In this session you will learn about:
- What sellers should expect - the contract process
- Contract terms to know in advance
- Value of deal structures
- Understanding post-sale liability
- Side agreements
- Other conditions to closing
About the GuestMr. Broderick is an attorney and partner with McCarter & English. He has been practicing law for 30 years with a majority of that time spent focused on merger and acquisition work. Mr. Broderick practices in the areas of corporate and securities law, including mergers and acquisitions, venture capital and strategic investments, public and private securities offerings, and joint ventures. He is particularly skilled in venture capital and private equity investment transactions.
Listen to the Webinar Here:
Read the Full Transcript Here:Slide - 2/12
Scott: Welcome everyone. My name is Scott Yoder with the divestopedia.com. We’re fortunate today to have as our guest speaker, David Broderick. David is an attorney and partner with McCarter & English. David has been practicing law for 30 years with a majority of that time spent focused on merger and acquisition work. David’s done hundreds and hundreds of deals representing both sides of the table - the buy side and the sell side. David is also an adjunct professor at Seton Law where he teaches Business Planning. So David’s a great resource for us today, and David’s going to talk to us about the sales process and what sellers can expect, and give them some sense of the deal terms and just the process in general, and also provide some pointers and some ideas. With that I’m going to kick it off and let’s get started.
Slide - 3/12
Scott: So again David, thanks so much for joining us today. Before we dive into the details of the various steps sellers can expect to go through can you begin by giving our audience a 30,000 foot view of the typical process?
David: Sure. I guess I would preface this by saying that I find that it’s most often the case that the business owner who is about to embark on selling his or her company knows their market and knows their business very well. But because the sale of a company is a once, or perhaps twice in a lifetime event, it’s not surprising that they are a bit like a fish out of water and have a lot of anxiety about how the process will unfold. So I do try to give them advice and an overview
and try to calm their fears and tell them how the process will go. So, the basic overall process can be broken down into a couple of different steps which we will be talking about.
The first would be the finding the acceptable buyer and a purchase price that is acceptable, and that would then be incorporated into a Letter of Intent which gets signed by both parties. After the letter of intent is signed, there is a simultaneous due diligence period where the buyer basically examines all the books, records, and properties and everything else regarding the seller’s business. At the same, their lawyers have been instructed to prepare the definitive binding purchase agreement. And the parties will typically try to negotiate that along at the same time.
The next step, assuming that all has gone well, would be to sign the definitive purchase agreement. Sometimes there’s a period after signing, but prior to the actual closing, which we’ll talk about, but sometimes after the signing you proceed directly to the actual sale which
is the closing. So, those are the general timeline and steps.
Scott: So David, as you just described, the first official legal step in the sales process is the letter of intent. Can you help us understand the purpose of this document along with some details and who originates?
David: Typically the Letter of Intent, or perhaps it might be called an offer letter, is something that the buyer prepares. It has to contain the essential terms of the transaction, most notable and most obviously the purchase price. But also if there are some particular items that the buyer is going to insist on as a condition of buying the company. For instance, if there are certain employees that the buyer wants assurance will stay with the company after it’s been sold. All of those should be laid out in the Letter of Intent so that each party knows exactly what is going to be required here in order to complete the sale.
One of the important points to know as the seller is that the Letter of Intent is not a legally binding document on the buyer. The buyer has no obligation to buy the company. In fact, they can even technically change their mind and walk away if something changes and they’ve decided they don’t want to buy your company. But on the other hand, there is usually at least one binding provision on the seller and that is that the seller will be required to cease any and all discussions that it has with other potential buyers. Usually this lasts for a period of 30 to 90 days. This is called the no-shop period.
The no-shop period is an important feature for the buyer because the buyer wants assurance that if it’s going to devote resources to do due diligence and to pay legal fees to have its lawyers draft documents; it wants assurance that the seller is not also negotiating with other potential buyers.
From the seller’s standpoint however, the seller has to be very sure that it wishes to accept this offer and wishes to sell the company to this buyer at this price, because it will be stopping all discussions with other parties. If something goes wrong with the negotiations with this buyer it may be difficult to restart those negotiations with the other potential buyers. So, it’s an important document.
From the seller standpoint, one very important feature is that the seller should require the buyer to specify where the funds are to going to be coming from. If it’s a very large company with a
lot of cash, maybe that’s not an issue. But if it’s a mid-size company or a competitor of the seller in the same industry and they’re going to have to borrow funds or obtain funds from investors, then the seller should really investigate that [and] require the buyer to spell that out, including a
For instance, if the seller’s been told that the buyer’s bank has approved the issuance of a loan to cover this, it is not unreasonable for the seller to say "Please show me a copy of that approval
so I can confirm that."
