Purchasing or selling a business can be a daunting task. Helping clients avoid the various pitfalls—of which numerous exist—requires a clear game plan and constant vigilance when putting together the transaction. When a client says “I want to sell my business,” a common misconception is that only a single transaction will be required. Frequently however, such a sale would be broken up into multiple components, comprised of an equity component (the intellectual property, the name and goodwill and reputation, and interests or shares) and an asset component (physical properties, land, and furniture). Depending on the needs of the client, one type of sale may be preferable, or a purchase, or even both. Here are some considerations and issues to watch out for:
What is being bought or sold
The first question needing to be answered: what parts of the company are being bought or sold? Asset purchase agreements include all physical property held by the company, which may include the building the company operates out of, or any land the building sits upon. Equity purchases include items like the name of the business, stocks, membership interests, the reputation, the intellectual properties; essentially the business entity itself. An equity purchase, where a buyer pays for all stocks or membership interests held by the original shareholders of a company, will include the entirety of all company assets and liabilities; the buyer has in essence purchased the entire company. Thus, as this would include the physical assets of the company, it sometimes obviates the need for a separate asset purchase agreement. While buying all stocks or membership interests may simplify the required paperwork, it allots a larger onus upon the purchaser to thoroughly research all issues and liabilities—especially the hidden ones—within the target company.
Liability in Transactions
Often, it is the liabilities of the target company, the one being purchased, that will dictate how a transaction would be structured. When dealing with a business entity of sizable liabilities, such as lengthy leases or significantly outstanding lines of credit, a common practice is to leave the company with its original shareholders and preform an asset purchase agreement that selects the non-affected assets to be included in the transaction. All types of purchases require due diligence, but in an equity purchase, where a buyer purchases the company as a whole, an exceptional amount is required: the purchaser will be responsible for all liabilities both known and unknown. Sellers should be aware that many purchasers will attempt to saddle them with a medley of possible liabilities, while the purchaser only pays for what they can discern as profitable or worthy of investment. In more complicated transactions, attorneys may combine both asset and equity purchase agreements, having purchasers take on a negotiated amount of the liabilities, while explicitly carving out liabilities to be left with the seller. Sellers and purchasers must ensure they have understanding of any liabilities that could inevitably be included in the transaction, as to ward off the possibility of being blindsided some months down the road by a late invoice or notice of default and acceleration.
Equity Swaps and Purchases:
Proceeding with a potential transaction means all parties must do as much due diligence as possible. This includes hiring consultants to assist with valuations of the target company, its revenue, the worth of its assets, and the size of the liabilities currently on the books. These numbers should be used to put a price on all items to be included in the purchase, whether it’s the entire company or something as minor as an office printer. When a larger company wants to acquire a smaller company, and is offering to pay the shareholders of the smaller company entirely in stocks or interests in the larger company, both parties must have an accurate understanding of the value of the respective companies and how their equity compares to each other. Occasionally, these types of equity swaps go awry because the smaller of the two companies company did not do enough due diligence and relied on the answers and valuations produced by the larger company, who spent much more than the smaller company would have ever dreamed of spending on evaluating the deal. This may lead the seller to trust the calculation of their own companies valuation by a third-party vendor, who is not operating in the best interest of the seller but the purchaser; an obvious conflict of interest. Furthermore, the seller must scrutinize which types of equity will be used as the basis of the deal in any equity swap. Sometimes the purchaser will offer shares or membership interests in the larger company that are dependent on the sellers remaining with the larger company for extended periods of time before the equity is vested. These situations are less than ideal, as it would require the seller waiting years for a payout that should have been provided, if they fought for it, at the time of sale. What if the larger business goes under during that time, or is forced to deal with a recession, or worse, a pandemic? What if the issued equity is a type that can easily be bought back or diluted at the purchaser’s discretion? All those scenarios would, in some cases drastically, decrease the expected payout, all because one party did not scrutinize or have their attorneys review the documentation. Conclusively, it is best for all parties preform their due diligence before, during, and after the sale or purchase of a business.
In a perfect world, the purchaser or seller would have attorneys review and draft their purchase agreements, but sometimes a deal can move faster than expected, or resources are tight and lawyers cannot be involved to an ideal extent. In those cases, we hope the aforementioned scenarios provide a good intro into equity and asset sales, and some common pitfalls that can be avoided as long as you practice one thing: your due diligence.