I am pleased to offer this two-part article series on the most frequently asked questions I have received over the last 25 years as a transactional lawyer helping scores of clients close merger and acquisition deals. The questions I address here are often asked by clients considering the sale or acquisition of a business.
Q. When should I engage an attorney in the deal process and what will they do for me?
Most clients want to engage an attorney once they have a deal – meaning they’ve typically signed a Letter of Intent (LOI) with the other party. There are a couple of situations where you should engage an attorney early in the process for tasks that will take only a handful of hours and cost very little, but potentially save you thousands of dollars in the long run.
First, you’ll want an attorney to review your engagement letter with your broker or investment banker. Many agreements will contain a “tail provision” if you do a deal with a prospect after the engagement ends, where you would still have to pay the broker. You’ll want this period to be as short as possible and also carve out any parties you’ve already begun talks with.
You’ll also want an attorney to review your LOI before you sign it. A key issue will be the structure of the deal – whether it is a stock sale or an asset sale – but there can be other issues to address as well. For example, I recently reviewed an LOI that was fully binding on my client, the seller, and tied him up so he couldn’t talk to other parties for months. While the LOI was fully binding on the seller, it wasn’t binding on the buyer at all, meaning the buyer was free to change any or all deal terms. Having an LOI be binding on one party only takes away their negotiating leverage.
Q. What should I consider before I start the process of selling my business?
Think about your contracts and consider which may require the other party’s consent to sell your business. Most leases do, as well as bank debt. Review your ownership and organizational documents for completeness as well as things such as preemptive rights and rights of first refusal that may need to be waived by other owners. Document, or at least identify and understand, any “handshake deals” your company is a party to. Finally, now is the time to consider any estate planning opportunities – most times, once you’ve signed an LOI, any transfers for estate planning purposes will need to be of substantially equivalent value.
Q. What is the difference between a stock sale and an asset sale, and why should I care?
A stock sale is where the seller sells stock or LLC interests in the company. In this sale, the owner of the business, and not the business itself, is the seller, and the business stays the same, but the owner changes. An asset sale is where the company sells the assets of the business. Here, the business entity is the seller and remains in place after the sale, but a new entity (the buyer) owns all of its assets. There’s a change in the business that will now be run by a new entity.
A stock deal is subject to one level of tax for the seller, typically at the capital gains rate. An asset deal is subject to two levels of tax: first at the corporate level on the gain/loss realized from the sale of the assets, and second, on the shareholder when the proceeds are distributed to him or her. An exception to this is if the seller is an LLC or an S corporation; then an asset sale is typically subject to only one level of tax.
Generally, sellers will prefer stock deals. There is only one level of tax, at lower capital gains rates, so the seller nets more money after taxes. These transactions are also simpler to accomplish because the business stays the same – only the stock changes hands. Conversely, buyers generally like asset purchases. A major tax advantage is that the buyer can “step up” the basis of many assets over their current tax values and obtain ordinary tax deductions for depreciation and/or amortization. Asset sales are more complicated though – as all assets and liabilities are transferred over – and these types of sales can be disruptive for employees, vendors, and customers.
There’s often tension between buyers and sellers on this point, which is best dealt with early in their discussions and fully documented within the LOI to avoid surprises later on, and can often benefit from legal guidance.
Q. What are the key issues parties need to consider in negotiating earn-outs?
An earn-out is typically structured as one or more contingent payment(s) of the purchase price after the closing which are payable when certain specified targets – such as minimum earnings before the deduction of interest, taxes, depreciation and amortization (EBITDA) – or a minimum number of new customers have been achieved.
When negotiating earn-outs, it is important to:
- Agree on a Target. Sellers tend to prefer top line, such as revenues, while buyers often prefer measures that take profitability into account. EBITDA is commonly used as a middle ground, perhaps with some adjustments.
- Agree on Time Frame. Earn-out payments typically occur over 1-3 years. If there are multiple payments over multiple years, the parties will determine what happens if the company fails to achieve the earn-out target in one period but makes up for it in the following period, or vice versa.
- Agree on Payment Amount. This could be a flat amount, a percentage of the target, or a multiple of the amount by which the company exceeds the earn-out. Buyers typically want to see a cap, while the seller will likely want a minimum amount.
- Consider how the Company will be run following Closing. Will the company have sufficient resources at its disposal to attain the earn-out target? Do new sales personnel need to be hired, or do certain people need to be retrained?
- Consider what happens if there’s another sale before the Earn-Out ends. What happens if the buyer wants to sell the company before the earn-out period has ended? Likely, the seller will want an acceleration clause stating that the full earn-out would be paid upon a sale.
This article has addressed why it’s important to work with an attorney as early in a deal as possible. We have also identified steps sellers should address before they move forward with a sale. We also reviewed the difference between stock and asset sales and which type of sale buyers and sellers often prefer. Finally, we laid out key issues to consider when negotiating earn-outs.
In Part II of this series, we will look at the myths and misinformation floating around about the deal process. You will learn more about what rep and warranty insurance is, how it works in a merger or acquisition, and how purchase price adjustments work. Contact me if you’d like to learn more.