Slide - 4/12
Scott: So David, assuming both parties agree on the LOI [Letter of Intent] and execute that agreement, then the next step is due diligence that you previously mentioned. What is the purpose of this step, who gets involved, and how long does it normally last?
David: The Due Diligence period basically refers to the period after signing to the Letter of Intent, and usually prior to signing the Definitive Purchase Agreement. The idea is that the buyer and its professionals which usually at a minimum includes the buyer’s lawyers and accountants. But for instance if it’s a scientific company, it may include outside experts to evaluate the seller’s technology or that type of thing. They basically are giving almost free rein, and I’ll say almost, to examine all of the books, records or property and other items that are connected with the seller’s business.
The way that this is accomplished these days is almost exclusively by setting up an online data room. There are a number of providers out there, and the price is about, I believe, between $2500 and $5000. The documents that correspond to what is usually a due diligence request list which the buyer will prepare are typically scanned in and are posted in an online data room under various categories. Some examples might be customer contracts, employee-benefit plans, pension plans, leases and that type of thing.
One of the difficult items to deal with is the fact, as we said before, at this point in time there is no binding agreement on the part of the buyer. Many business owners are rightfully skeptical and worried that perhaps the buyer is going on a fishing expedition, wants to learn the name of its customers, wants to learn the technology that it uses, and then with the intention of maybe breaking the deal off and using those on its own, even though there will be a confidentiality obligation either with a Letter of Intent or separately. But again, those are only as good as can
be enforced in a court of law.
It is typical that the most highly sensitive information regarding the seller is withheld until there is a definitive purchase agreement. This would typically include things like customer list, or what the people would simply call the 'secret sauce,’ the trade secrets, the technological advantages that the seller has.
One of the ways the parties often are able to satisfy the buyer’s legitimate need to find out some of these items is to, for instance in the case of the trade secrets, an independent third party who is sworn to confidentially will be hired to evaluate the technology and render a report. Their report will basically be results-oriented and will not give away the methodology or whatever the trade secret is so that an independent laboratory could be hired to evaluate a particular process that the seller uses. They could render a report to say, "Yes. In our view this process does work," but that report would simply be limited to that. It would never tell the buyer how that process works so they couldn’t replicate it.
Another example of a difficulty that private business owners often have is that you certainly don’t want to announce to your workforce, at least until you have a definitive agreement, that the company’s going to be sold for all sorts of reasons. But at the same time, responding to do due diligence and also providing substantive information is really too much for one business owner to
deal with. And so one of the things business owners have to do is come up with a core group of loyal employees who can be trusted to keep the fact that a Letter of Intent has been signed in their confidence, but at the same time assist them in providing the documents and also providing information. These would include people such as plant managers, HR directors, environmental and health safety directors, that type of item.
That in turn would lead to an issue when you sit down with those top managers and explain that the company may be sold. They of course will worry about their future; how do they know they’re going to continue to have a job. So, really have to have a script laid out as to how you’re going to either assure them that they will have a job because the buyer has told them that’s their plan or if there’s a good possibility they won’t, be prepared to offer them something like a bonus if they will
successfully stay with the company and see the process through.
Scott: As you just explained, since the Letter of Intent isn’t typically a binding agreement on the buyer but is binding on the seller regarding the no-shop provision, after the Letter of Intent is signed, the buyer could renegotiate the price and other significant terms and has more leverage at the phase….right?
David: That’s correct.
Scott: Do you see that happening in the deals you have been involved in?
David: Well, thankfully no. What I do is happening it is usually on the other side, I’m happy to say. It’s usually because some very major points have not been disclosed early on the process. Those would include things like, "Yes, our revenues were x dollars last year, but in the meantime we got a letter from our major customer saying that they’re going to cease purchasing from us and start sourcing product overseas." Key employees, particularly people like key engineers, have (you even notice) intend to leave or occasionally that there’s a very major piece of litigation out there. For instance, an employee lawsuit has not been disclosed, although usually legal items like that can be dealt with. But it’s usually when there’s been a failure to be completely candid by the seller.
Scott: Great points David, so sellers are best served by first doing their own sell-side due diligence to limit any surprises and to be candid with a buyer upfront.
Slide - 5/12
Scott: Alright, David. So now, we’ve gone through two steps: the Letter of Intent which is signed and agreed to by both parties and now both parties are going through due diligence. At the same time, I think they’re also drafting the definitive agreement or the purchase agreement. Is that right?
