10: Prepare for the Closing

Note: This section is primarily applicable to individuals and smaller companies. We suggest you begin preparing for the closing toward the end of the due diligence process.

Summary of the Process

A) Prepare the purchase agreement
B) Draft the allocation of purchase price
C) Open escrow
D) Transfer the lease or real estate
E) Prepare the transition plan
F) Set up your new company
G) Conduct pre-closing checks

Preparing for the closing involves finalizing the purchase agreement, which replaces the letter of intent (LOI) and becomes the binding contract for the sale. Additionally, the buyer and seller must allocate the purchase price among the business’s assets using IRS Form 8594 for federal income tax purposes. An escrow account may also be opened to securely hold funds until the transaction is complete. If applicable, the lease or real estate must be transferred, often requiring landlord approval. A transition plan should also be prepared, detailing training and knowledge transfer from the seller to you to ensure a smooth handover of the business. Finally, you must set up your new entity and begin preparing to take possession of the business.

A) Prepare the Purchase Agreement

Unlike a letter of intent, which is a non-binding, preliminary document, the purchase agreement is the final, binding agreement to be signed before or at the closing. The purchase agreement replaces any previous agreements, such as an LOI.

Who Drafts the Purchase Agreement

If the buyer is an institutional buyer, such as a private equity firm, family office, or independent sponsor, the buyer commonly drafts the purchase agreement. We often draft the purchase agreement on behalf of the buyer if the buyer is an individual or a smaller company.

Signing the Purchase Agreement

The purchase agreement is sometimes signed before closing occurs. If so, the business’s change of possession doesn’t happen until closing. If the purchase agreement is signed prior to closing, contingencies may remain, such as approval by third parties or a license transfer. If these contingencies aren’t satisfied, the sale may be canceled.

B) Draft the Allocation of Purchase Price

Allocating the purchase price or total sale price of a business among its various assets, or asset “classes,” is necessary for federal income tax purposes when a business is sold.

IRS Form 8594

The IRS requires that both the buyer and seller allocate the purchase price among the various assets of the business being purchased on IRS Form 8594. This form must be filed along with the tax returns for the buyer and the seller at the end of the year.

Asset Classes on IRS Form 8594

IRS Form 8594 breaks down the assets of the business being purchased or sold into seven classes or categories. Each type of asset is treated differently for tax purposes.

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

Stock vs. Asset Sales: In stock sales, the majority of the purchase price is normally allocated to the value of the stock, with the remainder allocated to the value of any non-competition agreements, consulting agreements, or any other assets that are personally owned by the seller and not the entity. For the sake of clarity, we recommend the parties allocate the purchase price even in a stock sale, despite the fact that some professionals believe this is unnecessary.

Sales Tax

You may have to pay sales tax on the amount of the purchase price allocated to the hard assets of the business (furniture, fixtures, and equipment) at closing, although this depends on the state. Consult with your CPA to determine if any sales tax is due. Note that escrow customarily handles the process of collecting and remitting the sales tax to the state if required.

Common Allocations

Class I: Cash and Bank Deposits

• Allocation: None
• Note: These assets are not typically included in the purchase. If they are listed at face value.

Class II: Securities, including Actively Traded Personal Property and Certificates of Deposit

• Allocation: None
• Note: These assets are not typically included in the purchase. If they are listed at face value.

Class III: Accounts Receivables

• Allocation: None or face value
• Note: These assets are normally included for larger transactions as a component of net working capital and not typically included in the purchase for smaller transactions. If they’re omitted, the seller typically retains ownership of the accounts receivables, and the buyer receives the outstanding payments and remits them to the seller post-closing. If they’re included, they’re commonly listed at face value.

Class IV: Stock in Trade (Inventory)

• Allocation: Normally valued at the seller’s original cost
• Note: If listed at the original cost, there’s no gain for the seller and, therefore, no tax due on the amount allocated to this asset.

Class V: Other Tangible Property, including Furniture, Fixtures, Vehicles, etc.

• Allocation: Normally valued at current market value, often “replacement value”
• Note: Any gain on the sale of tangible property is taxed based on ordinary income rates to the seller, and the buyer can begin to 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
• Note: Some intangibles are taxed to the seller at ordinary income rates, and the buyer can generally amortize most intangible assets.

