase agreement (APA) is used for an asset sale. In a stock sale, you sell the shares of the entity that owns the division and its assets. Because the entity owns the assets, there’s no need to transfer the assets separately.

Recapitalization

You also have the option of selling a percentage of your company, usually by selling a portion of the shares of your entity. But this method of divestiture defeats the purpose of focusing on your core competency because you’ll still own all divisions post-closing. This type of sale is often called a recapitalization, or “recap,” and is commonly used by business owners contemplating retirement but who aren’t ready to completely retire. 

Recaps are most commonly funded by financial buyers, such as private equity firms that purchase a minority or majority position in your business. The catch is that they expect you to use the equity injection as growth capital in your company, not for a cruise to the Bahamas. 

Private equity firms have a limited time horizon and are counting on you to grow the firm and exit your business in three to seven years. Recaps, or minority investments, are also made by corporations, but this is less common than those made by financial buyers. Recaps are best for business owners who want to receive the support of a sophisticated investor with deep pockets willing to inject some growth capital into the business. 

The decision to sell a division should begin with your long-term goals. If you wish to focus on your core division, a recap is likely not for you. On the other hand, if you want to diversify your risk and are willing to continue operating the business, a recap may be a sensible strategy.

Determining an Asking Price for a Division

The asking price for a division is determined using the same methods to value an entire business. In essence, you’re selling a cash-flow stream. To properly value the cash-flow stream, you must first measure it. And here’s where it gets tricky. 

If the two segments are closely interwoven, it may be difficult to calculate the EBITDA for each division separately. If the businesses aren’t being run as stand-alone units, a pro forma must be prepared. However, any errors in the pro forma will be magnified by the multiplier. For example, if you overstate income by $500,000 and your business is valued at a 5.0 multiple, your business will be overvalued by $2 million ($500k x 4.0 = $2 million).

Preparing a pro forma for a division can be tricky due to the difficulty of properly allocating expenses between divisions. While revenue may be easier to allocate than expenses, the impact of any inter-division transactions on revenue must also be considered. When allocating expenses, you must also decide how to allocate fixed expenses. 

For example, if your facility costs are currently $20,000 per month for both divisions, what would a reasonable rent be for each division separately? The same idea goes for allocating other forms of corporate overhead such as salaries, insurance, professional fees, advertising, and marketing.

An alternate method is to value the business as a whole and then assign weights to each division based on the revenue that each division generates. Such a calculation would only be reasonable if the two divisions have similar margins and expenses, such as with two similar product lines.

For example, if your company generates $20 million in revenue and is valued at $10 million, and “Division A” generates $12 million in revenue, or 60% of the total, and “Division B” generates $8 million in revenue, or 40%, then Division A would be worth $8 million ($10 million x 60%). 

While assigning weights to each division may seem to be a reasonable computation, some buyers may not accept this type of calculation. Buyers tend to be wary of such estimates because assigned weights are likely to understate the amount of fixed expenses and therefore overstate income or margins. Because of these inaccuracies, profitability may differ significantly between divisions.

Ideally, the divisions should be valued based on the profit each division generates. Unfortunately, doing so involves numerous assumptions that are prone to error. A back-of-the-envelope method for obtaining a ballpark valuation for each division isn’t difficult, but such a ballpark estimate is unlikely to suffice for most buyers. A ballpark estimate should only be used for internal planning purposes – and for valuing ballparks.

If a buyer is looking to obtain a division of your company for strategic purposes, different valuation methods should be considered. 

In such cases, you should prepare a pro forma P&L based on your division being integrated into the buyer’s company. It’s likely that certain functions for the division, such as HR, legal, and accounting, will be centralized by the buyer, which will reduce expenses and increase income for the business and therefore, increase its value. 

While a reduction in expenses is considered a safe bet, buyers are less likely to pay for revenue synergies than synergies resulting from reduced costs. Even in the case of operational synergies such as reduced costs, you must aggressively negotiate to receive value for these. 

This is compounded by the fact that buyers rarely provide you with their financial models or pro formas, so the best you can do is prepare an estimate and negotiate to receive as high a percentage of the synergies as possible. 

Selling a Division is a Strategic Decision

In some cases, it only makes sense to sell your business as a whole. In other cases, the wisest course of action is to sell your divisions separately. Your decision depends on a number of factors that a professional can help you evaluate. You should first examine the overall value of your business and the value of each division separately. Once you’ve done this, you should clarify your long-term objectives and determine if selling a division or selling your company as a whole is the best way to meet your goals.

Regardless, the decision to sell a division or segment of your business is strategic and should be based on your long-term objectives. Consider the following questions when deciding whether to sell your company as a whole or in parts:

• Would I be happier if I simplified operations and focused solely on my core business?
• Have I spread myself too thin? If so, would selling a division help sharpen my focus?
• Knowing what I know now, would I start both divisions again?
• Which division produces the most profit for me?
• Which segment of the business is most suited to my skills and strengths?
• How hard would it be to sell each segment separately?
• Is it practical to sell each segment separately?
• What’s the potential value of each division?
• What’s my number one bottleneck now? 
• Do I need growth capital to significantly grow my business? If so, would selling one of the divisions free up enough capital and energy to allow me to focus on my core competence?
• If I sold one of my divisions, could I reinvest the money in the remaining division and significantly boost revenue and income?

Once you consider the answers to these questions, as well as the operational and legal implications, you can determine the wisest course of action. Regardless, you should retain a professional to examine your business and advise you on the best way to proceed. Your plan of action depends on several factors that an expert can help you evaluate, including how much stake you want to have in the future of the company. Also, having your business valued as a whole and in pieces can help you decide what will yield the highest price. Either way, a professional will be able to assist you with selling your business however you want, so don’t be afraid to seek professional advice.

Remember that selling a portion of your business doesn’t mean giving up something – it only means letting go of a “part” to let the “whole” thrive. After all, the cost of keeping a non-performing or non-core division could be much higher than the returns.

Conclusion

As discussed, a $20 million all-cash offer isn’t the same as a $20 million offer with $1 million down and a $19 million earnout. When receiving an offer, you should evaluate the various financial and legal components to determine how favorable it is compared with others on the table.

You should first evaluate the form of consideration. How is the purchase price being paid? The purchase price can be paid as follows:

• Cash: This can include cash the buyer has on hand, third-party financing, or the assumption of long-term debt.
• Seller Financing: The terms of the seller note and the creditworthiness of the buyer should be considered.
• Stock: The financial health of the acquirer and liquidity of the stock should both be carefully considered.
• Earnouts: Earnouts are a complex matter and should be carefully considered before you commit to one.
• Employment or Consulting Agreements: These are normally guaranteed payments but are taxed at ordinary income tax rates to you, as opposed to long-term capital gains tax rates.
• Holdback/Escrow: Most transactions include a holdback, although the terms of the holdback should be analyzed to ensure they are reasonable.
• Royalties and Licensing Fees: Licensing fees are less commonly used and are designed to compensate you for new product launches.

