Prepare for the Closing

Note: If you represent an institutional buyer, such as a corporate acquirer, private equity firm, or family office, you will likely have your attorney prepare the purchase agreement. This section is, therefore, only applicable to individuals and smaller companies.

If you’d like us to prepare the purchase agreement on your behalf, the first step is to complete our preliminary closing questionnaire. The goal of this document is to ensure a smooth and uneventful closing. Closing the sale of a business can be stressful. Things may not go according to plan if last-minute issues arise – and they almost always do. In this section, we explain how to avoid last-minute snafus.

Closing Questionnaire

Our preliminary closing questionnaire is intentionally redundant. Many questions will not apply, or we may already have the answers. Morgan & Westfield compiles all questions into one concise document at the beginning to ensure all terms are mutually agreed upon from the start and to prevent eleventh-hour hiccups. The questionnaire should be completed as soon as possible in the process. If you’d like us to prepare the purchase agreement, we can’t do so until we receive the completed questionnaire. You should review the questionnaire several times, as consistency and clarity are critical.

Closing Checklist

Once your letter of intent is accepted and due diligence begins, we prepare a closing checklist and send it to the parties so they can begin preparing for closing. The checklist contains detailed instructions for dozens of events that must be successfully orchestrated to ensure a smooth closing. 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. Starting early in the process helps ensure you close on time.

Assigning the Lease

The lease is one of the most critical elements of the sales process and needs to be carefully orchestrated to ensure a problem-free transition.

Landlord’s Cooperation

The transfer of the lease is not always guaranteed, and delaying the landlord’s involvement can create issues that slow down the closing or prevent it altogether. We recommend the parties involve the landlord in the process as early as possible. It’s important to gain their cooperation and ensure they’re willing to assign the lease. It’s common for landlords to stall or withhold the lease transfer if they feel the buyer isn’t qualified. 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. 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.

Is the landlord’s consent required to assign the lease?

Yes, nearly every commercial lease requires the landlord’s consent to assign or sublet it unless the seller has obtained an assignment in advance, which is uncommon. Involving the landlord as early as possible in the process will mitigate this risk.

When should the seller contact the landlord about transferring the lease?

The earlier, the better. If sellers 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 is an “assignment” of the lease?

The assignment of a lease means the lease is transferred to the buyer 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. The fee 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.

What is a sublease?

In a sublease, there are two leases: One is for the landlord to the seller (master lease), and the other is for the seller to you, the buyer (sublease). Most leases do not allow a sublease.

The Role of a Landlord When Buying or Selling a Business

Transferring the Lease When Selling or Buying a Business

Purchase Agreement

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

Who Drafts the Purchase Agreement

The purchase agreement is commonly drafted by the buyer if the buyer is an institutional buyer, such as a private equity firm, family office, or search fund. We often draft the agreement on behalf of the buyer, whether they’re an individual or a smaller company. In these cases, we begin preparing the purchase agreement during due diligence and send it to the parties for review before closing.

Signing the Purchase Agreement

The purchase agreement is sometimes signed before closing occurs. However, the change of possession of the business does not happen until closing. If the purchase agreement is signed prior to closing, contingencies may remain. These contingencies can include denial of approval by key third parties such as the lender, lessor, franchisor, or licensor. If these contingencies aren’t satisfied, the sale is canceled.

M&A Purchase Agreement | A Complete Guide

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 tax purposes when a business is sold. This is the case regardless of whether the sale is structured as a stock sale or an asset sale.

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 via 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. While there is no legal requirement that the buyer’s and seller’s allocations match, most tax advisors agree that a match decreases the chances of an audit.

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: Where stock sales are concerned, 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.

Common Allocations

Class I: Cash and Bank Deposits

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

Class III: Accounts Receivables

  • Allocation: None or face value
  • Note: These assets are normally included for larger transactions and not normally included in the purchase for smaller transactions. If they aren’t included, the seller normally retains ownership of the accounts receivables, and the buyer receives the outstanding payments and remits them to the seller post-closing. If they are 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: The buyer may have to pay sales tax on the amount allocated to this class of assets. 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 can benefit you in numerous ways.

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.

Allocation of Purchase Price & Taxes