Class VII: Goodwill

• Allocation: The balance of the purchase price is normally allocated to goodwill
• Note: The goodwill of a going concern is generally treated at capital gains tax rates for the seller, and the buyer can generally amortize goodwill over a 10-year period.

You can often benefit from more favorable transaction terms if you’re willing to structure the transaction to mitigate tax implications for the seller. We recommend working with the seller and their accountant to design a tax-friendly tax structure to minimize the total tax obligations for all parties. Such a strategy makes the “pot” bigger for both parties, and then the parties can decide how to “split up the pot.”

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

Learn about the allocation of purchase price and its implications on taxes.

C) Open Escrow

Once the due diligence period has concluded and all contingencies have been resolved, an escrow account may be opened if required. Escrow may be required in certain states (e.g., California) depending on the type or size of the transaction, and some lenders may also require it.

Escrow is where funds will be held securely until the transaction is finalized. The escrow process can take 30 days or longer in certain states, so it’s important to begin this process at least 30 days prior to the scheduled closing date.

D) Transfer the Lease or Real Estate

The lease must be carefully orchestrated to ensure a problem-free transition. The transfer of the lease isn’t always guaranteed, and delaying the landlord’s involvement can create issues that delay or prevent the closing. If the landlord has any doubts regarding your ability to operate the business, the landlord may refuse to transfer the lease.

We recommend the parties involve the landlord in the process as early as possible. It’s important to gain the landlord’s cooperation and ensure they’re willing to assign the lease. It’s common for landlords to stall or withhold the lease transfer if they have concerns regarding the buyer.

Request that the seller ask the landlord what the most important qualifications are for a new tenant, such as experience, credit score, or financial strength, and address these in your presentation to the landlord. Some landlords are only concerned about your financial requirements, while other landlords are only concerned about your industry or operational experience.

Prepare a resume and financial statement, fix any blemishes on your credit report in advance, and otherwise position yourself in the best light possible for the landlord. You should be prepared to demonstrate to the landlord that you will be a stable and prosperous tenant and will be successful in the business, thereby assuring the landlord that rent will continue to be paid on time. Note that the landlord may charge an assignment fee, which the buyer customarily pays.

E) Prepare the Transition Plan

We recommend you begin creating a draft of the transition plan during the due diligence period. You will likely ask the seller dozens of questions regarding the operations of the business during due diligence, and these questions can serve as the basis for the training agenda. Compose a comprehensive list of any important items, issues, or questions you have about the business during the sale process that you think should be covered during the transition period. This will lead to a more effective transition period and maximize the use of the time agreed to in the training agreement.

Before you draft the actual transition plan, we recommend meeting with the seller to discuss the transition period.

The following is a suggested agenda for meeting with the seller to discuss the transition period:

• Operations During Training: Who will run the business while the training is in progress? The day after closing, you may not have the knowledge, skills, or experience to begin operating the business immediately. The parties should discuss who’s responsible for which activities to ensure a smooth hand-off.
• Commitment to the Transition Process: You should communicate to the seller that you’re fully committed to begin operating the business from day one. It’s important to wrap up other obligations and prepare to take advantage of the seller’s knowledge by clearing your plate of as many responsibilities as possible before the transition begins.
• Training Agenda: You and the seller will need to collaborate to create a training agenda. It should cover the standard business functions and any questions that arise during due diligence. It’s important to rely on the seller to develop the agenda since you’re not familiar with the business’s intricacies.
• People Involved in the Training: Discuss who will execute the training, such as the owner, the owner’s spouse or family, or key employees.
• Help Beyond the Initial Transition Period: You should also discuss the seller’s availability if any questions arise after the initial transition period concludes. We recommend structuring any additional assistance on an hourly consulting basis at times that are convenient for the seller.

Once you’ve discussed the transition plan with the seller, we suggest putting it in writing. This written plan will serve as a roadmap for the knowledge transfer and operational handover, ensuring clarity and minimizing misunderstandings during the transition period.