Next, you should evaluate the legal structure of the transactions. Most small and mid-sized transactions will be structured as asset sales. If that’s the case, the allocation of the purchase price is critical and will have a tremendous impact on your tax implications. The allocation of the purchase price should be carefully analyzed by your accountant to determine if it’s reasonable and to evaluate the extent to which taxes can be mitigated.

Sometimes it’s amazing that deals get done at all. There are many aspects of every transaction that must be worked out and agreed to by the parties. Here’s an important one that often flies under the radar until quite late in the process – how the purchase price is allocated for tax purposes.

Allocating the purchase price, or total sale price, of a business among the various assets of the business – or asset “classes” – is necessary for tax purposes when a company is sold. This is the case regardless of whether the sale is structured as a stock sale or asset sale. 

The allocation of the purchase price can become a contentious area of negotiation after the price, terms, and other conditions of the sale have been agreed to. In most cases, what’s good for you is bad for the buyer, and vice versa, which can lead to disputes. In the end, it’s crucial that both you and the buyer meet somewhere in the middle to satisfy your respective goals. An agreement has to be reached because both allocations should match, and a discrepancy can trigger an audit.

Unfortunately, many transactions have been known to come to a halt because a buyer and seller can’t reach an agreement about the allocation of the purchase price. This is more likely to happen when the negotiations have been more intense. The allocation of the purchase price sometimes becomes the final straw, causing a buyer and seller to abandon the transaction altogether. Don’t get blindsided by an afterthought at the end of negotiations. 

The allocation of the purchase price is a contentious area of negotiation. In most cases, what’s good for the seller is bad for the buyer, and vice versa, leading to disputes.

Why the Allocation of Purchase Price is Necessary

Before the closing can take place, you and the buyer must agree on how the purchase price will be allocated for tax purposes. After coming to an agreement about the purchase price, both parties are required by law to file Form 8594 with the IRS. This form must be filed with each of your tax returns at the end of the year. While there is no legal requirement that the buyer’s and seller’s allocations match, most tax advisors agree the chances of an audit are increased if the allocations differ.

The Purpose of IRS Form 8594

IRS Form 8594 breaks down the assets of the business being purchased or sold into seven classes. Each class of asset is treated differently for tax purposes. It’s therefore important that you carefully consider how you’ll classify each asset, as it can have significant tax and financial implications for both you and the buyer.

Specific allocations are referenced on the IRS form and are broken down as follows:

• Class I: Cash and bank deposits
• Class II: Securities, including actively traded personal property and certificates of deposit
• Class III: Accounts receivables
• Class IV: Stock in trade (inventory)
• Class V: Other tangible property, including furniture, fixtures, vehicles, etc.
• Class VI: Intangibles, including covenant not to compete
• Class VII: Goodwill of a going concern

As the seller, you should generally seek to maximize amounts allocated to assets that will result in capital gains tax while minimizing amounts allocated to assets that will result in ordinary income taxes.

Stock vs. Asset Sales

Where stock sales are concerned, most of the purchase price is normally allocated to the value of the stock, with the remainder being allocated to the value of any non-competition agreements, consulting agreements, or any other assets that you personally own, or sold by you (i.e., John Smith, not Acme Incorporated), and not your entity.

In a stock sale, the buyer doesn’t receive a stepped-up basis in the value of the assets, but instead inherits your existing basis in the assets. Most buyers prefer not to structure the transaction as a stock sale because they lose the tax benefit of being able to depreciate the assets at a higher, stepped-up value. 

For you, a stock sale is advantageous because you must pay the lower capital gains tax rates on stock held for more than one year, as opposed to the higher ordinary income tax rates. This is one of the reasons asset sales dominate smaller business sales – because the buyer can depreciate the cost of the assets they acquire, which reduces the buyer’s income taxes. On the other hand, with stock sales, there are no immediate tax benefits to the buyer.

Common Allocations

Here’s a description of the major classes of assets and common allocations for each:

Class I: Cash and bank deposits

• Allocation: None. 
• Notes: These assets aren’t usually included in the purchase. If they are included, they’re listed at face value.

Class II: Securities, including actively traded personal property and certificates of deposit

• Allocation: None. 
• Notes: These assets aren’t typically included in the purchase. If they are included, they’re listed at face value.

Class III: Accounts receivables

• Allocation: None. 
• Notes: These assets aren’t normally included in the purchase. You typically retain ownership of the accounts receivables as of the closing date, and the buyer receives the outstanding payments and remits them to you post-closing.

Class IV: Stock in trade (inventory)

• Allocation: Normally valued at your original cost.
• Notes: As a result, there’s no gain for you and, therefore, no tax due on the amount allocated to this asset.

Class V: Other tangible property, including furniture, fixtures, vehicles, etc.

• Allocation: Usually valued at current market value, often “replacement value.” Note that the buyer may have to pay sales tax on the amount allocated to this class of assets.
• Notes: Any gain on the sale of tangible property is taxed based on ordinary income rates to you, and the buyer can depreciate these assets based on their stepped-up value.

Class VI: Intangibles, including covenant not to compete

• Allocation: Normally less than a few percentage points of the purchase price.
• Notes: You must pay ordinary income taxes or capital gains taxes based on the amount allocated to intangible assets depending on whether the non-compete is considered compensatory or capital.

Class VII: Goodwill of a going concern

• Allocation: The balance of the purchase price is typically allocated to goodwill.
• Notes: Goodwill is treated at capital gains tax rates for you, and the buyer can amortize goodwill over a 15-year period.

Once the parties agree to the allocation, the allocation is usually attached as a schedule to the purchase agreement and signed at closing. The parties then file IRS Form 8594 at year-end, ensuring that IRS Form 8594 matches the allocation provided in the purchase agreement.

Additional Tips for Allocating the Price

Avoid placing a value on the hard assets of the business in the early stages of the transaction, such as in the confidential information memorandum or even during due diligence. 

For example, a buyer may innocently ask, “What’s the value of the hard assets, such as your equipment?” If you inflate the value, the buyer may later use this against you and argue that the value you provided should also be used for determining the allocation of the purchase price. 

Also, don’t be ashamed about giving the buyer a low or realistic value of your hard assets – remember, you’re selling an income stream, not a collection of hard assets. You and the buyer will each have a unique perspective when it comes to how to allocate the purchase price. Each asset class will have a different effect for you and the buyer. It’s important to give the allocation careful consideration because these differences can amount to significant tax and financial repercussions for you. You need to weigh the advantages and disadvantages of each allocation because it significantly affects your bottom line.

The type of entity you have will also impact the structure of your transaction, so it needs to be considered well in advance of starting the sales process. One of the primary considerations when structuring the sale of your business is taxes. Federal and state taxes can dramatically impact your net proceeds. 

