M&A Seller Financing: Handling a Buyer Default

Executive Summary

Sometimes buyers start out with the best of intentions yet end up realizing they have overestimated their capabilities to pay. Needless to say, dealing with buyers who have defaulted on a seller note can be disappointing.

As a seller, preparation is crucial. Knowing your options will spare you unnecessary conflicts should they arise.

If a buyer defaults, your options fall into two general categories:

• Mutual Agreement Options: 1) contractual solutions; 2) negotiation; 3) mediation
• Dispute Resolution Options: 4) arbitration; 5) small claims court, and 6) litigation in the superior courts

We answer the following questions in this article:

• Which option should you pursue first if the buyer defaults?
• Can you simply take the business back? If not, what steps do you need to take in order to take back possession of the business?
• At what point should you involve an attorney?
• Can you take back the lease if your name is no longer on the lease?
• Is the process different for an asset vs. a stock sale?
• What can you do to prevent a default in the first place?

We obviously hope you’re never in a situation in which you have to deal with buyer default. But as we said above, preparation is key. And a good way to start preparing is by reading the following article.

Mutual Agreement Options

You should first attempt to come to a mutual agreement with the buyer. In many instances, a default by the buyer can be simply and easily dealt with by talking to the buyer.

You should always first attempt to come to a mutual agreement before you pursue other options. It is also important to maintain a working relationship with the buyer throughout the transaction. If an excellent working relationship is maintained, most buyers will cooperate if they default, making it possible to work out a peaceful solution quickly and inexpensively.

Option #1) Contractual Solutions

When you have a dispute with your buyer, the first step is to look at the contract. How does the contract address conflicts? Typically, the contract will provide a procedure that guides the parties through specific problems or issues.

For example, in case of the buyer’s failure to pay the rentals on the business premises, the contract may allow the seller to take over the business and handle the payment of rentals. This contractual provision is typically used when the lessor requires the seller to guarantee the continued payment of rentals as a condition for transferring the lease to the buyer.

If the buyer agrees to follow the terms of the contract, a simple reference to the contract is all that is needed.

Option #2) Negotiation

If the parties disagree on the interpretation of the contract, or if the dispute involves factors not fully handled by the contract, the parties’ best bet is to negotiate an amicable solution.

This applies especially because the buyer will have physical control of the business. In our experience, most buyers will cooperate and work out a peaceful solution, whether by surrendering control of the business, working out another payment plan, or providing additional collateral.

Generally, no matter how justified you are, you cannot use force to compel someone to do something. For instance, you cannot simply break into buyer-controlled business premises — no matter how strongly you feel about your rights. Generally, you can only compel a buyer to do something via an order from a competent government authority. The downside is that getting such an order can take a considerable amount of time.

Option #3) Mediation

Mediation is a voluntary procedure that requires parties to work with a neutral third person to resolve a dispute. The session is private and is not open to the public. Technically, most attorneys would categorize mediation as a dispute-resolution option. However, from a practical standpoint, we consider mediation to fall under a mutual agreement process.

A mediator does not function as a judge and only facilitates communication. A mediator can only make suggestions, assist in answering questions, and explain all views shared during the discussion. They will let the parties decide on whether to settle or explore alternative outcomes and resolutions. Ultimately, as in other forms of mutual agreement, the parties must come to a consensus of their own free accord.

After meeting with the parties together to hear how each party views the case, the mediator normally meets with each party privately and shuttles back and forth between the parties with settlement offers in an attempt to resolve the case.

Costs and time: Mediation institutions typically charge between $100 to $500 to file a case. The parties also typically have to split the cost of the mediator’s time. This can vary between $100 to $300 per hour depending on the complexity of the dispute and the mediator. In our experience, mediation costs may run from $5,000 to $20,000 when resolving a dispute involving a small to medium-sized business. It may take one to two months to complete the mediation. These are rough estimates that can be affected by a myriad of factors.

Dispute Resolution Options

Problems arise when the buyer refuses to follow the contract or disagrees with the other party’s interpretation of the contract. This is where you must explore one of the dispute resolution strategies below.

