Bite-Sized Bits of Knowledge

Hi, thanks for tuning into another dose of Bite-Sized Bits of Knowledge, where we give you meaningful information in a short amount of time. 

Today, we’re talking about exit planning, but we’re continuing to talk about deal points. When you start talking about buying a business or selling a business, usually there’s an NDA, nondisclosure agreement, or confidentiality agreement. You want to keep things protected. Whatever you’re going to share with the other party. That’s usually the first thing that happens. 

Then there’s maybe a letter of intent. And the letter of intent is a really good idea because it high-level documents the understanding of the parties before you get into the nitty gritty legal. I always recommend doing that. It’s a really good idea. 

But say you progress through letter of intent and there’s a deal, it’s been conceptually agreed upon. Now, let’s document it with all the legal. What does that look like? What does a deal look like? We’ll just refer to a business in general, but there could be a cash payment. Cash gets paid, business gets transferred. Well, is it a business? Is it assets of the business? There’s a difference between buying the equity and buying the assets.

Buying the equity means you’re buying the liabilities. Buying the assets means you’re just buying the assets and not the liabilities. The general rule is you always want to buy the assets and not the liability or the equity. Generally, you’re only buying the stock of a company or the equity of the company for very specific reasons. So generally, you’ll see more common that it’s an asset sale to purchase and sell assets only. And that is the advisable way to go in most times. 

But as I said, so cash goes, business or assets go the other way. That might be one way to do it, but I don’t see that very often. I wouldn’t recommend it if I was the if I was the buyer. And the seller obviously wants cash and as quickly as possible. The buyer is the complete opposite. They want to give you as little as possible. And why is that? They want to give as little as possible. They want to defer risk. They want to make sure that what they’re buying is really what they’re buying. So what risks are there? The buyer is buying this business. There’s so many components that go into a business that can go wrong.

There’s liabilities – there’s tax liabilities, legal liabilities, there’s product liabilities. There’s employment issues. There could be employment issues, discrimination, harassment. There could be a ton of things there that are just waiting to come out. There’s intellectual property issues, ownership issues. Does the seller actually own what they say they own? 

I’ve very recently seen an issue where someone sold a business or they bought a business and they bought IP that was infringing on another company’s mark, and they immediately got hit with a cease and desist, and they had to spend money to deal with that, only to find out that what they bought really wasn’t what they bought. 

And so the only way to protect yourself and your business is to defer payment as long as possible until some of these issues have an opportunity to resolve themselves. I mean, you can’t do it forever, but you can give it a reasonable amount of time to see. 

And so the structure of these things typically takes the form of a down payment like a house and the financing of the balance over time, whether it’s two years, five years, 10 years, it’s all negotiable. What rate is being used is negotiable. What security interest is negotiable. 

But you will usually see a security interest and a personal guarantee when you’re dealing with the purchase and sale of a business. Why? Because you’re protecting against the risk that something happens that was not intended. The seller will take a security interest in the company, in the stock, in the inventory, the receivables, or some combination of those things. The buyer, in turn, will issue a personal guarantee, maybe, that gives the seller more comfort that they can go after the business or they can go after the buyer individually. 

If the buyer has no money, no assets, then what good is a personal guarantee? It’s just a piece of paper. So when thinking about these things in a practical sense, security interest, personal guarantee are very common to have both. 

So the next concept I would mention in this structure would be escrow. Very often you’ll have at least the money is in escrow, the money gets paid, cash goes to the seller, the balance gets put in escrow and is maybe released over some time as things unfold nicely. And if maybe there’s a problem and something emerges, that money gets applied to resolution of that problem, and that money gets paused until the problem is resolved.

There’s a lot of ways you can think about it, but the concept is the same. We’re deferring risk, protecting the buyer. As I mentioned earlier, the seller wants that money now, move on. The buyer has the competing interest of wanting to give as little as possible upfront and defer payment, defer risk as long as possible. 

So in terms of legal, people call me all the time. They have no idea what goes into this stuff. I mean, the diligence that goes in, the legal that goes into it, the advice. These are big things, so do it right or you pay the price later. 

So what goes into legal? You can expect to see purchase and sale agreement, which will be very thorough, assignments of ownership of the company, the assets, the intellectual property, and affidavits of non-ownership that say that I’ve given it over so I don’t own it anymore. Bill of sales, security interest, personal guarantees. As I mentioned, security interest can be in the company, it could be in the product, it could be in various things, accounts receivable, etc. It could be broader or limited. With security interest usually comes security agreements and UCC one filing statements. Personal guarantees, as I mentioned, of the buyer. 

There’s a lot that goes into these transactions. They’re like real estate sales. There’s a closing. There’s a lot of stress along the way. There’s an escrow and escrow agreement sometimes. So there’s a lot to do here. 

If you’re going to do a purchase and sale of a business, do it right, do your diligence, and structure it the right way. Generally, good lawyers can make a deal better than one good one, one bad one, or one lawyer on one side and no lawyer on the other side. That’s the way I look at it. Two lawyers that want to make a deal find a way to make things work quickly and fairly. 

So I hope that you found this to be helpful. Don’t forget to download the free business planning stress test. The link is below in the description. And thank you for stopping by and stay tuned for more.