Legal Issues to Consider in Preparation for the Sale of a Business

Posted by Thomas E. Sowers on

There are generally two types of legal issues for the sellers of closely held businesses to focus on prior to marketing their businesses for sale.  The first type involves protecting a business from the consequences of opening up its books and records for review by potential purchasers, which may include competitors of the business.  The second type concerns preparing a business for the transaction process. This means dealing with those issues that could be a hindrance to a transaction that the sellers would like to pursue, and those issues that could negatively affect the negotiating position of the sellers or the terms of the business deal the sellers ultimately receive.

Most sellers of closely held businesses are very aware of the protective issues (the first type), and they handle these issues early on in the sales process (generally by putting into place an enforceable confidentiality agreement to be signed by all potential acquirers and by negotiating relevant issues in a letter of intent, if there is one).  However, many sellers often fail to consider the legal issues relating to preparing the business to be sold (the second type) until faced with the issues when they arise during the course of the transaction.

This article deals with issues of the second type.  If you are the owner of a privately held business planning to sell your business, by devoting time and thought to the legal issues set forth below in advance of entering into discussions with a potential purchaser, you will be taking appropriate steps to strengthen your negotiating position and maximize the business deal you receive in the transaction while increasing the likelihood that a transaction that you would like to complete proceeds to a closing.

1.   Corporate Clean-Up Issues.
a.  Minute Book.  Make sure that the corporate record books for your company are complete and in order.  If your company is a corporation, you should be sure that all of your annual meetings have occurred and been properly recorded, and that your corporate record books properly document the ownership of the corporation.  A sophisticated prospective purchaser will want to look at your corporate record books, and it will send a positive message to the purchaser (in terms of your record-keeping for the company as a whole) if you provide a purchaser with corporate record books showing that you have followed the proper corporate formalities in the operation of your company.  Providing a purchaser with incomplete or sloppy corporate record books could cause the purchaser to worry that there are questions regarding the underlying validity of prior corporate actions by your company, or to call into question the accuracy all of the other business records that you provide to the purchaser for review.
b.  Service Marks or Trademarks.  If you have created a service mark or trademark for your company that you intend to transfer as part of the sale, consider registering the mark with the proper governmental authorities if you have not already done so.  If you have registered the mark, check to see that all renewals for the mark have been filed (in Georgia the registration of a mark is good for ten years). If a service mark or trademark is being transferred to a prospective purchaser, having the mark properly registered will obviously be appealing to the purchaser and again speak well of your record-keeping as a whole for the company.  If a significant amount of goodwill has been generated by your company through the use of a mark, a purchaser will have an expectation that the mark is registered.
c.  Agreements for Employees.  For any key employees of the company not currently subject to an agreement with the company that prohibits the employees from competing with the company or soliciting clients of the company after the termination of their employment, consider requiring these employees to sign such an agreement.  A prospective purchaser will want some assurance that after the acquisition of your company, current employees of the company will be prevented from competing with the purchaser or taking the clients of the company with them to a competitor for some period of time.

In Georgia, the continued employment of an employee is adequate consideration for restrictive covenants granted to a company by a current employee (as opposed to a new hire) so you would not necessarily need to make any additional payment to the employee to make the covenants enforceable.  If you have key employees who are not currently bound by a restrictive covenant agreement, you should speak to an attorney about what may or may not be appropriate with respect to restrictive covenants for these employees (particularly those employees whom you would not expect to be employed by the purchaser of your company).