David: Typically, two processes will go on simultaneously. The buyer will instruct their attorney, which is usually the party that drafts the agreement, to begin drafting a definitive purchase agreement. Occasionally, you’ll find a situation where there are maybe some very substantial due diligence issue like company does not have audited financials, so we want to confirm that their represented revenues were indeed correct. Lawyers hold off doing anything until we do that. But usually, there’s enough confidence in the information and the basis for going forward that the buyer will tell their attorneys to start drafting.
The purchase agreement is the document which is going to be the definitive agreement. They tend to follow some pretty standard forms, and also would have different arrangements that we’re going to talking about. And so for instance, just to go through my slides. Some of them are important items which a purchase agreement would contain. It would be whether or not this will be an asset or a stock sale, which we will talk about, has very, very important implications for both parties. The representations and warranties that the seller makes about its business, and what indemnification liability it may have if some of those turn out not to be true whether intentional or not; whether or not there are side agreements which will need to be drafted and negotiated, such as employment agreements with the seller or other key employees, whether there are leases which need to be negotiated. For instance, if the seller or the seller’s family owns the property on which the business is located. Usually, they’ll have to be some type of lease.
What the covenants not to compete on the part of the seller will be, again, always a feature. Oftentimes, there can be substantial negotiation over that. And then finally, one of the major items is it lays out what type of regulatory approvals and perhaps other approvals such major customers, landlords, and other third parties that may be necessary to be obtained.
Scott: In my experience, it’s key to have attorneys on both sides that specialize in merger and acquisitions. It really helps with the timing among the parties and with the deal actually occurring. When you have another attorney that doesn’t have experience in merger and acquisitions, then it really slows down the deal and can almost paralyze it at times. So that’s one, I guess, strong position for our listeners. It’s that they make sure they hire a good attorney with merger and acquisition experience when they’re going through this process. So, let’s move on.
Slide - 6/12
Scott: So David, an asset deal versus a stock deal is pretty common and one of the major opposing points in most transactions. Buyers and sellers seem to be somewhat aware of this fact, but don’t quite fully understand it. Can you give us some detail and some background on a stock deal versus an asset deal, and why buyer and seller have competing views of this?
David: Yes. This is probably the most important threshold question that the seller and the buyer of the business are going to face. It’s actually often dealt with early on in the Letter of Intent stage so that there’s no further negotiation or misunderstanding. However, sometimes you have Letters of Intent that indicate that the business will be bought and the parties will negotiate the form.
In general and just to be clear, an asset sale is where…let’s say your wholly owned corporation sells its assets so that it’s not X Corp that is being sold, but it’s X Corp that’s selling its assets. But for all intents and purposes, it’s the entire business; it’s all the goodwill, trade names, everything else that gets sold. In a stock sale, it’s much more direct. You are actually selling the stock. You, as the owner of X Corp, are selling the stock of X Corp, and whoever buys X Corp will continue on doing business in that corporate form.
The general rule that you’ll run into is that sellers will want to sell their stock. On the other hand, unfortunately, buyers will almost always want to buy the assets. The answer is why? There are two levels of discussion here. I would say the first and foremost is the typical tax consequences of an asset sale versus a stock sale. In asset sale, the buyer can basically buy all the assets and write them up to their fair market value.
For instance, let’s say you have a factory with some older equipment that you have fully depreciated for tax purposes so you’re not taking any further depreciation. Yet, that machinery has a pretty good fair market value, let’s say up to a million dollars. A buyer, if they follow proper
steps like perhaps getting an appraisal, the buyer when they buy that machinery can write it up to million dollars and depreciate it again, over the rest of its lifetime or depending what the tax rules are.
I have [buy side] clients that actually prepare analysis showing that the tax savings of an asset sale over a stock sale and in particular instances are huge. They end up giving a return on the investment to the buyer of something on the order of one-third to one-quarter more than a purchase of stock would do, all simply because of that depreciation. Unfortunately in an asset sale the seller may end up paying tax twice particularly if you own a corporation which is not an S corporation. In that case the corporation sells its assets, pays tax at the corporate level, and then in order to get the proceeds out to the stockholders, there’s another tax, either a dividend tax or some other types. Often the difference is very stark and again we’re talking perhaps 25% to a third more taxes being payable by the stockholders ultimately in the case of an asset sale versus a stock sale for certain types of entities. Other entities, particularly Limited Liability companies and subchapter S-corps, there’s less of an issue. So there’s the tax issue.