The type and amount of taxes you must pay depend on whether your company is structured as a partnership, corporation, LLC, or other type of entity. Tax implications can have a significant impact on the financial elements of the transaction for both the buyer and the seller. You should always consult with a qualified attorney or tax professional when considering how to structure your transaction. But a review of the concepts discussed here will give you a head start. 

Single and Multi-Member LLCs

Single-member LLCs are pass-through entities – there is generally no tax on the LLC itself. The sale of an LLC can be structured as a sale of assets or a stock sale – although technically, it’s a sale not of shares of stock but rather “membership interests” in the LLC. Regardless, the sale is treated and taxed as an asset sale, though some rare exceptions exist. Therefore, tax rates depend on how the purchase price is allocated. LLCs may also be subject to higher self-employment taxes than S Corporations, so I recommend consulting with your CPA prior to the sale.

If you’ve elected for your LLC to be taxed as a C Corporation, different rules apply.

Partnerships

If your business is structured as a partnership, the sale can only be structured as an asset sale. A partnership is a pass-through entity, which means that only the members pay taxes – the entity itself does not pay taxes. Taxes are paid at both capital gains rates and ordinary income tax rates, depending on how the purchase price is allocated.

S Corporations

If you own an S Corporation, the sale can be structured as an asset sale or a stock sale as follows:

• Asset Sale: If it’s structured as an asset sale, your tax rates will primarily be determined by how you allocate the purchase price. 
• Stock Sale: If it’s structured as a stock sale, most of the proceeds will be taxed at capital gains tax rates, with some minor exceptions – amounts paid directly to the owners, such as consulting fees, are subject to income taxes. 

S Corporations aren’t taxed twice at the federal level, which is their primary advantage over C Corporations. State income taxes may also vary from state to state. 

Some states, such as California, only have income tax rates and don’t have capital gains tax rates. For that reason, it’s crucial to investigate your state’s tax laws to ensure you minimize the tax implications of your sale.

If your S Corporation was recently converted from a C Corporation, the IRS has created a 10-year look-back period for this situation, and the transaction will be treated as if you were still operating as a C Corporation. If this might apply to you, I recommend consulting a CPA.

C Corporation

Your business is a C Corporation unless you or your shareholders have filed Form 2553 with the IRS electing to be taxed as an S Corporation. If the sale is structured as an asset sale, the C Corporation will sell its assets, and you will face two levels of taxation – once at the corporate level when the corporation sells its assets, and again at the individual level when the corporation distributes the proceeds to its shareholders in the form of a dividend.

There are three primary methods of avoiding double taxation:

1. Structure a portion of the sale as the sale of the owner’s personal goodwill, which is not a personal asset. Check out the legal case, Martin Ice Cream Co., 110 T.C. 189 (1998).
2. Structure the sale as a stock sale, which is primarily subject to capital gains tax rates.
3. Allocate part of the purchase price to non-competition, consulting, and earnout agreements, which may be subject to income tax rates if paid directly to the owner.

If your business is structured as a C Corporation, I recommend consulting with a CPA experienced in structuring the sale of companies well in advance of the sale. You have many options, such as structuring some of the sale as a bonus or salary – or negotiating the sale as a stock sale. 

A question in every M&A deal is whether the transaction should be structured as an asset or stock sale. In this section, I’ll define these terms and then go over some of the key differences between these two transaction structures. 

Asset Sale

Most buyers prefer an asset deal due to the lower level of perceived risk inherent in such a structure. In a stock sale, the buyer inherits all your liabilities, which include any unknown liabilities, which are commonly called contingent liabilities. In an asset sale, the buyer only inherits those liabilities the buyer explicitly agrees to assume in the purchase agreement, along with successor liabilities, which the buyer assumes via statutory law and the parties therefore can’t avoid regardless of the form of the transaction. As a result of the reduced potential for risk, the reps and warranties can be more narrow in scope in an asset sale than in a stock sale.

In an asset sale, the buyer purchases the individual assets of the business from you, and you will retain ownership of your entity after closing. 

The Purchase Agreement used in an asset sale is normally called an Asset Purchase Agreement (APA) and is often used synonymously with a Definitive Purchase Agreement. The only difference is that the former includes an indication that the purchase is structured as an asset sale.

Also, in an asset sale, your assets and liabilities are transferred to the buyer individually. The buyer forms an entity, and that entity purchases the individual assets of your company. The parties then jointly decide which assets and liabilities are included in that transfer. The sale usually covers all hard assets necessary to operate the business and long-term liabilities are seldom assumed by the buyer.

If the value of a business is less than $100 million, chances are the deal will be structured as an asset sale. From the buyer’s viewpoint, an asset sale is more desirable due to certain tax advantages and the avoidance of any unknown legal risks (i.e., contingent liabilities) associated with your entity. From your viewpoint, asset sales are usually less desirable because the taxes due on a sale structured as an asset sale can be significantly higher than if the sale were structured as a stock sale.

If the value of a business is less than $100 million, chances are the deal will be structured as an asset sale.

Stock Sale

If a buyer acquires the stock in your entity, they will inherit all your liabilities, whether known or unknown (i.e., contingent). As a result, reps and warranties in stock deals are broader in scope than in asset deals due to the greater level of risk present. If your transaction is structured as a stock deal, the purchase agreement will customarily include representations regarding the capitalization and liabilities the buyer will be inheriting. 

In a stock sale, the buyer purchases your entity, such as your corporation or LLC. By purchasing your entity, the buyer then owns the assets owned by your entity. 

The Purchase Agreement used in a stock sale is normally called a Stock Purchase Agreement (SPA) and is also synonymous with a Definitive Purchase Agreement. The name “Stock Purchase Agreement” indicates the transaction is a stock sale. Generally, in a stock sale, the Buyer acquires everything owned by your entity – including unknown liabilities.

Few transactions in the lower middle market are structured as stock sales. Buyers prefer to structure a transaction as a stock sale if they want to transfer something your entity owns that can’t be independently transferred. For example, some contracts are owned by an entity and can’t be transferred without the explicit permission of the counterparty. 

In those cases, structuring the transaction as a stock sale ensures these contracts are passed to the buyer, assuming the contract doesn’t state that a change in control requires the consent to an assignment of the contract, known as a “change in control provision.”

Most transactions aren’t structured as stock sales due to the potential for the buyer to assume contingent liabilities and because the buyer inherits the tax basis of your entity, with the exception of a 338(h)(10) election, which recharacterizes a stock purchase as an asset purchase for federal tax purposes. 

A contingent liability is a liability the buyer doesn’t know exists, so they don’t know what they’re inheriting. When they purchase the stock of a company, a number of unknown liabilities could exist, and they’ll assume liability for those issues when purchasing the entity. 

