The sale of a business involves an entire set of terms and conditions that relate solely to this transaction and are often new to first-time entrepreneurs. Here is a list of some terms (in no particular order) as well as some issues that the selling entrepreneur might consider before firming up the deal.
Currency – Should you take cash or the stock of the buyer?
You cannot lose by taking cash. And you want to only take cash if selling to a buyer whose stock is not publicly traded (from which if you took stock you would be postponing liquidation of your ownership, perhaps acquiring ownership in another high-risk venture).
The downside to accepting stock in a publicly traded buyer is that there is often a lock-up period (usually six months) during which sellers cannot sell their stock. Woe be to the seller who completes the transaction only to see the stock price of the buyer plummet during the lock-up period!
On the other hand, there are possible advantages to accepting shares of a publicly traded seller. Such a transaction may qualify as a “trade” for tax purposes, such that the seller only pays capital gains taxes upon the sale of the buyer’s stock (postponing taxation). It is also possible for the seller to donate some of the proceeds of the sale (stock of the buyer) and thereby write off as a charitable contribution the market value of the acquired stock without paying any taxation on that portion of the transaction.
Finally, buyers often have a currency of preference. For example, if they believe the public price of their shares is low, they may prefer to purchase your company with stock. Be alert to the fact that the buyer may be willing to pay a higher price with one currency than the other.
Earnouts – Should you accept, as a term, that a portion of the transaction price will be earned in future years, depending on the performance of your company as part of the buyer?
When buyers and sellers cannot agree on the selling price, the buyers will often suggest that a fraction of the selling price be deferred and be dependent upon the future performance of the company. Sales with an earnout are not an uncommon practice. There is little downside for the buyer in such a transaction:
- The immediate payment to the sellers is minimized;
- Both the buyer and the seller benefit if the company does well;
- The buyer pays less if the acquired company does not meet plan; and
- The seller is handcuffed to the acquiring company until the earnout has expired.
There are some distinct disadvantages to the sellers. First, some of the purchase price is deferred and often never earned. Second, the buyer has a propensity to want to merge the selling company into the operations of the purchaser and to expand the responsibilities of the seller management team, thereby reducing the focus of the seller management team on optimizing the earnout. Finally, earnouts can pressure the selling management team to optimize the earnout when fertile opportunities arise, either within or outside of the buyer’s company.
Non-Compete Contracts – The entrepreneur and some of the management team will likely be required to sign such contracts to finalize the deal.
Buyers expect to purchase exclusivity in the businesses they purchase. That is, they want to avoid situations in which the entrepreneur and/or the management team immediately leave the purchased business and start a competitor selling the same products to the same customers using the same technology and trade secrets.
Since the purchaser has paid millions for the seller’s company, it seems reasonable to expect the purchaser to insist that the key team members agree not to compete with the purchased company for a period of time. These key executives are often offered employment contracts for one to two years (perhaps longer), and the non-compete contracts usually extend for one or two years after the executive leaves the employ of the purchaser. The entrepreneur is expected to assure the buyer that key executives will agree to a non-compete agreement, as part of the purchase agreement.
Escrow – A fraction of the purchase price (in stock or cash) is usually held in reserve to be paid to the sellers after a specified period of time (often one year) to protect the buyer from unknown or undisclosed liabilities accrued prior to the purchase date.
The purchaser should not expect to pay for liabilities of the seller which were created during the ownership by the entrepreneur. For example, if a government deems the business to have underpaid taxes in a prior year, payment of these taxes should be the responsibility of the owners who underpaid them.
It is common for the purchaser to insist that ten to fifteen percent of the purchase price be reserved for such potential liabilities for a period of one year or so. It is not uncommon that a schedule be negotiated for the release of this escrow over time, such as quarterly after the purchase date. Payments against the escrow are often pooled and must meet a minimum, say $50,000 for example, before any payment can be made out of the escrow. Sellers insist on this provision to avoid being nicked for very minor and unexpected liabilities.
Selling Your Baby – Entrepreneurs often have divided loyalties; they want to have their cake and eat it too.
It is important to many entrepreneurs that the culture of the buyer match the culture of the seller. My advice to sellers is that they complete substantial due diligence on the buyer to specifically determine the degree of match and get comfortable. Two mistakes that entrepreneurs make are 1) insisting the culture and operations of the seller will somehow remain unchanged into the indefinite future, and 2) the buyer will actually adjust his corporate culture to match that of the seller. There is simply little chance that over the next few years the culture of the buyer will prevail.
My advice to selling entrepreneurs for whom culture is of critical importance is that they do substantial due diligence on the buyer to satisfy him or herself that the employees of the seller will be comfortable inside the new company. If so, do the deal and get out of the way. The buyer is, in fact, paying a lot of money for your company and will eventually run the company to fit within the ongoing mold of the buyer.
Tax Implications of the Sale – Under most conditions, the sellers should expect that the sale of their ownership should qualify for capital gains treatment under the IRS regulations.
While too complex for consideration here, entrepreneurs should consult with tax counsel to assure the terms and conditions of the sale are consistent with the capital gains regulations to avoid excessive taxation of the proceeds. Expect, however, that “kickers” such as deferred compensation, payment for signing non-disclosure agreements, etc. will not qualify for this preferential tax treatment.
Editor’s Note: The information in this article is provided for educational and informational purposes only. This information does not provide legal or other professional advice and is not the substitute for the advice of an attorney. If you require legal advice, you should seek the services of an attorney familiar with your specific legal situation and the laws of your state.
© 2006 Ewing Marion Kauffman Foundation. All rights reserved.