There’s also the liability issue, and that is when a corporation’s stock is sold; the law simply says that corporation continues on in legal existence, and all of the historic known and unknown liabilities related to that corporation are automatically, by law, stay with that corporation. So, for instance if you have a disgruntled employee and is angry at you and yet hasn’t taken any legal action. Yet, after the sale decides, "Well, it’s now a good time to file a discrimination lawsuit
or whatever against X corp." If the buyer has bought the stock of X corp, then that’s usually not your issue. X corp will have deal with it. They will have to pay any kind of judgment even though perhaps the employee is claiming that they were discriminated against for years while you own the company.
In the case of an asset sale, it is usually is the case but not always. If that were to occur, the seller would have to indemnify the buyer out of the proceeds and cover any particular liability that comes out of that. Again, that’s a major difference. But then again, I would say that most people would focus first on the tax difference and then secondly on the liability difference.
Scott: Right. So, two competing views between the buyer and the seller. In my experience in
the middle market and the lower middle market, it’s typical for more mature companies to really do asset deals, right? I mean, that’s pretty much the norm. If you look at your deal experience,
would you say most of the deals are asset deals or stock deals that you have represented?
David: Most of them are asset deals, and mostly because particularly if you’re assigned to or
are a larger corporation they want the tax depreciation and they don’t want to inherit the potential liabilities of the history of the company.
Scott: So now, if it’s an asset deal then the buyer will get the return because they get the tax depreciation and they don’t want to assume the liabilities. Is there way to bridge the gap between the buyer and the seller?
David: Well, yes. Again, this is pure negotiation. I wish I could tell you is some magic way to put everybody on the same side, but unfortunately there isn’t. What I have seen are sellers who have companies that are highly desirable and who go out to the market and say "I’m only going to sell stock" because of the reason we’ve gone through, and you have certain buyers who will do their tax analysis and say "Well, look. If you accept us buying the asset, yes you’ll pay more taxes but we’ll have a much higher after tax return in the years ahead. So, we’re going to increase our purchase price to pay you not the whole amount usually, but at least some amount which will allow you to pay some of those additional taxes."
Unfortunately, you end up in a dog chasing its tail scenario because as you may be familiar with the concept of gross up, every additional dollar or purchase price will itself be taxed at whatever tax rate will apply. And so you end up having to actually pay a much larger amount in order to compensate the seller for the additional taxes.
Scott: I think you might even cover this later in the presentation but I think there are some opportunities too in the way you structure the deal, using personal goodwill, or non-competes, or consulting agreements help with some of the tax differences. Another thing too is you mentioned double taxation if you’re a C-corp. Is there an opportunity that sellers should start thinking about, maybe of converting their C-corp to another entity form prior to going to market?
David: Yes. Unfortunately, as you might imagine, the IRS does not make life easy for business owners. They basically have a look back rule of ten years where if you are a subchapter C-corporation and you’re able to convert to a subchapter S but there are some additional rules there, like you have to have individual shareholders, you cannot have companies as shareholders, etc. But if you’re able to do that, unfortunately the IRS will look back ten years and do a very complicated formula, will tax, at least a portion of the proceeds of the sale as if you were still a C-corp.
So certainly for anybody who comes in today and wants to form a business, we highly recommend using the limited liability company form or the subchapter S-form. But it’s difficult to change if you intend to sell your business in the next two or three years.
Slide - 7/12
Scott: Alright David, you just walked us through one of the major sticking points for buyers and sellers; stock versus asset deals. This is another major key item that buyers and sellers should be aware of - the reps, warranties and indemnifications. Help us understand what these are and what effect it would have on the seller.
David: Yes. This often an area that takes some time to have a business owner who’s about to
sell his business properly appreciate this and understand how important they are. I like to say that from the buyer’s standpoint, the representations of warranties basically are a snapshot and paint a picture of what the company looks like and what its assets are, what its revenues were, what potential liabilities it might have, and basically almost anything else you can think of.
So, the idea behind this is that the seller obviously knows its business, and so the seller basically says, "Okay. I will represent and warrant to you, (for example) that the revenues from last year were X dollars," and of course they’ll have financial statements which may or may not be audited, but the seller is putting his or her personal integrity and personal word behind those. Although the buyer will be doing due diligence and will probably have an accounting firm which will go in, look at the work papers, look at the revenue receipts and records, and will verify that, they are also going to rely to a large extent on the representation made by the seller.