Note: Shares in an LLC are technically called “membership interests.” However, for the sake of simplicity, most parties refer to the transaction as a “stock” sale.

Reps and warranties in stock deals are more comprehensive than in asset deals. 

Successor Liability

Regardless of the transaction structure, there’s a possibility of successor liability. Successor liability is a state law doctrine that allows a creditor to seek recovery from the purchaser for liabilities that weren’t assumed as part of the acquisition. Product liability, environmental clean-up, and employment law are areas where the doctrine of successor liability is most commonly applied.

Successor liability can be mitigated to a certain extent through reps and warranties, a holdback, and other protective measures. But for certain matters, successor liability can never be eliminated, such as for tax or environmental issues. 

In other matters, such as employee issues, successor liability can be mitigated by reducing the possibility of being labeled a “continuation” if the sale is an asset sale. The business is considered a successor, or continuation, if the product lines, employees, and other aspects of the business are substantially similar both before and after the closing. In other words, if the business is essentially the same, the courts may characterize the business as a “mere continuation” and impose successor liability. This happens in most M&A transactions, meaning that successor liability exists in most M&A transactions. As a result, many of the reps and warranties are designed to address these potential areas of liability.

Here are some of the tools the buyer usually proposes to reduce successor liability:

• In an asset deal, the buyer may explicitly list any liabilities they are assuming and any liabilities you are retaining.
• The buyer may also propose stringent reps and warranties regarding potential issues that may be susceptible to successor liability, such as environmental issues.
• Indemnification with reduced baskets for issues relating to successor liability may be included in the purchase agreement.
• A buyer may also attempt to reduce the appearance of “business continuity” to minimize the possibility a court may label the business as a mere continuation and therefore impose successor liability.
• A buyer may also require you to keep your entity open and liability insurance in place as long as possible. In certain cases, such as environmental or tax issues, liability may be indefinite, so the time the entity remains open should be carefully weighed against the potential for and the size of the risk. 
• A buyer may also propose a triangular acquisition structure to isolate liabilities in the subsidiary entity. In a triangular structure, the buyer entity forms a subsidiary entity, and the subsidiary entity either acquires or merges into the target. This structure isolates the liabilities within the subsidiary entity.

Why Most Transactions Are Asset Sales

Most transactions are structured as asset sales for two primary reasons:

1. Tax Purposes: If a buyer purchases your entity, they inherit your tax basis, with the exception of a 338(h)(10) election. But if they purchase your assets, they can often begin depreciating those assets again and experience more advantageous tax benefits. Asset sales dominate business sales because the buyer can write up the value of the assets and depreciate the cost based on the stepped-up value of the assets. On the other hand, in a stock sale, the buyer inherits your tax basis, with minor exceptions, and receives fewer tax benefits. 
2. Risk: If buyers purchase your entity, they inherit any unknown legal risks associated with it. These are known as “contingent liabilities.” For this reason, buyers prefer to form a new entity that doesn’t have any unknown risks.

One of the few reasons a buyer may want to purchase your entity has to do with the continuation of contracts or licenses. If your business has valuable contracts or licensing that may be interrupted by a transfer of ownership, the sale is sometimes structured as a stock sale. Be careful, though, as many contracts have a “change of ownership” clause that states that a substantial change of ownership in the company is treated as an effective change of ownership and explicit consent is therefore required.

The bottom line is that you can assume your transaction will most likely be structured as an asset sale if the value of your business is less than $100 million.

Definition of Buyer and Seller

When I refer to “Buyer” or “Seller” in a legal context, such as a reference to a party to an agreement, I’m referring to the individual or entity participating in the transaction. If the seller is an entity, such as a corporation or LLC, that’s what I’m referring to, not the individual. The same applies to a buyer. If the buyer is an individual, as in John D. Buyer, the buyer is John D. Buyer. 

The same rule applies to the buyer if the buyer is an entity, such as Acme Buyer Corporation. This distinction is important in the context of understanding the key differences between an asset and a stock sale.

Next, I’ll describe the financial components of the transaction structure in more depth and how they affect your overall deal structure, as well as the norms across transactions. 

Cash

Cash is king. Sellers always prefer cash, but buyers generally only put down as much cash as is required to motivate you to accept their offer. In most cases, the buyer will put down 60% to 80%, and the remainder will consist of an earnout, seller note, and holdback.

Can I sell my business for all cash?

The short answer is “Yes.” That’s the long answer, too, but the chances of selling your business decrease, and the timeline for selling your business increases if you demand all cash. While most businesses go to market without a price, asking for all-cash offers can significantly decrease the chances of selling your company. Buyers almost always consider multiple options when buying a business, and pigeon-holing them into all cash can make them hesitant. 

Debt and Liabilities

It’s essential to understand what happens to long-term debt when you sell your business. In some instances, the debt is absorbed in the transaction as part of the sale. But this isn’t the case most of the time. 

Short-term debt, which is a component of working capital, is usually included in the purchase price and is therefore assumed by the buyer. Short-term debt consists of accrued payroll and other ongoing obligations, such as rent, and payments to suppliers and vendors. 

The assumption of long-term debt is almost always excluded from the purchase price. There are three options for handling long-term debt at the closing:

1. You could settle the debt at closing through an escrow account. This is the most common method.
2. You can pay off the debt before the closing.
3. The buyer could assume the debt.

In most transactions, long-term debt isn’t assumed and is paid out of the proceeds at closing through an escrow account.

Seller Financing

How does seller financing work? If a business sells for $10 million and the seller carries a note for 20%, the buyer would put down $8 million and make payments on the remainder until the note is paid in full. Most M&A transactions in the middle market include s0me component of seller financing, though the amounts are low, often 10% to 20% of the transaction size. Seller notes are also commonly used in conjunction with third-party financing.

Advantages of a Seller Note:

• Lower taxes since you don’t pay taxes until you receive the money. But be sure the note is structured so it’s non-negotiable. 
• Less stringent requirements are needed for the buyer than obtaining a bank loan, which reduces the risk of a financing contingency if no third-party financing is involved.
• Minimal closing costs.
• Quicker closing time. 

A seller note is also commonly used in lieu of a holdback. One advantage of a seller note for buyers is the ability to offset the note against indemnity claims, otherwise known as a “right of offset.” Structuring a portion of the purchase price as a seller note can be used when the buyer is concerned about the veracity of your reps and warranties in the purchase agreement. The seller note would then have a right of offset based on the purchase agreement’s indemnification language. This right gives the buyer the ability to deduct amounts due under the promissory note for any indemnification claims. The seller could then argue that a holdback is not needed due to the right of offset in the seller note. 

The parties can also include negative covenants in the note, though this is rarely seen. Negative covenants reduce the payments if the business performs poorly, but also make the note appear more like an earnout, and most sellers won’t look favorably on this structure since the payments are essentially contingent. 

