Small Business and the Law

After you have found your target New York business to acquire, you (and/or your corporate attorney) have to negotiate the terms of the business purchase transaction.  In this article I will outline some of the typical terms of a term sheet for the purchase of a small business and some of the things you need to consider.

As I mentioned in “Buying a Small Business in New York”, you need to put together a  “term sheet” (also known as a “LOI,” “letter of intent,” “MOU,” or a “memorandum of understanding”).  This can be done as you and your corporate attorney are conducting your due diligence on the target business.

The term sheet should consist of the broad basic terms of the deal.  As that the stock purchase agreement or asset purchase agreement will be drafted from the term sheet, you need to be as specific as possible with respect to contingencies to closing, offsets to the purchase price and other obligations (it will be hard to convince the seller to agree to terms in the resulting agreement differing from the deal points already agreed upon in a term sheet).   The term sheet, will set forth the parties’ mutual understanding of the terms of the small business purchase.

Having a term sheet serves purposes in addition to acting as the blue print of the business deal from which to draft the stock purchase agreement or asset purchase agreement.

The business purchase term sheet communicates to the seller that you are serious about purchasing the small business.  Depending on how the term sheet is drafted, while you may have an “out” to walk away from the business acquisition, it shows that you are committed to culminate the purchase;

It can lock the seller into looking for other purchasers of the small business; and

The term sheet helps flesh out the major issues that often arise in a business purchase and sale, so to avoid surprise roadblocks that may pop up along the way to closing;

Here is a list of typical terms and other issues to be addressed in a term sheet to buy a business:

1.    The Names and Contact Information for all parties that are involved in the purchase transaction — buyer, seller, buyer’s corporate attorney, seller’s company attorney, names of any business brokers involved in the deal, and the names of the financial advisors and/or accountants.  If any of the parties are not individuals, you should have the full entity’s legal information (including state of incorporation, officer’s names and contact information, etc.)

2.    Purchase Price and Other Consideration – Will this be a cash deal, or a combination of cash and other real or personal property, stock, or intellectual property?

3.    Payment Terms. If a cash deal, will it be paid in a lump sum, or paid in installments?  If in installments, will it be tied to profitability, or other contingencies?  If seller financed, at what interest rate and term?  If financed by a third party, is the deal contingent on obtaining that financing?  Will there be a downpayment?

4.    Collateral (or security) for the Purchase Price. If the business is being sold with seller financing, the seller may want collateral for your promise to pay back the loan.  Perhaps the security interest pledged will be the stock of the company, some or all of the business property or business assets, or some other real or personal property that you own.  Of course, if you fail to make the financing payments, the seller will want to then be able to foreclose or repossess the collateral that is being pledged against the seller financing.

5.    Structure of the Deal. Will it be an Asset Purchase or Stock Purchase?

Assuming that the business target is a corporation or limited liability company (LLC), you can structure the purchase in one of two ways — either it will be a stock purchase or an asset purchase.   There are advantages to both, and both may have significant tax implications.  You should structure the transaction after obtaining advise from your financial advisor or accountant.

From a legal perspective a stock sale is quite different from an asset sale.  In a stock sale transaction, you are buying all of the stock of the company — so the company’s assets, liabilities, goodwill, contracts, intellectual property, real property stays with the company (assuming that there are no prohibitions of or conditions to transfer contained in any of of the documents relating to same). In a stock purchase, you are buying the company entity “lock, stock and barrel.”  That also means you may be buying the company’s headaches as well (like lawsuits, and other contractual obligations).  So when you buy the stock of the company, you and your corporate attorney should conduct intensive due diligence into the business’ history, contracts, minute books, financial reports and records.

In an asset purchase, you are cherry-picking and buying the plum assets that you need for your own business (or even a division of the seller’s business).  In an asset sale (or asset purchase)  the company’s liabilities and other headaches stay with the seller.  You can buy all or substantially all of the assets of a business in New York, with little risk that you will be held responsible for the debts and obligations of the business incurred prior to the purchase of the business by you.

6.  Transfer Issues.  Whether the business is being sold as a stock sale or as an asset sale, you have to be concerned about whether there are restrictions to transferring the assets of the business.  When conducting due diligence, you (with the help of your corporate attorney) should determine which assets may need prior consent for the transfer (like business space leases, major contracts with customers or vendors, or bank loans or credit agreements).  Depending on how the restriction is worded in the respective contract, a mere transfer of any stock or a controlling interest of the ownership of the business stock, may trigger the obligation to obtain consent.

7.    Covenant not to Compete.  Generally, how successful the the business you are buying was in the past was a result of the management and ownership of the business.  So you might want to consider keeping those employees on after you buy the business for continuity purposes and have them enter into employment agreements or consulting agreements with you.  Of course, if you have the expertise to run the business from day 1, then you may want to “buy” the benefit of having the prior management and prior business owners from competing with your newly purchased business.  You would want to enter into an agreement with covenants not to compete (sometimes referred to as a “non-compete agreement” or “forfeiture for competition agreement”), to prevent the sellers from immediately soliciting their old customers or competing with you.   Under New York law, covenants not to compete (or “non-compete agreement” or “forfeiture for competition agreement”) are valid as long as they are reasonable in duration and scope.

8.    Non-binding Nature of the Term Sheet.  As I discussed in “Buying a Small Business in New York”, you should consider having a “non-binding” term sheet (e.g., there should be contingencies when you can walk away from the deal without liability).  But note, the term sheet should be drafted properly so that certain provisions of the term sheet should be binding, like the provisions regarding limitation of liability and confidentiality, among others (you don’t want the seller to sue you nor disclose your confidential information like financial information).

9.    Post-Closing Seller Obligations or Buyer Obligations that Continue after the Sale of the Business. As discussed above, there might be times that you want the seller to continue to provide consulting services to the business after the sale of the business.  Maybe you decided to close the deal before all of the non-material consents were obtained or prior to when the applicable taxed needed to be prepared and filed.  Any post-closing obligation that need to be written in the stock purchase agreement or asset purchase agreement should be included in the term sheet.

Which is Better – An Asset Purchase or a Stock Purchase of a Company? From first impressions, you might think an asset purchase is more advantageous. Generally, buyers prefer an asset purchase for reasons of tax deductibility and cherry-picking the favorite assets (without being saddled with the liabilities). However, in a stock purchase you can buy the business as a going concern with minimal interference of the business (and sellers prefer to sell the entire business with all its blemishes and liabilities). Of course, the bottom line will be price (an asset purchase will probably be more expensive than buying the stock of a company).

If you are considering a buying a small business in New York, make sure to check with your accountant and/or tax adviser and a New York Business Lawyer.  There may be important tax and other legal consequences to consider before making the decision.