The way this usually works is there’s a list of these representations or warranties in the purchase agreement, and then there’s a schedule of exceptions which is the Disclosure Schedule. So you’ll have something that says, for instance in the document, "Accept this said forth on the schedule. This business has no pending lawsuits." And then we go to the schedule it will say, "Yes, we have a lawsuit from an ex-employee. We think it’s meritless and our insurers are defending it." But basically, you have to go on record as indicating that each of these items are out there so that you have a record that the buyer knows about them.
One of the things that I often run into in the case of representing sellers is the sellers will say, "Well, okay but in the data room that we just talk about in due diligence we posted all of the court filings and records relating to that. So what am I going to tell them again?" The answer is because you need to have one official depository, one official record of the bad things, like you told them about your company, and that’s the Disclosure Schedule. The data room is going to disappear after the closing, but the purchase agreement or disclosure schedule will live on and on.
I always tell sellers that it’s always in their best interest to disclose things as much as possible even if you’re not worried about them. One example which I recently had was: there was a phone call in the middle of negotiation of the purchase agreement from a customer saying that not they were going to cease buying, but they might be reducing their purchases in this company in the future. The seller, our client, thought it was a way to negotiate to a lower price and didn’t really think much of it. But nevertheless, using my advice, they actually made a record of that on the Disclosure Schedule. Then, it was up to the buyer to sit down and decided whether or not this was something to worry about or not. It turns out they went ahead without any kind of issue.
One of the things we’ll talk a little further on is in the event that some of these representations or warranties may turn out to be false. Again, maybe it’s not a case where you even as a seller had any reason to know that they will be false, and certainly you are not trying to conceal anything. But if some of them turn out to be false, then you may be liable to return a portion of the purchase price through indemnification which we will be talking about.
Scott: Alright. Let’s move on to that.
Slide - 8/12
Scott: Alright David, tell us about indemnification and what they are all about, and how buyers use them to protect themselves.
David: Yes. The theory behind indemnification which is basically the seller returning a portion of the purchase price to the buyer is that: if the buyer had been aware of certain things prior to the signing of the purchase agreement, it would have negotiated a lower purchase price to cover those types of things. For instance, let’s say there’s a representation or warranty which says there’s no threat in litigation. It could be that an unfortunate situation where a letter was sent into, perhaps a lower level employee, from a disgruntled ex-employee saying, "I believe I was discharged in violation of the law and I intend to sue you," but somehow that letter never made its attention up to the human resources manager or to the owner of the business. So in complete good faith the owner of the business, the seller, said that there is no threat in litigation. But after the closing unfortunately, the employee files through with his threat and the letter comes out.
Even though it really was just one of those unfortunate mistakes, most purchase agreements will place the onus for paying any judgment for the cost of hiring defense counsel on the seller because the seller, even though it was in good faith, did not reveal that. That typically would apply to each of the representations and warranties. Usually the indemnification period last for a period of between one and two years after the closing. So at some point there’s going to be closure where the seller of the business can breathe a sigh of relief, "Okay. Now I know I’m not going to be paying any additional indemnification," because the idea is if there are any issues like that they’ll probably show up in the first one to two years.
There are few exceptions to that. Mostly notably, say in a stock deal, the tax representation usually goes for the full federal and state tax statute of limitations which I believe is three years. So, if IRS comes in and audits the prior year, say three years out, then the seller could be liable to pay any additional taxes. But with those exceptions, most of the indemnifications slip away over one to two years.
I would say indemnification is probably one of the, if not the most heavily negotiated portion of any purchase agreement. Typically, the case that you’ll have limitations on the seller’s requirements to provide indemnification and these takes the form of usually two items. One is called a threshold or a deductible which is like what it sounds. That is that if you’re selling your business for $100 million you can expect there will be some things coming out of the woodwork. "So, don’t even bother coming back and looking for indemnification unless your damages are one percent of the purchase price," and in that case $1 million.
Then you have a negotiated point of, "Okay. Is it a deductible like an insurance company deductible where the first $1 million is paid for by the buyer? Or is it what’s called the threshold where after you pass the million dollars it goes back to dollar one?" Again, these are all the things that your lawyer will be negotiating on your behalf.
There’s the threshold, and then there’s also probably the more important - the so called 'cap.’ Usually, there’ll be a limitation on the absolute upper limit of what a seller would ever have to pay back. This is not scientific but typically between say 8% and, I’ve seen as high as a third although that’s pretty unusual. I’d say between 8% and 20% would be fairly standard. The issue there is if, particularly if you have a big purchase price, there has to be something seriously wrong that comes out of the woodwork after the closing in order for the indemnification to ever even approach those limits.
