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Article Author:

Evaluating the Noncash Issues in Selling Your Business, Part 2 of 2

Stella Y. Su, MBA, CPA, ABV
Senior Manager, Corporate Finance Consulting
ssu@BlackmanKallick.com, 312-980-2912

Part 1, "What’s Actually Included in the Offer Price for Your Business?" addressed the financial aspects of valuing an offer to buy your business. Part 2 deals with legal and other issues involved in selling your company.

The sale isn’t finished at the closing

Selling a company is much more complex than selling your house, where the deal is signed, sealed and delivered on the day of closing. When you sell an ongoing operation, certain aspects of the agreement must be estimated before the closing and the final amounts determined weeks or even months afterward.

Here are some items to consider if you are thinking about selling your company or acquiring one.

Escrow plays a key role in the transaction

The purpose of escrow is to protect the buyer of a business. Understanding the various pieces the escrow covers is critical to both the buyer and seller. At the closing, instead of paying the seller the full purchase price, the buyer will place a specified amount in an escrow account until certain issues are finalized, including:

• Working capital. The working capital figure used at the closing is an estimate negotiated in the sales agreement. After the closing, an outside auditor reviews the company’s financials to determine the final working capital. The seller should then have the right to review the final working capital statement presented by the buyer. If the final working capital is less than the estimate, the buyer will receive a refund of the difference out of escrow and the remaining escrow balance, if any, will go to the seller. If it is more than the estimated working capital, the seller will get the balance of the escrow account plus any additional amounts due from the buyer.
• Tax. The buyer typically asks for tax escrow to cover any potential tax liability before the closing, including federal and state income tax as well as other state taxes.
• Indemnification. The seller is likely to be responsible for any obligation of the company before the closing. If the representations, warranties or covenants of the sales agreements are breached, the buyer has the right to seek indemnification.

Escrow is usually managed by a third party and is not released without written notice from both the buyer and the seller.

Setting an escrow time frame

From the seller’s perspective, the shorter the escrow’s time frame, the better. Cash today is better than cash tomorrow; the seller is not getting the full offer price if there is a delayed payment, even if the full escrow amount is ultimately released to the seller.

The most appropriate time frame will depend on the type of escrow involved. Here are examples of several factors that may affect the time frame:

• Fundamental representations. The seller represents his ability to conduct the sales transaction and to transfer the shares in the company free of claims from any third parties.
• Tax subject to statute of limitations. As the seller, you can negotiate how long you want the tax escrow to remain in the account.
• Patent disputes. Other individuals or organizations may attempt to infringe on your company’s patents. The buyer will want a cushion for legal fees and other potential liabilities to defend against such patent infringement. The buyer may also want an independent third party to determine whether your company’s patents are enforceable.
• Product recalls, OSHA and EPA issues. The buyer will ask for escrow for a specified time period (e.g., three months or six months after the closing) for the seller to pay the costs of any product recalls as well as to resolve any issues with OSHA or the EPA. After the specified time, the seller is reimbursed for the unused funds.

Set a liability limit

As the seller, you will want to establish a liability cap to restrict the buyer from seeking unlimited recourse from an indemnity as a result of a breach of the sales contract. It is important to assess the likelihood and magnitude of a potential breach to the buyer.

The use of baskets for indemnified matters

A basket is a dollar threshold of indemnity. Reaching the threshold—i.e., using the amount of money in the basket—triggers the buyer’s claim against the escrow account. In the case of a contract breach, the buyer first needs to use up the basket amount before he can make a claim.

There are two types of baskets: tipping and true.

• A true basket works like the deductible on an insurance policy. It enables the seller to recover only amounts in excess of the basket amount once the threshold is reached.
• A tipping basket is a threshold which, after it is reached, enables the buyer to make a claim against the escrow account from dollar one and seek reimbursement of all damages. Tipping baskets are potentially very dangerous to the seller.
  
  Example: A sales transaction included a basket of $400,000 and an escrow amount of $3 million. The buyer incurred $750,000 in expenses for fixing various product issues. If the basket were a true basket, the buyer would be able to make a claim for $350,000 ($750,000 in expenses minus the $400,000 basket). If, on the other hand, the $400,000 threshold had been a tipping basket, the buyer would be able to claim the full $750,000 in damages.

Buyers may co-invest with sellers

In many cases when a business is sold, the buyer feels more comfortable if the seller indicates his confidence in the future of the business by co-investing in the company. There are several terms in the sales agreement that may affect the future economic value of the seller’s investment:

• Call option. A buyer may want to buy the seller out early if the business is going very well so the buyer can realize higher returns at exit. Depending on the contract, there can be a remedy to the seller if this occurs.
• Dilution. The buyer can dilute the seller’s share of the business by issuing options to other new management members. The seller’s shares of the company can also be diluted by mezzanine lenders converting their debt to equity.
• Seller investment without further involvement in running the business. Sellers should be cautious about this option, as they will have their money invested, but will no longer have any control over managing the business. If you are not fully confident in the buyer’s ability to manage the business, you’re better off taking the cash at closing. Conversely, co-investing may enable you to take advantage of the buyer’s business skills and access to capital to take the organization to the next level.

Consider your life insurance needs

Think about how much life insurance you will need after the sale of your company—as well as your ability to buy coverage on your own once the sale is completed. If you may find it difficult to purchase life insurance outside the company at favorable rates, negotiate the transfer of your life insurance as part of the sale.

Consider your personal tax situation

As you prepare to sell your company, your BK representative can show you ways to minimize your tax liability and transfer assets to your children. A family limited partnership is one avenue you may want to consider.

Evaluate litigation concerns such as fraudulent conveyance

Sellers must be very careful of highly leveraged deals by the buyer. Such transactions can expose sellers to lawsuits if high bank financing is thought to deprive the acquired company of the means to pay its debts to its general debt holders— whether or not the transaction was actually intended to do so. As a seller, it is crucial to consider the financial viability of the buyer and get a third party’s opinion on the transaction, if necessary.

Choose a financial advisor carefully

When the time comes to sell your company, finding an experienced financial advisor whose interests are aligned with yours is key. Look for a skilled negotiator who can facilitate all aspects of the transaction and the business, and who understands the deal structure, operations aspects and the accounting issues. A trusted financial advisor can be your advocate every step of the way, ensuring a smooth and successful sale.

For more information on how to evaluate a business purchase offer, contact Stella Su at 312-980-2912.

 

This publication is part of Blackman Kallick’s marketing of professional services, and is not written tax advice directed at the specific facts and circumstances of any person and/or entity. Contents of this publication are of a general nature, and you should not act on this information without obtaining professional advice from your business advisor that is appropriately tailored to your individual needs and circumstances. This written advice is not intended or written to be used, and cannot be used by any taxpayer, for the purpose of avoiding penalties that may be imposed under the Internal Revenue Code.