Five Steps to Buying a Small Business In New York – Part 2: Negotiating the Terms of the Deal

See Part 1 here; Part 2 here; Part 3 here; Part 4 here; Part 5 here;

Once you have found a business that seems like a worthwhile acquisition (a “target”), you are ready to negotiate the terms of the transaction.  But what are the typical terms of a small business purchase?  What is there to consider? In other words, what are you in for?

Enter:  the “term sheet,” also known as a “letter of intent” or “memorandum of understanding.”

A term sheet sets forth in writing the basic terms of the deal
before the drafting and negotiating of the sales agreement begins.
After parties have done a lot of talking and investigation of the
business, they will usually come to a basic understanding on how the
business is going to be sold.  In order to have everybody on the same
page, they often execute a term sheet.  By looking at a typical term
sheet, you will gain an understanding of the terms of a small business
purchase.

In addition to getting everybody on the same page, a finalized term sheet:

•    shows the seller that you are serious about the business
purchase.  While you could still walk away from the deal, you are now
committed to bringing the purchase to completion and will stop looking
at other potential targets;

•    prevents future negotiation roadblocks about major points at a
time when the parties have already spent a lot of time and money on the
transaction;

•    serves as a roadmap for the attorney drafting the sales
agreement and saves you money by not having to explain everything to
the attorney.

While there is no limit to the terms that may be put into a term sheet, the following items are the usual suspects:

1.    Names and Contact Information for all involved parties, such as seller, buyer, attorneys, business brokers, and accountants

2.    Purchase Price

3.    Payment Terms

Do you have to pay the purchase price in one lump sum or in several
installments?  If you have to pay in installments (also known as
“seller financing”), what amount of interest is the seller charging
you?  What is the amount of the down payment and when is it payable?

4.    Security for the Purchase Price

If the seller is financing your purchase by letting you pay the
purchase price in installments, he or she will not be content with your
promise alone.  Not that the seller doesn’t trust you, but things can
and do happen to the best businesses out there.  Thus, sellers usually
take a “security interest” in some of the business property you are
buying or some other valuable property you own.  If they hold a
security interest in the business assets and you do not pay your
installments, they can then repossess those assets and get what is owed
to them.

5.    Structure of the Deal: Asset Sale or Stock Sale

If the business target is a limited liability company (LLC) or
corporation, you have basically two options in structuring the
purchase. You can do an asset sale or a stock sale.

Let’s step back for a moment to understand.  A corporation is
considered a legal entity separate from the owners of such entity, who
are called shareholders (the same is basically true for an LLC, but to
keep it simple, I’ll limit this explanation to corporations).  That
means that the corporation owns all of the assets of the business, not
Joe Seller, the shareholder.  It follows from this that you could take
over the target by buying all of the assets of the corporation from the
corporation or by buying all of Joe Seller’s shares in the
corporation.

What is the difference for you, the buyer?

Liabilities

In a stock sale, you buy the entity with all of its debts and
liabilities—obviously, a very risky undertaking, which requires a lot
of probing into the business’ history and records.

In an asset sale, you buy only the assets of the corporation. The
debts and liabilities stay with the corporate shell that remains after
all of the assets have been transferred to you. While there are some
exceptions to this rule, when you buy all or substantially all of the
assets of a business in New York, chances are low that you will be held
responsible for the debts and obligations of the business incurred
before the transfer of the business to you.

Tax Consequences

In an asset sale, you, as the buyer, have the chance to deduct the
entire purchase price you paid for the business assets from your tax
bill.  You may be able to deduct some immediately, and some over the
course of several years.  Your attorney may talk about a “stepped-up
basis” in the business assets.

In a stock sale, your ability to deduct the purchase price for the stock of the corporation is basically non-existent.

Technicalities of Transfer

In an asset sale, you have to be concerned about the transfer of
each individual asset you are buying.  The transfer of equipment may be
different in requirements and concerns from the transfer of the lease
for the business space.

In a stock sale, all that has to be transferred are the stock certificates which evidence ownership of the corporation.

Flexibility

In an asset sale, you have the ability to pick and choose the assets you want.

In a stock sale, you automatically acquire with the entity all of
the assets that are owned by the entity.  If the seller wants to keep a
certain item of equipment, the corporation has to first transfer the
equipment to the shareholder before transfer of all of the shares to
you.

What’s the bottom line for a buyer?

You might have guessed it: an asset sale does sound more
advantageous for the buyer.  While this is generally true, be aware
that sellers favor stock sales for a variety of reasons.  In the end,
everything has a price and you might adjust the purchase price to
reflect and compensate for the disadvantages of a stock sale.

6.    Assets Included in the Purchase

Unless you are structuring your purchase as a stock sale, you must
be very specific about which assets of the business you are buying.
However, in the term-sheet phase, the parties usually limit the
description to “all of the assets of xyz business,” or “or all of the
assets of xyz business, except for ________.”

7.    Covenant not to Compete

In most cases, the past success of the business you are buying had
to do with the owner who was heavily involved in the day-to-day
management of the business.  As if it weren’t difficult enough to
convince your customers that the business will be the same or better
under “new management,” what you really want to avoid is that the old
owner opens a new shop right down the block and siphons off his old
customers.  The way to prevent this dilemma is to obligate the seller
to not compete with you for a certain amount of time in a specific
radius around your business.  This “covenants not to compete” is legal
under New York law, so long as it is reasonable.

8.    Confidentiality

Some sellers don’t want the public to know that they are about to
sell, or have a lot of trade secrets and other confidential information
that they don’t want to be disclosed to you without being sure that
they are not going to leak beyond this transaction.  Since the term
sheet is non-binding, they might even want to enter into a separate
confidentiality agreement or make only this part of the term sheet
binding.

9.    Procedure and Timeline

Parties usually try to agree on a time frame for the conclusion of
the transaction, if only to keep everybody on track.  This section may
also have a list of items that still need to be investigated by the
buyer.

10.    Non-binding Nature of the Term Sheet

Even though the term sheet is in writing, you do not want it to be a
binding agreement.  There are situations where you might have to walk
away from the deal or where circumstances change dramatically and terms
need to be adjusted. Thus, make sure that any kind of term sheet
contains language similar to this: “this term sheet does not constitute
an offer or commitment on the part of the buyer or the seller.  All of
the terms herein are subject to the completion of due diligence and the
execution of a sales agreement.”

11.    Obligations of Seller and/or Buyer after the Sale

Should the seller have ongoing obligations?  Since the seller
probably used to be the main force behind the business you are buying,
it might be a good idea to keep his services for some time while you
are learning the ropes of the new business.  Then again, you might have
seen enough of the business while investigating it prior to closing to
make this unnecessary.

Stay tuned for Part 3:  “Due Diligence”

See Part 1 here; Part 2 here; Part 3 here; Part 4 here; Part 5 here;

If you need help with buying or selling a business in New York, contact a licensed small business attorney in your area.

About Imke Ratschko


Imke Ratschko is a New York Attorney helping small businesses, business owners and entrepreneurs with all things "Small Business Law," such as litigation, contracts, business owner disputes, shareholder and operating agreements, sale or purchase of a business, investors, and starting a business. You can reach her at 212.253.1027.

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