The other part of this is that the buyers will almost always require that a portion of the purchase price be held back and placed into escrow in order to secure this indemnification obligation so that they’re not out chasing the seller who may have moved to Tahiti and trying to get the money back. The money is actually sitting in a bank account or a lawyer’s attorney trust account, and can’t be released unless both parties tell the bank or the attorney to release it. So, it provides some leverage on the part on the buyer to try and negotiate any indemnification levels.
Again I would say, as the seller, you have to expect that this will be requested, you have to expect that there will be some type of escrow, although it would be nice to say that you refuse either of those concepts. As a practical matter, most sellers are required to agree to them.
Scott: David, is the escrow amount similar to the cap amount or is it typically some lower negotiated amount?
David: Usually, it’s a negotiated lesser amount. Although again, sometimes that’s not exclusive. A lot depends on whether or not the shareholders, let’s say, are going to be around after the closing. Some people literally want to drop off face of the earth, and are not going to be active and are going to be hard to reach. In that case, the buyer is going to insist on a higher escrow.
Slide - 9/12
Scott: David, you just walked us through the Letter of Intent agreement and you’ve also given us some of the highlights of the definitive agreement or purchase agreement. There are also a lot of numerous other agreements that are associated with the whole process. Maybe you can walk us through some of the more typical side agreements that you see and that are pretty common for sellers.
David: Yes. Typically if an important component of the value of the business are the customer relationships, and that’s almost every service business or business-to-business company that I’m aware of. The buyer is not going to want to have the seller simply drop off the face of the earth. The buyer is definitely going to want the seller to either be working full time or substantially full time for some transition period; transitioning the customer relationships to the new people that the buyer will be putting in place. Or perhaps if the seller is an older person and looking at this as the start of their retirement, there are at least some type of consulting arrangement where that person is available for some period of time - one year at a minimum or maybe one to three years - for instance, to go to trade shows, to visit customers, to basically introduce the buyer and its new people as the new face of the company and assure them that there’ll be no diminution in quality or anything else.
Again, I guess you might have a situation where somebody literally just retires and a business owner has no further involvement at all, but I think those are pretty rare. The other item that you often will see is that particularly if it’s a family-owned business because of advice that they previously receive from their accountants. The real estate is actually held by different entity, often a family-owned partnership. It’s been my experience that most buyers do not want to buy the real estate; they’re not interested in real estate. They want to buy the business and its ongoing operations. They want to enter into a lease for the real estate.
The existing lease which is probably very simple lease between the family partnership and the corporation, or whatever business entity is, was probably setup more in terms of "how do we get some of the money out to the individual family members in a tax efficient manner" than it was in terms of "What’s the real fair market value rental of this property?" And so it is pretty typical to
either have the seller, before they start to sell the business, hire reputable third party appraisal firm to come up, look at the property and provide an opinion as to what the fair market rental is, or if that doesn’t occur prior to the sale process, to do that during a process, and then both parties will agree to live with the results. Because obviously, now you have a new tenant even if it’s the same corporation or ownership. It should reflect a fair market rental.
Scott: Right, so the rent being charged historically will be reset to fair market value which
changes the cash flow to the buyer.
Slide - 10/12
Scott: Here’s another sale agreement, the covenant not to compete. I think it’s probably one of the most common agreements associated with a sale. Talk us a little bit about this and what sellers need to know.
David: Sure. Every buyer is going to want certainly at a minimum the seller and possibly even some other people such as key employees or family members to agree not to compete in this business at least with respect to the geographic area in which is the seller is currently operating because obviously they usually are paying a premium for the goodwill of the business, and this protects the goodwill. So, this is a feature you are going to see in all deals.
The typical non-compete period in my experience is something between five and ten years. It’s really long enough so that if the person does get back into the business and the area, all of the customer relationships and other types of relationships will have gone and been sort of old and cold at that point. So, there’s less concern at that point of being able to go back to the customers and trying to get them and have them work for other companies.
It used to be that geography was an important issue and I guess in some cases, it still is. I’ve done, for instance, sales of companies in the waste industry which, as you may know, companies are licensed to work in certain states and certain areas. There was a very definitively carved out area that the sellers couldn’t work in the waste industry or around it. They could continue in the business and in fact, that’s what they did. They moved their operations and their expertise, and they moved to a different area. They did not bring any customers with them as they shouldn’t have, but continued on in the business.