Nearly 85% of small business purchases involve seller financing.

How To Protect Yourself From Buyer Default

Because you’re functioning as a bank, you should pre-qualify the buyer before committing to financing a portion of the sale. A strong promissory note should be drafted with clauses that directly address either late payments or non-payments. A Uniform Commercial Code (UCC) lien should also be filed against the assets of the business to prevent the buyer from selling the business or its assets during the term of the note. 

You should also select a buyer you think will succeed from an operational standpoint. Additionally, you can require the buyer to maintain specific financial benchmarks post-closing, such as maintaining a minimum inventory level and working capital or specific debt-to-equity ratios. I also recommend that you have access to monthly or quarterly financial statements. This should enable you to spot problems early on, before they spiral out of control.

You can also obtain a buyer’s financial statements to ensure they have sufficient liquidity and are profitable, and research their previous acquisitions. Talking to the owners of companies they’ve acquired in the past may also be helpful. Depending on the size of the business, it may be prudent to perform due diligence on the principals of the company that wants to acquire your business.

Most problems related to seller financing originate from the seller accepting a low down payment. Otherwise, I see few problems regarding seller financing. Here are some common questions regarding seller financing: 

What interest rate is fair to charge?

In recent years, the interest rate charged on most promissory notes has ranged from 5% to 8%. The interest rate being charged depends more on the amount of risk involved than on the current cost of money. 

Some buyers argue that current interest rates are much lower and that the rate should be competitive with these. I explain to these buyers that such a loan is risky for the seller and that little collateral is available other than the undervalued assets of the business. If you default on a real estate loan, the bank can repossess the real estate used to collateralize the loan. But, if you default on a loan used to buy a business, there often isn’t anything to take back other than a struggling company.

Other factors that should be considered in determining the interest rate to charge include the total purchase price, the buyer’s level of experience and reputation in the industry, the buyer’s financial position, and perhaps most important, the amount of the down payment. The lower the down payment, the higher the interest rate that can often be justified.

What’s a third-party loan processor?

If you choose to finance the sale of your business, I recommend using a third party to service the loan. An experienced third-party loan processor can handle all aspects of collecting, crediting, and disbursing third-party payments. They simplify the day-to-day management and collection process as well as record-keeping – all of which frees up your time for more important tasks. An often-overlooked benefit of a third-party loan processor is that they serve as a buffer between you and the buyer if payments arrive late. That buffer can be extremely important in maintaining a good working relationship with the buyer post-closing. 

Can you sell the note for cash?

Yes, you can often sell the note after it’s matured for 6 to 12 months. There are many investors who purchase these notes, which effectively cashes you out. Unfortunately, investors will want to buy them at a steep discount from face value. If you’d like to leave this option open, it’s important to ensure that the note can be transferred or assigned to a third party.

Should you hire a private investigator?

If you’re considering financing a significant portion of the purchase price and doubt the buyer’s credibility, you should protect yourself. Money spent on an investigation could save you countless heartaches down the line if you find out the hard way that your prospective buyer is a bad credit risk.

A private investigator can reveal information about those who want to purchase your business. This information can help you determine the character of your buyer’s past and their creditworthiness.

It’s important to note that a signed release may be required by law to obtain this information. The buyer has a right to refuse the release, although they should understand your need to protect yourself if they ask you to finance the loan. Explain to the potential buyer that it’s a necessary action considering the financial risk you’re taking. They would have to do the same thing with a bank or financial institution. For more advice on this, consult your attorney. 

What documents need to be drafted?

You’ll need a promissory note and security agreement that address the key terms of the seller note. A Uniform Commercial Code lien on the assets of the business should also be filed post-closing. 

How many years should the note be for? 

Most notes range from two to five years. Common sense is the rule of thumb here. The cash flow from the business should more than cover the debt service (i.e., debt coverage ratio). Note that the term has a larger impact on the amount of the payment than the interest rate. If the cash flow is inconsistent, you should build in some cushion and structure the note so the payment is lower. This generally isn’t a problem unless the seller note constitutes a significant portion of the purchase price.

Third-Party Financing

By my estimate, third-party financing is involved in over half of mid-sized transactions. The buyer usually arranges the financing behind the scenes, so they don’t require any assistance from you in obtaining it. The one aspect of third-party financing that you may need to be aware of is the extent to which lenders include covenants in their loan agreement with the buyer. The lender must approve the terms of the transaction, and there are times when the buyer may need to propose new deal terms due to a lender’s requests. Knowing when this is a legitimate request vs. knowing when this is a ruse to renegotiate the terms is critical to protecting your interests.

Stock/Equity

Granting equity is most appropriate if you’ll remain in the business long-term and retain some level of involvement in the business moving forward. Technically, equity isn’t granted but instead is rolled over. For example, the buyer may only purchase 80% of your shares, so you retain a 20% interest. 

Long-term earnouts of five years or more should usually be replaced with equity. The primary advantage of equity as an alternative to earnouts is that equity often does a better job of aligning incentives and is also more suitable as a long-term strategy. Equity incentivizes you to think both short-term since profits can be taken out as distributions, and long-term due to growth in the value of the business over time. But both parties should also consider how you, as the seller, will eventually liquidate your ownership interest in the business. In most cases, this will happen through another exit in the future, which is the most common liquidity event. It’s also paramount that the parties draft bylaws, a shareholders’ agreement, and a buy/sell agreement to protect their interests and serve as a mechanism for resolving any potential disputes. 

Granting equity is most appropriate if you’ll remain in the business long-term and retain some level of control.

Stock-for-Stock Exchanges

A Type B reorganization is a stock-for-stock exchange in which the buyer pays for or “exchanges” your shares with stock in its own company. Simply put, you and the buyer are exchanging shares. In this situation, you receive stock in the buyer’s company, and the buyer receives stock in your company and your company remains as a stand-alone subsidiary of the buyer. A stock-for-stock exchange is most practical if the buyer is a publicly traded firm with a ready market for their shares, or if you don’t require liquidity now and see a strategic advantage in merging with the buyer. If the buyer’s stock isn’t readily traded, you will now hold illiquid shares and have difficulty cashing out the investment. Regardless, in most cases, you’ll have restrictions regarding when you can sell the shares and may argue for registration rights, which enhance your ability to sell your stock. A Type B reorganization’s primary advantage is that it’s tax-deferred since you won’t pay taxes until the new shares are sold.

Earnout

An earnout is a form of deferred payment that’s contingent on certain events occurring depending on the performance of your company after closing. An earnout can be tied to revenue, EBITDA, or a non-financial metric such as the retention of key employees or issuance of a patent. Earnouts aren’t magic bullets – they aren’t suitable for most transactions. Earnouts should primarily be used to bridge price gaps, mitigate risks, and incentivize you to remain with the business. 

