Selling your business can be a minefield for the unprepared. Deborah Chew takes us through the contractual and legal issues – The first question a business owner should ask when thinking about selling their business is, what exactly do I want to sell?
If your business is conducted by sole traders, by a family trust or by individuals in partnership, and the assets are owned, and its staff are employed by the business owners or partners in their individual capacities or by the trustee on behalf of the trust, an asset sale is the obvious choice.
If, on the other hand, your business is operated through a corporate vehicle (for example, a proprietary company) you may be much better off, both commercially and from a tax point of view, if you sell the shares in the company instead of its assets.
Take a company owned by a family trust (which is a pretty common scenario). If you sell the shares in the company, you will be able to take advantage of the 50 percent capital gains tax discount (assuming that you have held the shares and run the underlying business for at least 12 months), which means that you will pay tax on your capital gain at half your usual tax rate (or a maximum tax rate of 24.5 percent). If you acquired your shares before September 1985, you may not have to pay any tax when you sell them. If you own a small business, you may also be able to access other CGT concessions (depending on the nature of the assets being sold and the net value of the assets you and your related entities own). A share sale may also be easier to complete than an asset sale, as you may not need to get any consents from third parties to sell your shares.
If your company sells the assets of the business instead, the company will be required to pay 30 percent tax on its gain from selling those assets, and you will have to pay further tax if the company pays the sale proceeds to you through a dividend. Purchasers often will prefer an asset sale, however, because a share sale brings with it the increased risk of taking on unforeseen liabilities, including, in particular, any tax skeletons. In a share sale, the fact that there is no change to the entity carrying on the business means the company's existing liabilities will effectively be assumed by the purchaser as a result of the sale.
There are various ways to convince a purchaser that a share sale can work for them as well as for you. A purchaser can reduce the risk of exposure to unforeseen liabilities through doing due diligence (that is, conducting a detailed investigation into the company’s finances and business) and through the warranties in the sale agreement (more about these later). You also may be willing to be paid less for your shares than you would require in an asset sale because the amount that will be left after the tax is paid will be higher in a share sale. If the purchaser is still unwilling to buy the shares in the existing company because of the possibility of assuming unknown liabilities, you may be able to achieve both your and the purchaser’s goals by setting up a new company, with no liabilities. You would then transfer the business to that new company before the sale, and sell the purchaser the shares in the new company.
The sale agreement will cover at least four key areas: the price to be paid; the conditions to completion (that is, what has to happen before the shares or business will be sold); representations and warranties by the seller about the business; and, usually, a restraint of trade (that is, restrictions on the seller’s ability to compete with the purchaser’s business after the sale).
Asset (or business) sales are often priced on a different model than share sales. In an asset sale, the focus is on the value of the various types of assets to be sold (such as plant and equipment, stock, intellectual property, customer lists and the like), plus a general catch-all amount for the value of the business as an ongoing business (usually called goodwill). In a share sale, the pricing focus often isn’t on the value of the company’s assets but instead on the earnings that the business is expected to generate into the future. Purchasers will often base their pricing in this context on a multiple of EBIT or EBITDA (that is, earnings before interest and taxes, or before interest, taxes, depreciation and amortisation).
Not surprisingly, there can be a huge difference between what a seller thinks his business is worth and what a purchaser is willing to pay. Part, if not all, of this difference may be based on differing expectations about how the business will perform in the future. In some sales, the pricing gap can be narrowed or closed through deferring the payment of a portion of the purchase price until it is clear how the business has performed – this is called an ‘earn-out’. A seller might be paid instalments at the end of one, two and three years after the sale, for example, based on the business achieving agreed EBIT levels for those years or based on some other performance measure.
While an earn-out can result in a seller getting a higher price for his or her business, you need to be careful about relying too much on the earn-out mechanism. The future is a notoriously difficult thing to predict, and it is all too common for earn-out targets not to be met. The problem with foretelling the future is compounded by the fact that the purchaser, having bought the business, is now in control of it rather than the seller, and as a result can influence whether or not the earn-out target is met through the use of techniques like delaying the recognition of revenues and bringing forward expenses. In fact, a seller should not resort to an earn-out unless the seller will continue to be significantly involved with the business during the earn-out period (and therefore will have some influence over how the business is run).
