In these economic times, there are three kinds of businesses that may be interested in buying or selling a business.

a. Those businesses, who are fortunate enough to be making a profit and are thinking about buying a business to expand in measured steps;

b. Those businesses, who are not so financially fortunate and are looking to sell their business for a reasonable price; and

c. Those businesses, who are just surviving (breaking even, making a little profit some months and losing a little other months) and may be interested in combining forces (e.g. merging) with another business or invest in purchasing a reasonably priced business, because the company must either grow or fail.

AVOIDING LITIGATION IN A BUSINESS PURCHASE AGREEMENT

Prodigy Law has been retained by several businesses that have needed legal assistance when the purchase or sale of a business has gone wrong, where the buyer or seller of a business has been forced to incur business litigation expenses. Prodigy Law has been proud to provide excellent legal services in these matters.

However, in most of these cases, if the purchase of the business for sale had been done properly, much of the legal issues could have been avoided. We have drafted this article to help small and mid-sized business understand the basics of how the purchase or sale of a business should work.

BUYING OR SELLING A BUSINESS

Step One:  Get Your Business in Order Prior to Buying or Selling a Business

In the sale of a business, the business for sale will be scrutinized. Any and all equities, liabilities, profit & loss statements, multiple years of federal and state tax returns, ownership withdrawals, and other information that will shed light on the profitability and value of the business will be reviewed. So, have this information ready for inspection.

The buyer of a business must be able to prove that the buyer can afford to purchase the business now and in the future (if payments are spread over time). The seller will investigate the net worth and income of the buyer, including the buyer's books and tax returns. The buyer must genuinely prove that it is able to buy the business by ensuring financing, lines of credit and/or shore up cash positions.

Step Two:  The Mutual / Bilateral Non-Disclosure Agreement

After the buyer sees the opportunity in the seller's business and the seller agrees to entertain the buyer as a prospective purchaser, before the business activity can move forward, each side's secrets must be kept confidential.

It does not matter if the buyer and seller of a business have known each other for years, a Non-Disclosure Agreement (NDA) is required. One major reason is that there is no such thing as protection of trade secrets based on "friendship". Trade secrets are a large category of know-how, business techniques and intellectual property that is not copyrightable, patentable or trade/service markable. Trade secrets are only protected under the law, as long as the business that holds the trade secrets maintain the secrecy of the know-how, technique or intellectual property. Only a Non-Disclosure Agreement can document that you protected your business' secrets appropriately.

For businesses that do not know each other, the reason for an NDA is obvious, unless the buyer and seller would like their conversations and business information exchanged to be open to whomever the other wants to tell.

An attorney should draft the NDA, and carefully draft the limited purpose and use for the information being exchanged, so it can be used for no other purpose than what the buyer and seller intend.

Step Three:  Negotiate the Business Terms

Once the prospective buyer and prospective seller have signed the NDA, it is time to get to know each other. Discuss the parameters of what you would like and the other party would like. This is a critical conversation to see if both parties are in the same ballpark on basic deal points, such as (1) the cost of the business / method of valuation of the business; (2) what assets or portions of the business are being purchased, including what intellectual property will be included in the deal; (3) whether there is any pending litigation or other debts that need to be avoided in the transactions; (4) the goals of each party in seeking out a deal; (5) timing of the deal - does it meet your needs and timeline; (6) the money - finance terms, lump sum payments, escrow etc.; (7) the involvement of the buyer and seller after execution of the purchase agreement - does the seller have to work actively to transition over clients and vendors to the buyer, etc., and (8) agreements by the seller to not compete with the business being sold to the buyer.

Some words of advice: never do business with anyone you feel you cannot trust. If at any point in any of your dealings, if one party seems to be providing inaccurate or deceptive information or otherwise acting in bad faith, I strongly recommend that you do not move forward.  

Step Four:  Create a Letter of Intent

The purpose of the letter of intent is to embody any tentatively agreed terms in writing from the negotiation, so one party cannot say later that there was a misunderstanding during the verbal discussion of business terms for the purchase agreement. This letter needs to be worded carefully to convey the intentions of both parties and should be drafted by an attorney and signed off on in principal by both parties. If there are any basic misunderstandings as to the basic terms of the agreement, it should dealt with now, before there is a lot of time and money spent on the steps below.

Step Five: Due Diligence

The purpose of due diligence is to verify with documents the veracity of words and deeds of both parties. If you are the buyer, ask for financials, list of bank accounts and amounts, tax returns, inventory list, corporate or business entity records & resolutions, background of employees that are part of the transaction, lists and descriptions of intellectual property, contracts with clients and vendors, copies of any leases or subleases etc. (In retail or cash environments, it is considered standard practice to place a person in the business to verify cash being taken in the drawer, as a verification of written financial documentation and tax returns.) All of these items and more are required to establish the value of the business to be sold is accurate and that there are no legal or contractual impediments to purchase or sale of a business.