If you and the buyer can’t agree on a price, you should determine the reason for the price gap. Once the cause is determined, you and the buyer can decide which mechanism is most appropriate to bridge the gap or address the buyer’s concerns. Start by evaluating your objectives, and then decide what deal structure is most appropriate to meet those objectives. Some buyers, particularly financial buyers, want to ensure you have as much skin in the game as possible after the closing and therefore commonly propose earnouts. In most cases, several of these tools are used collectively to mitigate the buyer’s risk and keep you on the hook for as long as possible.

Earnouts should primarily be used to bridge price gaps, mitigate risks, and incentivize you to remain with the business. 

A Clawback or Reverse Earnout 

A clawback is simply a reverse earnout. Money is given to you at closing and then “clawed back” if certain targets aren’t met. Instead of withholding a portion of the purchase price, you receive the entire amount at closing and must then reimburse the buyer if the goals outlined in the agreement aren’t met. Clawbacks aren’t popular with buyers or sellers – buyers don’t want to chase a seller down to get their money back, and sellers don’t want to give back the money they’ve likely already spent. Clawbacks are most common when money is provided to a business for expansion purposes, and the business owner hasn’t used the funds.

Employment Agreement

Employment agreements are suitable if you’ll continue to play a defined role in your business, and are commonly used in combination with earnouts to compensate you for your continued involvement in the business. Earnouts tend to be based on high-level metrics for the company, such as revenue and EBITDA, while employment agreements provide a base salary, often in the range of $200,000 to $400,000 for most mid-market companies.

Consulting Agreement

Consulting agreements are often designed to facilitate the business’s transition to the buyer. In most consulting agreements I see, the seller agrees to help the buyer on an ad-hoc basis for a flat hourly or monthly retainer fee and is available by phone, online, or email to assist with detailed transition matters. This is most fitting when the buyer wants to ensure you’ll be available to assist with the transition. In most consulting agreements, you won’t have control or influence over the performance of the business. The primary disadvantage of employment and consulting agreements is that they’re tax-inefficient for you because they are taxed at ordinary income tax rates, although they are deductible for the buyer.

Holdback

Most M&A transactions include some form of holdback, also known as an indemnity escrow. Note that the term escrow can also be used to refer to an escrow agent who is charged with collecting and disbursing funds at the closing. With a holdback, the parties appoint an independent third-party escrow agent to hold a portion of the purchase price, usually between 10% and 20%, to satisfy any post-closing indemnification claims. Because the funds are held by a third party, holdbacks offer the buyer a guarantee that funds are available if problems are discovered and the seller is unwilling or unable to make payments.

Holdbacks are tied to the reps and warranties and the indemnification section in the purchase agreement. They’re used to ensure the buyer can recover damages if the seller has committed fraud, made material misrepresentations, or otherwise made an inaccurate representation regarding the business. 

Representations and Warranties

Reps and warranties constitute about half of the content in a typical middle-market M&A purchase agreement. Representations – or “reps,” for short – are statements of past or existing facts. Warranties are promises that the facts will be true. In reality, reps and warranties are used interchangeably, and there isn’t a distinction between them. Reps and warranties are designed to force you to make key disclosures regarding your business before you sign the purchase agreement. If any reps and warranties prove to be untrue or are breached – in other words, if the seller knowingly or unknowingly lied to the buyer – the buyer has a right to indemnification through the holdback account. 

Reps and warranties are strongly debated in most transactions and often include minimums, maximums, and other mechanisms that are triggered when an indemnification claim can be filed. For example, if a minimum – usually called a “floor” – is $100,000, the buyer cannot file an indemnification claim if the claim is less than $100,000. Reps and warranties are fundamentally a method for allocating risk between the buyer and seller. If the buyer is concerned about certain specific risks in the business, it may be possible to address the buyer’s concerns through strongly worded reps and warranties instead. The reps and warranties can then be funded with a holdback.

Buyers can find many things with which to concern themselves. Most of the time, they’re simply being prudent. However, there are situations that can legitimately merit a holdback.

A buyer purchasing a manufacturing company may be concerned about the environmental condition of the property. Any type of business that has industrial activity is at risk for contamination. Assessment and cleanup of the property can be expensive, time-consuming, and risky. A buyer may be apprehensive that hazardous materials have leaked onto the property or that they have been stored improperly. 

This example is a sound reason to request a holdback. Another might be if the same buyer is worried about future liability to employees working on the property or nearby dwellings and their inhabitants. These things can affect the value of the business and can ultimately hinder its performance.

Another common concern to business buyers is fraud. This is understandable because we’re facing a time when fraudulent activities are at their height. In fact, the Association of Certified Fraud Examiners found that private companies have an occupational fraud frequency rate of 42%, mainly due to a lack of internal controls. Protection against fraud is another sound reason to request a holdback. 

Reps and warranties force you to make key disclosures regarding your business before you sign the purchase agreement.

Why is a holdback necessary?

Holdbacks give the buyer assurance that money will be available to cover their expenses from litigation and losses if, for example, any of your reps or warranties later prove to be untrue or for other breaches in the purchase agreement. 

One example is in the case of the sale of a manufacturing plant with considerable machinery and equipment. The seller may have represented that the machinery is operable and in good repair. If a piece of machinery breaks after the closing, and the buyer determines there was deferred maintenance on the machine and the problem was concealed by the seller, the buyer can file a claim to seek reimbursement for the machine.

This money is normally held in escrow for 12 to 24 months. The funds go into a holdback account of a neutral third-party escrow agent and are governed according to the terms of the holdback agreement. These funds are normally only released upon the buyer’s and seller’s mutual agreement. The holdback agreement defines the specifics of when the funds are released and the method for handling disputes. Most disputes are made in the last few weeks before the holdback period expires. If there are no claims at that time, the money is released to the seller. 

Are there alternatives to a holdback?

Yes. Most M&A transactions include some form of deferred payment, and nearly any deferred payment can also function as a form of holdback. Here are several alternatives:

• Promissory (Seller) Note: The promissory note can also include explicit language that affords the buyer the right to withhold future payments in the event of a breach – called an “offset.”
• Earnout: Earnouts can also include a right of offset; however, the likelihood of the seller receiving any earnout payments should be considered. The less likely the seller is to receive payments via the earnout, the less suitable an earnout is as a replacement for a holdback.
• Consulting or Employment Agreement: Consulting and employment agreements can also include a right of offset although this may not be allowed in certain states that prohibit what are known as setoffs against employment agreements. 

Sellers are likely to resist a right of offset against guaranteed, deferred payments, such as a promissory note and consulting or employment agreements. That’s because such arrangements afford the buyer a significant amount of leverage since the buyer “controls” the money. Allowing the buyer to simply withhold payments may afford the buyer too much power, and sellers may justifiably prefer a holdback.

What are the major terms of the holdback agreement?

