Business Law

Buying & Selling a Business

Business acquisitions can take the form of purchase of the underlying legal entity, usually a corporation or LLC, owning and operating the company or sale of all or most of the specific assets of the business. These can include such tangibles as the business premises, furnishings, and equipment, as well as such intangibles as intellectual property and contractual agreements. In an asset purchase, the exact property being conveyed must be spelled out precisely. That the seller is the full legal owner of all items and rights to be conveyed must be verified.

Acquiring the stock of a corporation or an LLC’s “membership units” is frequently used in the purchase of larger companies and conveys all of the property of every kind owned under that LLC or corporate “umbrella.” There is less necessity to set out every item of physical and intangible property being transferred. In entity sales, all liabilities and all rights of the business are usually passed along to the buyer.

Entity vs. Assets Sales: Tax Impacts

The stock or LLC units purchase vs. asset purchase decision has tax implications as well. An “entity sale” is often to the advantage of the seller, while buyers can gain tax benefits from a sale of assets. In sales of the entity operating the business, seller usually pays tax on their gain from the purchase at long-term capital gains rates. In an asset sale, the purchase price is allocated between different categories of assets being acquired. Gain realized by seller on what are deemed to be “capital assets” is taxed at lower capital gains rates, while gains from the sale of non-capital assets are taxed at often higher regular income rates.

Sellers usually want as much of the purchase price as possible allocated to acquisition of capital assets, which include equipment, tools, computers, furniture, vehicles, real estate, intellectual property, and the “goodwill” of the seller. Non-capital assets include business inventory and supplies, accounts receivable, and most covenants not to compete. The “going-concern” value of a business is usually treated as part of the “goodwill” of the seller.

Sellers are required to pay back “depreciation recapture” to the IRS from the proceeds of the sale for depreciation previously taken on items transferred. Because of these depreciation recapture requirements, sellers will typically want to place a higher value on the “good-will” and ongoing-concern value being conveyed and less on already-depreciated physical property. Buyer will usually seek the opposite.

Seller can gain tax advantages from assigning a low value to already-depreciated items being conveyed. Buyers benefit from a higher value being placed on such depreciable items as equipment so that buyer can begin to take larger depreciation deductions immediately following the purchase. This is among the primary reasons buyers often desire an asset sale. Allocation of the purchase price between categories of assets should be agreed upon well in advance of the closing and set out in the final purchase agreement. Tax strategies are also impacted by whether a corporate seller is an “S-corporation” or “C-corporation.”

If a “tax-free reorganization” of the business being sold is an option, this is usually achieved by structuring the transaction as a merger. Such a tax-free reorganization can be based upon either a conveyance of stock or transfer of assets and postpones, rather than eliminates, resulting tax obligations. Stock of the buyer often comprises either the entire, or a large part of, consideration to the seller.

Forms of Payment

Payment for a purchased business is most frequently in the form of a cash amount accompanied by a promissory note for the balance. This promissory note should be backed up by a security agreement covering the assets of the business. If the buyer is not an individual, seller may want to obtain a personal guarantee of the promissory note. A portion of the purchase amount can also be held in escrow for use as indemnification for any breaches of warranties or other obligations by seller.

An employment or consulting agreement for the seller often also comprises part of the purchase price and can also contribute to spreading out payments from buyer over time, reducing taxes. The ability of seller to make future payments required under the note, and employment or consulting agreement, should be thoroughly investigated. This background and financial examination of a potential buyer should begin well before  drafting of final sale documents.

Financial Disclosure & Due Diligence

Seller should obtain a full set of financial disclosure documents from buyer, CPA audited and certified if possible. In larger transactions, seller’s financial statements should be audited and certified. Buyers should be alert for necessary, but deferred, expenditures and check that all required withholdings for income taxes, social security, Medicare, workman’s compensation, etc. have been made and transmitted to the applicable governmental entity. All presently unfulfilled sale and purchase commitments of seller should be disclosed. Unfunded compensation obligations of seller should be listed and conveyed to buyer, especially those that may be triggered by a change in ownership. Any sensitive information should be protected from further disclosure by a confidentiality agreement.