The conditions precedent to a sale are those things that the sale agreement requires to happen before the sale is required to take place. Conditions focus on the things that must happen in order for the business legally to be transferred, or things that, if they didn’t happen, would have a significant negative effect on the business. It is very common to have conditions that the consent of various third parties be obtained, such as landlords, major customers or regulatory authorities if the business is in a regulated industry. If there are key employees that the purchaser wants to make sure will stay with the business, there may be a condition precedent that employment agreements be entered into with each of those employees.
Sellers want as few conditions precedent as possible, because the more conditions there are, the higher the chance that a condition might not be satisfied. If a condition is not satisfied, the purchaser usually will have the right not to complete the sale and to terminate the sale agreement. Because of this, sellers should fight hard to make sure that conditions that are within the control of, or which are the responsibility of, the purchaser are not included in the sale agreement.
Common examples are due diligence and financing conditions. Under a due diligence condition, a purchaser doesn’t have to complete the sale if the outcome of its due diligence investigation into the seller’s business is not satisfactory to the purchaser. (The seller’s argument against including this condition is that the purchaser should do its due diligence before the sale agreement is signed, not after.) Under a financing condition, the purchaser doesn’t have to complete the sale if unable to raise the necessary financing to fund the payment of the purchase price. (Again, a seller should argue that the purchaser should get the financing commitments in place before, and not after, the sale agreement is signed, and in any event a failure to obtain sufficient funding should be the purchaser’s
risk, not the seller’s.)
Representations & Warranties
A sale agreement often includes extensive warranties (which may go on for 10 to 20 pages) about the state of the business. Warranties usually cover matters such as the accuracy of the financial statements in respect of the business, title to assets, the material contracts of the business, compliance with various kinds of laws, the accuracy of the information that was provided to the purchaser, and a host of other matters.
Sellers tend not to focus on the warranties because they are long, detailed and often very legalistic. It is important to go over the warranties carefully, though, because they can be a liability trap for a seller. If a warranty is not true, the purchaser may make a claim against the seller to recover the purchaser’s loss from the warranty not being true. A number of small breaches of warranties can add up to a significant liability, and a few big breaches can mean that a large part of the purchase price for the business may need to be paid back to the purchaser.
There are various ways that sellers can protect themselves against warranty claims. The best way is to disclose any and all warts about the business to the purchaser upfront, as part of the purchaser’s due diligence process. The disclosure will qualify the warranties, which means that the warranties will be taken not to be breached because the purchaser knows about the problems. If the problem areas are not significant enough to cause a purchaser to back out of the sale, the seller (with good spin management) may be able to keep them from having a negative impact on the purchase price.
The warranties also should be limited in various other ways. The length of time after the sale that a claim for a breach of warranty can be made should be as short as possible – for larger sales, 12 to 18 months is common for most warranties (other than tax warranties, where the claims period usually is much longer). In small sales, where sellers tend to have less bargaining power, the warranty claims period might be anywhere from two to four years. A seller should also try to cap the total amount that he can be required to pay for breaches of warranties–the cap usually is the amount of the purchase price. A seller may also be able to negotiate claims thresholds (both for individual claims and in the aggregate), where the purchaser’s loss must reach at least a specified amount before any claim can be made.
Restraint Of Trade
The sale agreement usually will include a restraint of trade provision, or non-compete, which will prevent the seller from engaging in or being involved with any activities or business that competes with the purchaser’s acquired business. The seller also is likely to be prohibited from enticing away any of the purchaser’s customers, suppliers, or employees. Unlike in the employment context, where a restraint of trade of more than six months or a year may be found to be unreasonable, restrictions in the context of a sale of a business are likely to last for much longer (often three to five years) and to be enforceable for that longer period (depending upon the circumstances).
It would be unusual for there to be no restraint of trade in a business sale. Sellers instead should focus on negotiating exceptions to the restraint, such as allowing the seller to continue to engage in businesses he currently is engaged in, or allowing the seller to engage in businesses that might compete but are arguably only ancillary or complementary to the purchaser’s main business.
* Deborah Chew is partner at Hall & Wilcox lawyers, Melbourne (www.hallandwilcox.com.au).