2.  Contract Review.
a.  Real Property Leases and Other Contracts.  You should review any contracts that the prospective purchaser will likely assume in an asset purchase transaction, such as any real property leases, to see whether they can be assigned without the consent of the other party to the agreement (in a stock purchase transaction your agreements would need to be reviewed to make sure that the transfer of the stock does not require the consent of the other party, or trigger any obligations on your part).  If the consent of the other party is required, then it may make sense to contact the other party as soon as possible to determine whether the other party is willing to consent.  For any contracts that a prospective purchaser may not want to assume, review the termination provisions of those contracts to see whether you are able to terminate the contract at will, and if you can, what is required in order to terminate.  Many agreements will require a party to pay a fee to be able to terminate the agreement.  Other agreements may require a specified notice period that must be adhered to before you are able to terminate the contract.  Deals can be delayed or fall apart over a seller’s failure to receive an important third party consent.  Therefore, it is important that you understand the assignment, change of control, and termination provisions of all of your contracts so that you can plan ahead and be prepared to take action (e.g., terminate an agreement) at the appropriate time.
b.  Employee Benefit Plans.  Just as with the leases and other agreements to which your company is a party, you should review any employee benefit plans that the company has so that you are prepared to be able to assign or terminate those plans.
c.  Shareholders Agreement/Operating Agreement.  If you and any business partners are parties to an agreement relating to the operation of your company (for example, a shareholders’ agreement or an operating agreement), you should review the agreement to be certain that you understand whether the sale implicates any of the provisions of the agreement.  You may want to consult with an attorney to deal with those issues and to help you properly terminate the agreement and dissolve your entity, if this is your intention.  A prospective purchaser will be extremely wary of proceeding with a transaction where there are any lingering issues among the sellers.  Make sure that you have a handle on all of these issues prior to engaging in discussions with a potential purchaser.

3.  Ownership of Intellectual Property.
If intellectual property is a significant asset of your business, you should be certain that you can document your company’s title to the intellectual property prior to marketing the business for sale.  A prospective purchaser could very well be dissuaded from proceeding with the transaction if you are unable to document the company’s ownership of the intellectual property.  Though you may believe that your company owns all of its intellectual property, if the intellectual property being sold involves inventions or works of authorship created by an employee or independent contractor not subject to a well-drafted agreement that addresses ownership of these creations, you could have an issue.  If intellectual property is an important asset of your business, you should be sure to have an attorney analyze any potential issues as to the ownership of the intellectual property prior to marketing the business so that you have time to address any issues.

4.  Structure of Transaction.
Most small business sales will be structured as an asset sale or as a stock sale.  In general, most purchasers will prefer to buy the assets of your company, as opposed to the stock you own in your company, for two primary reasons.  First, in an asset purchase transaction, a purchaser can pick and choose those liabilities of your company that it agrees to assume, and it is not generally liable for all liabilities of your company as it would be if the purchaser purchased the stock of the company.  Second, there are usually tax advantages to an asset purchase transaction for a purchaser.  Specifically, in an asset purchase transaction, a purchaser receives a step up in basis of the assets it acquires equal to the purchase price, which allows the purchaser higher depreciation and amortization deductions.  When a purchaser buys stock, however, there is no step up in basis.

In general, an asset purchase transaction will have less favorable tax consequences for you and your company than a stock purchase transaction.  For instance, if your company is structured as a C corporation and the transaction is structured as an asset purchase, then you will have to incur a double tax (your company is taxed on any gain in the assets sold at the corporate level and you are taxed at the individual level).  Even if your company is not a C corporation, but is a pass through entity (such as a limited liability company or S corporation), the likelihood is that, in an asset purchase transaction, a portion of the purchase price will be taxed at ordinary income rates, whereas all of the purchase price would be taxed at capital gains rates in a stock purchase transaction.

The key is to understand the net after-tax effects for a sale of your company in an asset purchase transaction and a stock purchase transaction.  You should meet with your tax advisor before marketing the company.  The net after tax effects to you and your company can vary quite substantially depending on the structure of the transaction.  By understanding the implications of the structure of the deal to your bottom line early on in the process, you will be in a better position to negotiate with the purchaser on the issue.  One strategy could be to offer a purchaser two different purchase prices depending on the structure of the transaction.  If you try to negotiate this issue too late in the game, you will likely find that the purchaser is not going to be too sympathetic to your issue.