It all depends on the industry. If you are a manufacturing company that sells worldwide, then don’t be surprised if the non-compete will simply say "You can’t participate in this industry for five years anywhere in the world," because they want you moving to Taiwan and doing what you’re doing now in New Jersey.
Aside from the fact that the seller is going to have to accept this, one other issue that always will arise is that for tax purposes a portion of the purchase price has to be allocated to this. The IRS views this as almost the way they would view a salary if you are going to work for the seller. The portion of the purchase price that gets allocated will be taxed to the seller at ordinary income rate which today…the highest rate has gone up 39.6% versus the capital gain rate, which as people may know, just moved up from 15% to 20%, but it’s still about half of what the other rate is.
As a seller, you will want to try to minimize the amount of the purchase price that is allocated to you. Just as we saw in asset versus stock, unfortunately the buyer will want to maximize it because these amounts can be amortized and written off overtime for tax purposes. So again, you have a natural tension here. I don’t think it’s anything that ever stops a deal, but it’s something that you have to be very aware of because if the buyer is saying that a very large amount, 10% of the deal, is allocated to non-compete, all of a sudden you’re paying a lot more taxes than you thought you’re going to be paying.
Scott: With the non-compete, is that linked at all with any of the escrow’s money or the indemnifications or any of those?
David: Well, yes. Certainly, if you have violate the non-compete or if there’s a claim that you violated a non-compete, then the escrow amount is at jeopardy and the buyer will make a claim they need to compensated and need a portion of the escrow amount.
Scott: So the escrow typically like you said maybe two years but it might be a little longer, so maybe after the escrow is over with then they would have to come after them personally.
David: Right. Again, it’s not unusual in some industry for people to be very aggressive in defending this and bring lawsuits to establish the principle that they will enforce the non-compete.
Slide - 11/12
Scott: So David, you’ve gone through all these steps. You’ve spent all this time negotiating. You have a Letter of Intent signed; you’ve got a Definitive Agreement about ready to be signed; the due diligence is over with, but you got other things to think about from the sellers and buyer’s viewpoint. Tell us about some more common things that folks need to be preparing for and thinking about.
David: Yes. One of the important things which has to be identified very early on, even prior to Letter of Intent if you can, is "What types of third party approvals are going to be needed in order to accomplish this sale?" I would break those down into two different categories. One is: what types of regulatory or legal approvals are going to be needed?
If you work in a particular industry such as…if you’re a defense contractor of financial services like a broker dealer, waste hauling, I’m sure there’s a million other regulated industries. You’re probably familiar with the regulatory bodies that govern you, and you probably have some idea as to what you would need to do to, for instance, transfer a license or transfer a controlling interest. And you should really plot out and determine what you’re going to do with respect to those early on.
Usually, there’s not a substantive issue here. It’s really a case of getting administrative agencies which are not used to working very quickly to factor them into the timetable. For instance, if an agency typically takes 60 days to approve a request for a transfer of a license, you have to make sure that you work that into your timetable so that there are no surprises.
And then there’s also other approvals which may or may not apply to your particular case where your professional advisers will the best sources to advise you. Two of them I’ve listed on the slide are environmental…In New Jersey there’s a very strict law called ESRA, Environment Site and Remediation Act, which basically (unless you’re exempted from the act) requires approval by the environmental authorities for sales of industrial establishments or sales of the stocks of industrial companies. So, again, not something you should be necessarily aware of but something that your advisors need to explore.
If you’re purchase price meets a certain threshold, today it’s about 68 million, then you also need to file with the Federal Trade Commission and the Federal Department of Justice under the Hart-Scott-Rodino Anti-Trust approval. Again, they are actually pretty good. They usually provide the approval within three weeks or so, assuming there’s not a substantive anti-trust issue. Usually there isn’t, but again you need to work it into your timetable.
The other key consents you have to identify early on and come up with a plan for obtaining them are from private parties. For instance many, many leases will contain a provision that says the lease is not assignable, which you will need to assign in case of an asset sale, or if there’s a change in the identity of the stockholders, of the tenant, that’s considered an assignment. So, that would catch you if you’re doing a stock sale. Again, it’s usually not an issue but some companies might have some very favorable lease terms.
If they signed their lease at a time when the market was down, and the landlord now can view this as an opportunity to renegotiate the rent and perhaps make it higher, which in turn has a ripple effect because the buyer was assuming that its expenses would be a certain amount. Now all of a sudden, there’s a couple of hundred thousand a year, let’s say, being added on to the expenses. They may well come back to reduce the purchase price because of that. So, these could be important things.