The parties should consider the following terms:

• Amount: Most transactions include a holdback that ranges from 10% to 20% of the purchase price. The size of the holdback should correlate to the likelihood and magnitude of the potential risks and whether other forms of deferred payments also contain an explicit right of setoff. 
• Time Period: The period for most transactions ranges from 12 to 24 months, but I’ve seen holdbacks as short as 6 months and as long as 36 months. Most buyers prefer to prepare a full year’s P&L statement and close the books, so they can examine an entire accounting period, which is why most periods are at least 12 months. In most cases, two years is more than sufficient to uncover potential risks.
• Conditions: The holdback agreement should prescribe the conditions of the holdback and who controls its release, which is normally mutual, and how disputes are handled. 
• Interest: Who should receive interest on the amount held in escrow?

How are disputes normally handled?

Disputes regarding the purchase agreement will be governed by the terms of the purchase agreement in conjunction with the terms of the holdback agreement. In some cases, supplemental agreements, such as a non-competition agreement, may have separate dispute mechanisms. 

Most disputes will be governed according to the terms laid out in the “Indemnification” section of the purchase agreement. There’s no such thing as a “standard” indemnification provision. Indemnification language may be strongly debated by both the buyer and seller. 

In most cases, if a buyer discovers a problem or a breach, the buyer must notify you, and you’ll have time to resolve the problem – often known as the “right to cure” – contest the damage, or reimburse the buyer. If the parties can’t immediately resolve the issue, the money will remain in holdback while they attempt to reach a resolution.

A final question to consider is whether the holdback should be the buyer’s exclusive remedy or whether the buyer may be afforded additional remedies.

Royalties and Licensing Fees

Royalties and licensing fees are most applicable if tied to product sales. These fees are appropriate if you have a product in development that you expect to launch shortly but for which the revenue is difficult to predict. They may also be used if you have numerous other products in development, either owned by your company or independently. 

For instance, I recently encountered this situation with an online retailer of proprietary automotive parts. Fully 90% of the revenue was generated from one product line, but the seller had a second product line in development that, once launched, was expected to comprise 30% to 40% of the revenue. We discussed cordoning off the product line into a separate company, but that proved too difficult. In the end, we decided that a royalty or licensing fee would be the most practical approach. 

As the seller, your goal should be to:

• Maximize the cash down you receive
• Maximize the likelihood a buyer can obtain third-party financing
• Minimize the possibility of less favorable forms of payment, such as:
  • Stock
  • Consulting agreements
• Minimize the probability of contingent payments, such as:
  • Earnouts
  • Seller financing
  • Escrows/holdbacks

Here are some tips for you to maximize your deal structure.

Prepare for the Sale

One of the best methods for ensuring a favorable deal structure is to prepare your business for sale well in advance. 

For example, when I assess a potential client’s business, I identify potential major risk factors that could lead to an earnout as a component of the transaction structure. If you minimize risks that a buyer is likely to see in your business, it’s less likely a buyer will propose contingent payments in the first place. The lower the overall confidence level a buyer has in your company, the more likely they’ll propose a less favorable deal structure. 

One of the most critical areas of preparing your business for sale is the degree to which your business is dependent on you, the owner. If the buyer considers a business to be highly dependent on its owner – with the owner having close personal relationships with employees and customers, or if the business’s identity is tied closely to the owner – the buyer will consider the business excessively risky. As a result, they’ll counter the risk through a low purchase price or other mechanisms designed to limit their risk. On the other hand, if you’ve developed a strong management team and your business doesn’t depend heavily on your personal involvement, you’ll receive more cash down at closing. 

Most earnouts and other restrictive deal mechanisms are proposed because of major risks or other forms of uncertainty that may exist in a business. These risks can be mitigated to some extent in advance of the sale. Even if you don’t plan to sell your business in the near future, it’s still sensible to minimize risks from an operational standpoint. Mitigating risks will reduce the possibility of a buyer proposing restrictive deal mechanisms and increase your business’s value. Value is simply an element of potential return and risk. The lower the risk, the higher the value. 

One of the best methods for ensuring a favorable deal structure is to prepare your business for sale well in advance. 

Conduct Pre-Sale Due Diligence

Pre-sale due diligence is vital to ensuring you receive a favorable deal structure. By performing your own due diligence in advance, you’ll be able to identify and minimize risks before you put your company on the market. When buyers uncover risks within your business, not only will they view it as less valuable and potentially reduce the offer price, but they might also propose contingent payments or other protective mechanisms. 

Yes, it’s expected for buyers to propose such mechanisms in the later stages of the deal if they uncover problems that weren’t initially disclosed, even if they didn’t include these mechanisms in their LOI. The best method for avoiding the potential of protective payment mechanisms being introduced later in the process is to retain a third party – such as an accountant, attorney, or M&A advisor – to perform pre-sale due diligence and then address the problems they uncover before you go to market.

As a seller, it’s critical to understand the role of due diligence and be prepared for the thoroughness of the process. Nearly every buyer will perform meticulous due diligence. This means you should be emotionally prepared to survive this painstaking period and not take personal offense at a buyer’s requests. Buyers will become nervous if you overreact or become secretive during the process. Those behaviors represent an increased risk for the buyer, making them more likely to structure part of the purchase price as contingent payments, such as an earnout or seller note. 

Maximize Negotiating Posture and Momentum

Aside from conducting pre-sale due diligence, the next best tools in your arsenal for ensuring a favorable deal structure are a strong negotiating position and expert negotiating skills. Your negotiating posture is strengthened by negotiating with many buyers and not having to sell. Your posture can also be maintained by displaying an even disposition throughout all discussions with the buyer. 

Setting expectations with buyers is critical. Many buyers will attempt to feel you out to detect the likelihood of re-trading. Re-trading is when the buyer attempts to renegotiate the purchase price at later stages in a transaction after an LOI has been signed and agreed upon. During due diligence, unscrupulous buyers will search every nook and cranny of your business for any flaw they can find. Opportunistic buyers will then use these flaws as negotiating leverage to renegotiate the price or terms. As part of this strategy, they may overreact to any “bad” news and tell you how distraught they are. But then they’ll let you know that they might be willing to move forward if you agree to lower the price or restructure a portion of the consideration as an earnout. 

By preparing your business for sale, you minimize the number of flaws a buyer may discover during due diligence that they can later use as leverage against you. 

Momentum is also a critical component to consider during negotiations. Many buyers may intentionally slow down the process to wear you down. Most buyers know that several months of negotiations and the obligation to deal exclusively with them puts many sellers in a weak position and subjects them to last-minute negotiating ploys. 

By properly preparing your business for sale, you minimize the number of flaws a buyer may discover during due diligence that can later be used as leverage against you. 