Put the Following Information in Writing:

• Topics: A list of all topics to address in the transition period, such as operations, sales, marketing, accounting, bookkeeping, legal, and HR
• Agenda: An agenda for procedures, tools, and skills you must be trained in
• Timeline: A timeline for the process as a whole, as well as timelines for each step
• Priorities: Priorities for each item on the agenda
• Modality: How the training will be performed, such as in writing or in person
• Video: Plans to video record technical or detailed processes for later access

Specific Agreement: The purchase agreement should contain a clause specifying a “transition agreement” between you and the seller. This clause should specify the length of the transition period, including how many hours and on what terms any training will be provided, preventing any potential miscommunication between the parties.

F) Set Up Your New Company

*Many of the items in this section only apply if you’re setting up a new entity (e.g., Corporation, LLC, etc.) to acquire the business.

Below is a checklist of items to complete prior to the closing. Many steps are interdependent, and documents must be obtained in a certain order to ensure a smooth transition. We suggest tackling these items simultaneously while you conduct due diligence. Some items require waiting periods, such as forming an entity, and must be done regardless of which business you purchase, so it’s wise to take these action steps early. Starting early in the process helps ensure you close on time and helps prevent delays.

Legal

We recommend hiring a general corporate attorney and CPA to assist with the following:

• Form New Legal Entity: If you intend to form an entity, such as a corporation or LLC, to acquire the business, you should begin forming this entity 30 to 60 days before closing. Your entity must be active at closing if you wish to purchase the business in your entity’s name.
• Obtain EIN and State Tax ID Number: You must obtain an Employer Identification Number (EIN) and state tax identification numbers (if required) prior to closing to use when withholding payroll taxes. The following information may be needed before applying: Certified Articles of Incorporation or Organization.
• Apply for a Business License: A business license is often necessary in order to open a business bank account; therefore, you should apply for a business license before opening a bank account. The following documents may be needed before applying: Certified Articles of Incorporation or Organization, EIN, State Tax ID number, DBA, Certificate of Occupancy; and other permits (health, fire, air, water control, sign, etc.).
• Obtain or Transfer the DBA (Doing Business As): In some jurisdictions, the seller may need to apply to abandon their current DBA before releasing the DBA to you, although some jurisdictions allow concurrent filings. If publication is required, it may take 30 days or more for a certificate to be issued, so we recommend applying for a DBA as soon as possible. Incorporated businesses may not need to obtain a DBA unless they’re doing business under a name different from their legal entity’s name. If a DBA is needed to open a bank account and the jurisdiction does not allow concurrent filings (if the seller has already filed the name and that certificate will not be abandoned until closing), we suggest you visit a nearby city or county to obtain a certificate with the same name.
• Apply for All Licenses and Permits: Obtain a list of all current licenses and permits from the seller, such as a Certificate of Occupancy, an Air and Water Pollution Control Permit, a Health Department Permit, and so on. Apply as early as possible and contact the city, county, state, and federal governments for a list of all requirements to operate the business. The following website is helpful for determining which licenses and permits are required: www.sba.gov/licenses-and-permits.

Banking

• Open New Bank Account: A bank may require the following when opening a business checking account: Certified Articles of Incorporation or Organization, Certificate of Good Standing from the Secretary of State, EIN, business license, and DBA.
• Open Merchant Account: You will need to set up a business bank account prior to opening a merchant account. In the meantime, you can use a Square.com or PayPal account. The following documents may be required when applying: Certified Articles of Incorporation or Organization, Certificate of Good Standing from the Secretary of State, business license, DBA, EIN, and bank account number.

Tax

We recommend hiring a CPA or accountant to assist with setting up your tax matters and assisting you in applying for licenses, permits, etc. Most CPAs and accountants assist in all activities required to transfer a business, such as setting up the accounting, bookkeeping, and payroll systems.