Clarify What Is Being Transferred

A business purchases raises the question of exactly what rights and obligations of the seller will or won’t be assigned to and assumed by the buyer. In an asset purchase, it is especially important to define this clearly as such rights and obligations will not be automatically transferred. Will, for example, buyer acquire seller’s accounts receivable? Will buyer assume responsibility for existing accounts payable? Will balances in cash accounts be transferred to buyer? How much customer information will be passed on to the new owner? Which current contracts of the business will or won’t be assigned to and assumed by buyer? That seller has the right to assign these, or whether a third-party’s consent must be obtained, needs to be confirmed.

Covenants Not To Compete

Covenants not to compete are an important part of many business purchase and sale agreements. These should be no more burdensome on the seller than is required to protect the buyer and their term should be limited in accord with applicable state law. Geographic parameters should be included together with the specific types of business activity from which seller will be temporarily barred. The seller’s future ability to earn a living should, however, not be excessively impaired. Restrictions against employee recruitment from the business being sold can be included as well.

Letter of Intent & Final Agreement

At an early stage of negotiation, a non-binding “letter of intent” can help indicate that both parties have a similar understanding of, and agreement upon, the basics of a potential acquisition. Schedules, including a Bill of Sale itemizing all tangible property being conveyed, should be appended as Exhibits to the final Purchase and Sale Agreement. Assets that may seem to be owned by the seller but are not to be transferred should be specifically excepted. Contracts, including commercial property and equipment leases, to be assigned to and assumed by buyer should be attached as well.

All promises and understandings between the parties in relation to the sale should be encompassed in the final agreement. If assets to be transferred are encumbered by security filings, provisions should be included regarding when and how the underlying obligations will be paid and by whom. A disclosure letter from seller to buyer prior to closing can list issues or problems with the business or its assets not readily visible and protect against a later claim of seller misleading buyer.

Purchase of Online Business

Those acquiring an online or other technology-based business will want to be especially thorough in their due-diligence investigation regarding ownership of, and rights to, IP assets. The exact status of important intellectual property rights held, or previously conveyed, by seller should be thoroughly examined. All significant contracts of seller, such as licensing agreements regarding IP assets, should be listed in the appropriate Schedule and also appended as Exhibits.

Assignments and assumptions of rights regarding IP assets, including trademarks, should be documented and attached as well. If significant IP rights need to be clarified or secured, this should be done prior to closing. All website accounts to be maintained by buyer should be transferred. Records and data of seller to be conveyed to buyer should be specified. In the sale of a technology-based business, confidentiality provisions should always be included in non-compete provisions.

Online Business Valuation

Website and online business valuations should not be based on overly simplistic multiples of annual earnings, but instead reflect also the future durability of the business, its particular risk-factors, and how “solid” and long-lasting its present assets actually are. Which are likely to soon become outdated, obsolete, or decline sharply in value? Buyer should be informed of relevant intellectual property rights seller may possess but not be transferring to buyer and those that require the permission of a third-party.

Actual conversations with the seller to collect as much relevant information as possible and scan for “red flags” are a good idea. Seller should be requested to show proof of sales, verification of traffic, documentation of advertising revenues, and site features that cannot be accessed by the public. A personal conversation can also reveal the real reason(s) a site or online business is being sold. Buyers should be alert, as well, for hidden value in a site not realized by the current owner that can be achieved through  relatively simple, low-cost steps.

Escrow

In website and online business purchases the parties are often in widely different locations. This can make a payment escrow process crucial to ensure buyer receives all that he or she has contracted for. An escrow process for transfer of IP assets can be especially important to ensure that all steps necessary to complete these conveyances are taken. Broker sites for online businesses may contain useful feedback regarding a seller’s previous transactions on that platform, subsequent disputes, and the nationality and geographical location of seller. Will, for example, seller be subject to the jurisdiction of U.S. courts if the deal goes sour?

IP Transfers

All patents, trademarks, copyrights, and domain names to be transferred should be itemized and this Schedule appended to the final agreement. If trade secrets are being purchased, these should be set out in detail in writing.  Assignments of trademarks should be recorded immediately following the closing with the U.S. Trademark Office. Copyright transfers should be recorded with the U.S. Copyright Office. Conveyances of business names should be filed with the Oregon Secretary of State and domain name assignments with the appropriate registrar. In all of the above stages of a purchase and sale of business transaction, the assistance of business counsel can prove highly valuable.

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