The seller of the business needs to ask for any financial records needed to ensure payment. If the sale of the business includes future payments on future profits, then you also need to ensure that the buyer has an appropriate business plan and strategy that will allow them to make those future payments.

Again, keep on the look out for untrustworthiness. No matter what protective terms and liquidated damages clause that your attorney places in the purchase agreement, there is a strong likelihood that a bad faith party will breach, and this will force the non-breaching party to make a business calculation as to whether to enforce the protective terms and/or liquidated damages clause at the expense of attorneys fees and costs (that may have to be paid upfront until reimbursed through an attorneys fees provision, where the prevailing party is awarded reasonable fees and costs).

Step Six:  Business Entity or Corporate Legal Clean-up

If all goes reasonably well during the due diligence process, it is time to clean-up any issues found during due diligence that are correctable and not deal killers. The kind of clean-up includes: if the business to be sold is a corporation or limited liability company, all major transactions, such as leases, opening bank accounts, credit cards, etc. must be approved by the directors or members of the business entity. If any of the vendors or leases require approval by a third party prior to assignment of their services or property, those approvals must be obtained in order to green light the final deal. A competent attorney should be used to ensure all of this technical legal clean-up is performed properly.

Step Seven:  Drafting the Purchase Agreement

Once the legal clean-up is moving smoothly and there has been tentative approval received from any third parties required to approve the sale of the business, an attorney should be drafting the actual Purchase Agreement for the business. This should incorporate all of the business terms set forth in the signed letter of intent, and include all additional terms, conditions, warranties, intellectual property protection, non-compete clauses, attorneys fees clauses, arbitration clauses, etc. There will be changes back and forth, until there is final agreement on the legal language in the contract.

Drafting of the purchase agreement can be done by either the buyer's or seller's attorney. If one party is unrepresented, then the party with the attorney will most likely draft the purchase agreement.

However, it should be made clear that the attorney is not representing both sides of the transaction. We strongly recommend against any dual agency or joint representation in a purchase or sale of a business, even if both parties desire to waive the actual conflict of interest. It is practically impossible for an attorney, and certainly a business broker, to actually keep both parties' best interests at heart in every paragraph and every part of the deal. Dual agency or joint representation of both sides of a deal is extremely dangerous in my opinion (and please note that I or any attorney would receive no benefit from writing this recommendation, because an attorney would lose out on attorneys fees by refusing dual agency and joint representation). This is just bad practice, except under the most special circumstances.

Step Eight: Additional Steps

There may be additional steps necessary, depending on the unique circumstances of the business being sold and purchased, such as securities filings and other things that go with more complicated "mergers & acquisitions" transactions. This outline is intended to provide the basic structure for small and mid-sized businesses to purchase or sell a small or mid-sized business.

Step Nine: Signing the Purchase Agreement & Fulfilling Each Party's Responsibility

After completing steps 1-8, a deal is reached and the parties are ready to sign the agreement and carry out their responsibilities.

CONCLUSION

For many business owners, the buying and selling of a business is a mystery, but it does not have to be. The basic steps outlined here should prepare you to ask the right questions of a potential buyer or seller, and when interviewing an attorney to assist you with the purchase or sale. If an attorney is not able to recite the basic information outlined above, you should look for a different attorney. If you would like to buy and sell a business, Prodigy Law stands ready to assist you. You may contact us at (408) 977-7771 or at dennis@prodigylaw.com.

*PRODIGY LAW ARTICLES ARE CREATED BY DENNIS W. CHIU ARE FOR INFORMATIONAL AND EDUCATIONAL PURPOSES ONLY. ANY SUGGESTIONS CONTAINED IN THE ARTICLES IS ONLY THE GENERAL OPINION OF DENNIS W. CHIU. PRODIGY LAW ARTICLES ARE NOT WRITTEN WITH ANY SPECIFIC FACT PATTERN OR CASE IN MIND. THEY DO NOT REPLACE ORIGINAL LEGAL RESEARCH AND CONSULTATION WITH AN ATTORNEY REGARDING YOUR SPECIFIC MATTER OR CASE. PRODIGY LAW ARTICLES ARE PRESENTED "AS-IS", AND DO NOT GUARANTEE THE ACCURACY OF THE INFORMATION CONTAINED THEREIN, SINCE CASE LAW AND LAW CAN CHANGE RAPIDLY.