Option #4) Arbitration

Arbitration involves hiring a private person to act as a judge for your dispute. The arbitrator makes a decision on the merits of the case after a hearing. The parties may give testimony and listen to the other party’s testimony and evidence. After the arbitrator listens to opening statements, testimony, and closing arguments, the arbitrator(s) makes a decision on the merits of the case.

The parties’ contract may provide arbitration as the preferred mode of dispute resolution. Alternatively, the parties may agree to resort to arbitration even in the absence of a prior stipulation.

This is primarily used when the parties would like an expedited hearing conducted in a more cost-efficient manner than traditional litigation, resulting in a decision on the merits of the case. Arbitration rules are more relaxed and far less bureaucratic than court procedures.

The arbitrator’s decision is only binding on the parties if they agree to this ahead of time, whether in their contract or in their submission to the arbitration institution.

Costs and Time: Arbitration institutions typically charge between $100 to $500 to file a case. The parties also typically have to split the cost of the arbitrator’s time. These costs can vary between $100 and $400 per hour depending on the complexity of the dispute and whom the parties choose to be the arbitrator. In our experience, arbitration costs may run from $10,000 to $50,000 when resolving a dispute involving a small to medium-sized business. It may take three to five months to complete the arbitration. Of course, these are also rough estimates subject to great variation depending on things like the location of the arbitration, the contentiousness of the dispute, the number of witnesses, and the size of the claim.

Generally, arbitration is the most expensive form of dispute resolution when looking at up-front costs. Unlike the case of a courtroom judge, who is paid by the government, an arbitrator’s fees must be covered by the parties. The more experienced and technically qualified the arbitrator, the higher their fees typically are.

However, while litigation usually has lower costs up-front, the lengthy and complex nature of most litigations usually results in greater costs than arbitration. Clogged court dockets mean that weeks or months may pass between hearing dates. The parties’ sheer amount of time spent attending court hearings and grappling with the labyrinthine procedures of discovery, pre-trial, and trial represents a hidden cost not often considered.

Option #5) Small Claims Court

Small claims courts hear legal disputes without the expensive and time-consuming process of a full trial. Small claims cases are usually informal proceedings where litigants can present their own evidence and make their own arguments directly to the judge. The judge then renders a verdict after hearing both sides of the case.

Small claims courts have an upper limit on the amount of money that a party can claim. The amount depends on the state, but the typical maximum is $10,000.

Many states do not allow parties to be represented by lawyers in small claims court because some of the main advantages of small claims cases are their informality and low cost. Some states, however, do allow attorneys, but many impose additional rules and procedures on parties that choose to be represented. Regardless of whether your state allows attorneys, you are still permitted to consult with an attorney outside of court, so long as you file and argue the case yourself. In addition, many counties have small claims advisors who can assist litigants on a pro bono basis.

Costs and Time: To file a suit in small claims court, you will need to pay a filing fee. The amount varies from about $15 to $200 depending on the state as well as the amount being claimed. If you consult with an attorney outside of court, small claims litigation costs may run from $500 to $2,000 when resolving a dispute involving a small to medium-sized business. It may take four to eight months to complete the litigation. Of course, these are also rough estimates subject to significant variation.

Small claims courts represent an excellent alternative for parties that find the fees of a mediator or arbitrator overly burdensome. However, a major disadvantage of small claims court is the limited amount that you can claim.

Option #6) Superior Court Litigation

Generally, a claim greater than $10,000 will likely need to be filed with the state’s general trial court, usually called a “superior court.” In some states, the general trial court may be called a “district court” or “court of common pleas.”

While the preceding information is subject to various exceptions, the technicalities of court jurisdiction in each state are beyond the scope of this article. Superior courts generally require compliance with technical rules of evidence and litigation procedure. In this regard, the assistance of an experienced trial lawyer is indispensable.