• Set Up Sales Tax Permit: The seller’s (sales tax) permit is not usually transferable, so you must apply for a new permit. You should call the state to determine the amount of deposit needed to open a sales tax account. Note that the seller must often obtain a written release from the state before closing can occur. Escrow normally handles obtaining releases. You must have the permit in place before closing to avoid paying sales tax on the inventory. The following documents may be needed to obtain a seller’s permit: Certified Articles of Incorporation or Organization, DBA, bank account number (a business must often have a separate bank account for collecting sales tax), merchant account documents, business license, and liquor license number (if applicable).
• Set Up Payroll and Other State Tax Accounts: We recommend consulting with an accountant or payroll company to set up a payroll system. The following information may be needed: Certified Articles of Incorporation or Organization, EIN, and bank account number.
• Set Up Unemployment and State Disability Insurance: Contact the federal and state agencies for information on obtaining unemployment and state disability insurance policies. The following information may be needed before applying: bank account number.

Insurance

• Contact Insurance Providers: Request that the seller provide you with the contact information for all insurance carriers so you can continue using the same carriers if you wish to do so. Most insurance, including workers’ compensation, is not transferable. It’s usually easiest to continue using the same insurance companies the seller has used and shop for the best rates after you’ve completed the transition period. If the seller is financing a portion of the sale, you should provide the seller with a Certificate of Insurance on an annual basis that covers the assets of the business. The following are different types of insurance to consider: General Liability Insurance, Workers’ Compensation Insurance, Commercial Property Insurance, Commercial Auto Insurance, Health Insurance, Unemployment and State Disability Insurance, Umbrella Policies, Professional Liability Insurance (E&O) or Product Liability Insurance.

G) Conduct Pre-Closing Checks

Conduct Final Inspections

• Conduct Preliminary Inventory Count: You should meet with the seller to count the inventory several weeks before closing to eliminate last-minute surprises.
• Conduct Final Inventory Count: You should also meet with the seller the day before closing to perform an inventory count. Alternatively, an inventory valuation service can be hired to perform the count. The inventory is customarily valued based on the seller’s original cost. If you’re using escrow, you should also provide an inventory list to the escrow holder the day before closing.
• Conduct Pre-Closing Equipment Inspection: You should also schedule a time with the seller to inspect the equipment well in advance of the closing.
• Conduct Final Walk-Through: We also recommend performing a final walk-through of the business to ensure there are no surprises at closing.

Contact Third Parties

• Contact DMV Regarding Transfer of Motor Vehicles: We recommend contacting the Department of Motor Vehicles (DMV) to find out the process for transferring any vehicles. Although the vehicles will be included in the asset list and bill of sale, they must also be transferred through the DMV because they are titled property. Please request a copy of the vehicle titles from the seller if they’re not provided in the data room.
• Contact Equipment Leasing Companies: You should also contact any equipment leasing companies to complete the transfer of any equipment leases. Some leases may not be transferable and may have to remain in the seller’s name until paid in full.
• Contact Web Host and Domain Registrar: The seller should contact their web hosting and domain registration company to ask how to transfer any website content, domain names, and email addresses. We recommend doing this well in advance, as the process can be time-consuming. The actual transfer should not happen until closing.
• Contact Telephone Service: You will also need to call the telephone company to ask about the transfer process. The seller must sign transfer documents that allow the buyer to retain the same phone number. The actual transfer happens at closing.
• Contact Utility Providers: The seller should make a list of all utilities that need to be transferred (e.g., electricity, water, gas, trash, security). The buyer and seller should contact the utility companies to determine the process for transferring utilities to the buyer. The bills may be prorated if the transfer does not occur on closing day.

Frequently Asked Questions

Is the landlord’s consent required to assign the lease? Yes, nearly every commercial lease requires the landlord’s consent to assign or sublease. Involving the landlord as early as possible in the process helps mitigate this risk.

When should the parties contact the landlord about transferring the lease? The earlier, the better. If the parties wait too long to inform the landlord, they run the risk the landlord may refuse the transfer. Contacting them upfront reduces this concern and helps ensure the landlord is flexible and agrees with the terms of the transfer.

What’s an “assignment” of the lease? The assignment of a lease means the lease is transferred to you while the seller remains on the lease as a guarantor. If the seller assigns the lease to you, the landlord may charge a fee for doing so, which varies by landlord.

How is the security deposit handled? Landlords often retain the seller’s security deposit, and the buyer reimburses the seller for the deposit at closing.

Understand the pivotal role of landlords in the process of buying or selling a business, including the complexities involved in transferring leases.