One of the other items that I’ve seen which is extremely important is, for instance, in the drug field where companies have licenses for certain drugs and certain patented formulas. They might have negotiated a license many years ago before anyone realize just how much revenue and how much success a particular product might have, and the license sure enough has the same kind of clause that I was talking about earlier. When you go to the other party, they view this now as their opportunity to renegotiate the royalties or whatever the payments are to a much higher level. So again, these could quite important.
The other issue is that usually you don’t want to go after these other third parties until you have a signed agreement so that you have assurance that the deal will go through and, for all intents and purposes, the deal is now public. And so, you don’t have to keep it confidential if you’re going to go after these approvals. On the other hand, you do need to get them before you can close. So to some extent the other party knows that you’re ready to close and you could almost smell the purchase price. Unfortunately, they’ll often use that to their advantage and negotiate a higher price.
Scott: So it’s almost like a chicken before the egg concept where you need a vendor’s approval, but you need the definitive agreement so you’re comfortable with approaching the vendor but this opens up an opportunity for a seller’s vendor to change the price. How does that affect the purchase price for the buyer and seller?
David: As I’ve said, unfortunately if you have for instance a landlord who insists upon an increase in the rent as a condition of giving its approval, other than playing chicken and saying "You’re going to move away," which is usually impossible. Usually, they’ll have to be in an accommodation where perhaps the seller will have to take a haircut on the purchase price to reflect the fact that the ongoing net revenues of the company will be less than anticipated.
Scott: So that’s probably built into the definitive agreement and so if the seller can’t secure the necessary approvals at the same favorable cost and terms they should expect a haircut of the price?
David: Right. The definitive agreement assumes that all these consents will be obtained without any change in terms. If there is a change in terms than the party or in particular the buyer is free and negotiate a higher price.
Slide - 12/12
Scott: Alright David, so, the last slide of your presentation. We’ve learned a lot so far. Now take us over the goal line and tell us about how we get this deal closed, and some things post-closing.
David: Yes. Closing is the event that you’ve been working towards throughout this entire process. I just wanted to indicate that many, many deals will sign and close on the same day. If there is no need to obtain approvals or any third parties or from any regulatory parties, it’s not unusual to sign an agreement, then immediately the funds transfer.
The closing is the event which the title to the shares, if you’re selling stocks, or the title of the assets passes to the buyer, and the seller receives the purchase price. I’d say, from the standpoint of the seller, one of the most important things is managing the process so that your employees, customers and the public are informed of this in a coordinated manner that makes sense. So for instance, it’s probably the case that you, with respect to your employees, that you brought a few trusted employees into the inner circle. They know about the deal but the assumption is that if you have a shop floor and other lower level employees, you would not have told them about this. So this would be immediately after the lawyers finished their thing and the money is safely in your account. Usually, the buyer and the seller will call the employees into a joint meeting and you, as the seller, will indicated that you just sold the company and introduce usually the CEO or some other high person of the buyer. The buyer will hopefully give them some assurances that their job is safe and the company is going to grow and everything is going to be great.
And so that is usually the bullet point script that is worked out beforehand between the buyer and seller. And again, it’s designed to give the employees assurance that what will be a pretty shocking event to them is not going to adversely effect their future. Also with customers; most customers will not have learned about this. Perhaps you brought a few into your confidence and perhaps the buyer has insisted that a few be brought into the confidence and to get their reaction as to what the impact would be.
But one of the first things you’re going to want to do is call your major customers and say: "before you read it in the papers, I want to tell you we just have the sale. I wanted to tell you that your products will continue to get our highest priority." If the sellers going to stay with the company, the seller usually emphasizes "I’ll continue to be one servicing your account. You’ll not see any differences." Or at that point, there’s usually an introduction and maybe a lunch setup with whomever from the buyer is going to be working there.
And then finally, there’s usually a press release to the public. The purchase price is usually not disclosed unless the buyer is a public company, then you have to do that. There is an indication and discussion of the fact that the company has been sold; it’s going to be under new ownership. Usually there are some nice quotes about how both the buyer and the seller view as an excellent opportunity for the company to grow and how their customers will continue to get the great service they’ve always gotten.
Scott: That’s a wealth of information you just shared with us, David. Thank you so much for doing this and for educating our audience. If people want to get hold of you, what’s the best way to do so?
David: I can be reached at the law firm, McCarter & English, here in Newark, New Jersey. My email address is: [email protected], or feel free to give me a call at 973-639-2031. And thank you, Scott.