Costs and Time: To file a suit in court, you will need to pay a filing fee. The amount may vary from $100 to $500 depending on the state as well as the amount being claimed. In addition, you will need to pay your lawyer’s fees, which may range anywhere from $250 to $500 per hour. Litigation costs may run from $10,000 to $50,000 when resolving a dispute involving a small to medium-sized business. Note that there is no upper limit on how high costs may spiral out of control for contentious disputes or complex issues. It may take one to three years to complete the litigation. Of course, these are also rough estimates subject to significant variation.

Frequently Asked Questions

At what point should I involve an attorney?

Of course, it is ideal to have an attorney guiding you on all legal questions. However, the reality is that attorneys are expensive, and you must balance the costs and benefits. As a practical rule of thumb, you may involve an attorney when you feel you have a solid chance of a favorable outcome, and when the attorney’s cost will be less than 30% of the value at stake. An ethical and competent attorney will honestly advise you of your chances and will be able to give you a rough estimate of their probable costs.

On the other hand, litigation at the superior court level will invariably require the guidance of an attorney due to the technicality of the proceedings.

Can I simply take the business back if the buyer defaults?

You cannot take the business back without the buyer’s explicit permission or without first resorting to any dispute resolution process. Remember, when the bill of sale is signed, ownership of the business transfers to the buyer. From that point, even if the buyer is behind in their payments, the buyer has the exclusive right to the business. Without the involvement of the authorities, you cannot force the buyer to return the business no matter how legally justified you believe yourself to be.

If it’s not clear to you if the buyer has allowed you to repossess the business, ask yourself:

1. Can I take the business back without breaking any locks or otherwise forcing my way into the premises?
2. If the buyer were physically present, would they stand aside and let me take over?

If the answer to either question is “no,” you must resort to a mutual agreement or dispute resolution process to get the business back.

How do I take back the lease or franchise if my name is no longer on the agreement?

The complication with leases and franchises is that the approval of a third party is necessary. Hence, even if the buyer allows you to retake the business, you cannot operate it under your own name until the lessor or franchisor agrees. One possible solution is an irrevocable power of attorney. In case of default, the buyer can be deemed to have irrevocably appointed you to operate the business as their agent and under their name. However, you will have the right to collect the business’s income. In this manner, you will be able to take over the business for the time being while legal title to the lease or the franchise remains with the buyer.

Is the process different for a stock sale?

There is no fundamental difference to the dispute resolution process in the case of a stock sale. Instead of seeking the return of the business assets (or completion of payment for them), you will be dealing with the return or completion of the stock shares. With respect to leases or franchises, the same issues concerning third-party approval may present themselves since leases and franchises typically require the lessor’s or franchisor’s approval for the change of control of a business entity.

Is the process different if I still own a percentage of the business?

There will likely be no fundamental change in the process if you continue to own a percentage of the business. Instead of retaking business assets, you may need to retake majority control of the company. As mentioned above, most third parties will treat such a change of control as equivalent to changing the lessee or franchisee and therefore requiring third-party approval, even if the business entity holding the lease or franchise remains the same.

Can I prevent a default in the first place?

In our experience, there are two ways you can prevent a default: 1) perform careful due diligence on the buyer and 2) maintain a cordial relationship with the buyer after the closing.

Don’t underestimate the value of your face-to-face assessment of the buyer’s trustworthiness. There have been many instances where sellers felt something “off” about a buyer’s body language or negotiation methods but continued with the transaction anyway in their eagerness to close a deal — much to their regret later.

With respect to cordiality, common courtesy will go a long way toward allowing the parties to communicate clearly and effectively in an environment unclouded by emotion. When the parties can clearly articulate their needs, most of the time, an amicable solution can be achieved much more quickly.

Summary

If the buyer defaults, you should first attempt to achieve a mutual agreement with the buyer for either 1) completion of payment on the balance or 2) retaking control of the business. If an amicable resolution fails, you may consider the various dispute resolution alternatives discussed above. The ideal procedure will depend on your resources, the amount involved, and other circumstances. In all cases, you must keep a cool head and maintain cordiality. Clear, rational communication will trump anger or hostility every time.