Build and Maintain Trust With the Buyer

Trust is the most powerful weapon for preventing a restrictive deal structure. Buyers often propose contingent payments such as earnouts because they lack trust in the seller. By building a trustworthy and respectful relationship with the buyer, you reduce their perception of risk, thereby helping to ensure they don’t propose a restrictive deal structure. This means that how you conduct yourself is of particular importance in maximizing your deal structure. You must present yourself as a level-headed, trustworthy individual in all interactions. Never lose your cool. Never. Ever. Losing your temper, even once, can spell doom for your entire transaction structure. 

Another key to developing trust is honesty. When selling a business, truth is the safest lie. Buyers will conduct painstakingly meticulous due diligence that’s bound to uncover even the most infinitesimal of inconsistencies. If a buyer discovers you’ve been anything but forthright, they’ll likely pile on the protections in the form of earnouts, holdbacks, reps and warranties, and other mechanisms designed to reduce their risk. A lie can erode even the most attractive deal. At even the whiff of withholding information, the buyer will construct numerous provisions to minimize the impact of any additional untruths and their attendant risks – that is, if they don’t walk away entirely. If the buyer believes you to be a strait-laced, conscientious, reliable individual, they’re more likely to propose a conservative deal structure with more cash down at closing.

Trust is also important in the event of disputes. Even the most carefully drafted agreements don’t guarantee a painless transaction. Most earnouts and other contingent payments, such as holdbacks, lead to disputes. But if the parties share a fair and trusting relationship, even the most intractable conflicts can be quickly and efficiently resolved. In the absence of trust, the disputes can quickly become costly and consume enormous amounts of time and money. 

Here are a few common deal structures to illustrate how the various financial components work together to comprise the purchase price:

• Scenario 1:
  • 80% cash down
  • 20% earnout – used in lieu of a holdback
• Scenario 2:
  • 60% cash down
  • 20% earnout
  • 20% holdback
• Scenario 3:
  • 50% cash down
  • 20% seller financing at 48 months at 6% interest 
  • 20% earnout
  • 10% holdback
• Scenario 4:
  • 50% cash down
  • 30% third-party financing
  • 20% holdback

Before diving into the individual components of the transaction structure, here are some common guidelines regarding the primary components of the purchase price:

• Cash: Cash accounts for the majority of consideration in most transactions. The amount of cash down ranges from 60% to 100% for most mid-sized to large transactions.
• Earnouts: After cash, earnouts are the most frequently used component of middle-market M&A transactions. Earnouts typically comprise between 10% and 20% of the purchase price.
• Stock: Stock in the existing buyer’s entity is commonly offered as a form of consideration in larger transactions in which the buyer is a publicly traded firm. Sellers generally prefer that the stock has sufficient trading volume and is therefore liquid. Equity rollovers are also used in transactions where you retain equity in your business, which is technically a new entity. In other words, your equity is being rolled over with the target. For example, a buyer may purchase 70% of your stock or equity at closing, while you retain 30% of the stock or equity. The 30% piece of equity that you retain is said to “roll over” to the new entity the buyer forms.
• Third-Party Financing: Financial buyers often use debt, or leverage, to maximize their returns, while strategic buyers use leverage less frequently, especially if the target is significantly smaller than the buyer. If third-party financing is involved, it’s delivered in the form of cash to you at closing. If a seller note is also involved, it will be subordinated to any senior lenders’ positions. Earnouts, and other terms of the transaction, may also be subject to the approval of the lender. 
• Seller Financing: Seller financing usually ranges from 10% to 30% of the total purchase price. Seller financing may also be used in lieu of a holdback.
• Holdback (Escrow): A holdback is commonly used to fund indemnification claims for a seller’s breach of reps and warranties, which are contained in the purchase agreement. Holdbacks typically range from 10% to 25% of the purchase price. They are often held by a third-party escrow agent in line with the survival period for the reps and warranties, which normally ranges from 12 to 24 months.

“The value of a financial asset is directly related to the ability to finance it.”

– Jacob Orosz

When negotiating a letter of intent (LOI), there are many aspects of the transaction you must take into account to ensure you receive the best deal possible. In this chapter, I’ll discuss the primary elements of the deal structure you need to consider when evaluating an offer, which can be broken down into two components – financial and legal.

• Financial Components: A $20 million all-cash offer isn’t the same as a $20 million offer that consists of 10% down, a seller note for 40%, and an earnout for the remaining 50%. When evaluating an offer, one of the first things you should evaluate is the form of consideration, or how the purchase price will be paid. Here are the major financial components of an offer:
  • Cash: Cash is generally preferred by sellers over all other forms of consideration. Most buyers put down 60% to 80%.
  • Debt and Liabilities: The purchase price usually includes working capital, which includes short-term debt (i.e., accounts payable). Long-term debt is rarely assumed by buyers.
  • Seller Financing: Seller financing is common in transactions of all sizes unless the buyer can obtain significant financing from a third party. 
  • Third-Party Financing: Corporate acquirers have many options available to them to finance an acquisition.
  • Stock/Equity: It’s common for the seller to retain equity in the business if they plan to remain with the company after the closing. This strategy is commonly used by private equity firms to ensure alignment with the seller if the seller will continue to operate the business.
  • Earnout: Earnouts constitute a significant portion of the purchase price if they are used to bridge price gaps or for high-growth businesses in which future growth is difficult to predict. Otherwise, earnouts usually comprise 10% to 20% of the purchase price.
  • Employment Agreement: An employment agreement is often used in lieu of, or in addition to, equity to retain you for a defined long-term role in the business.
  • Consulting Agreement: A consulting agreement is often used to ensure your short-term assistance with the transition and can be structured on an hourly or salary basis.
  • Holdback (Escrow): Most transactions include a 10% to 20% holdback to cover any indemnification claims due to a breach of the reps and warranties.
  • Royalties and Licensing Fees: Licensing fees are sometimes used to compensate you for new product launches that haven’t yet generated revenue and are therefore difficult to value using other means.
• Legal Components: Just as important as the finances of the transaction are the various legal structures that can shape how a transaction is completed. Here are several of the most important you should take into consideration when evaluating your deal structure:
  • Asset vs. Stock: Whether the sale will be structured as an asset or stock purchase is a key consideration in any transaction. The LOI should specify the legal form. Most transactions are structured as an asset sale due to the potential for contingent or unknown liabilities.
  • Entity Structure and Entity Type: The type of your entity – for example, corporation vs. LLC – may also impact how the transaction will be structured for legal and tax purposes. 
  • Partial Sales: In some instances, it may be possible for you to sell a portion of your company as opposed to the entire business. If that’s the case, there are numerous ways to structure a partial sale from a legal and financial standpoint.
  • Taxes and Allocation: Ideally, the LOI should also define how the purchase price will be allocated for tax purposes. The IRS requires that the parties allocate the purchase price among the assets being purchased. How the price is allocated will determine the tax implications of the transaction for both you and the buyer.