Introduction Buying a business is one big legal transaction, made up of a whole slew of discrete legal issues. You'll need to master all these subsidiary legal issues to get the larger legal transaction right.
If you don't, you risk not getting all the benefits that you bargained for. For example, if the seller is going to remain responsible for some or all of the business's past debts and liabilities, you ...
Buying a business is one big legal transaction, made up of a whole slew of discrete legal issues. You'll need to master all these subsidiary legal issues to get the larger legal transaction right.
If you don't, you risk not getting all the benefits that you bargained for. For example, if the seller is going to remain responsible for some or all of the business's past debts and liabilities, you want to make sure you have legal recourse against the seller if he or she fails to pay creditors as agreed. And typically you'll want the seller to agree not to compete with the business once you become its owner. To get these and many other legal protections, you'll need to carefully craft a sales agreement and other legal documents. This chapter will introduce the key legal measures you can take to protect your financial interests throughout the sales process.
Later chapters will tell you more about how to deal with legal issues.
You'll find clause-by-clause details of a sales agreement in Chapters 11 through 17 and examples of other necessary legal documents in Chapters 18 through 20.
This book provides the information you'll need to handle all or most essential legal tasks yourself. But especially when lots of money is involved, it usually makes sense to have a lawyer review your handiwork. In addition, we'll alert you here to legally fraught or tricky situations in which professional help is especially important. For an overview of specific ways that lawyers can help with legal issues, see Chapter 6.Understand the Differences Between Buying a Business Entity and Buying Just Its Assets
Any business you're consideringbuying is probably being operated as either a sole proprietorship, a partnership, a corporation, or a limited liability company (LLC). If a business is legally organized as a corporation or LLC, there are, broadly speaking, two principal ways to structure the purchase. The first method is to buy the corporate or LLC entity. The second method is to buy all or most of the entity's assets and let the seller hold on to the entity.
If you'll purchase a sole proprietorship or a partnership, you can skip this chapter. That's because with a sole proprietorship, there's no separate legal entity to buy; by definition, the seller, as the sole proprietor, will be selling just business assets. And although it's theoretically possible to buy a partnership by substituting new partners for old, a sale of a partnership is also almost always structured as an asset sale.
The importance of understanding the differences between asset and entity sales will come up repeatedly in this book. It affects everything from how you write off the sale price on your tax return, to liability issues and how ownership will be transferred. So although this material is seriously short on sex appeal, you'll want to master it.
How an Entity Sale Works
Let's assume that the business you're considering is either a corporation called Protobiz Inc., or an LLC called Old Stuff LLC. Here's how an entity sale will work. If you're buying Protobiz, a corporation, the shareholders will sell you all their stock in Protobiz Inc. In that case, you'll become Protobiz's owner and will have the right to control all the assets the corporation owns: furniture, fixtures, equipment, inventory, intellectual property, and so on. The corporation, under your ownership, will remain responsible for the debts and other liabilities of the business. Likewise, if you're buying Old Stuff LLC, the members of the company will sell you their membership interests, making you the owner of the LLC itself -- again, with the right to control all its assets. The LLC, under your ownership, will remain responsible for the debts and other liabilities of the business.
How an Asset Sale Works
Now let's assume that you're considering buying the assets of Protobiz Inc., or an LLC called Old Stuff LLC rather than either entity. Here's how an asset sale will work. If you're buying the assets of Protobiz, the shareholders will arrange to have the corporation sell you all or most Protobiz Inc., assets, but not the corporation itself. That means the existing shareholders will continue to own what amounts to nothing more than the Protobiz corporate shell. The corporation will have no (or few) assets other than the promissory note you sign for the balance of the purchase price.
Similarly, if you decide to buy the assets of Old Stuff LLC, the company's members will agree to have Old Stuff LLC sell you all or most of the company's assets. The LLC members will continue to own the LLC shell. If the LLC sells its assets to you, its only remaining asset will probably be the promissory note you sign. When you buy the assets of the LLC, you won't automatically become responsible for the debts and other liabilities of the business, but you may agree to assume liability for at least some of them.
When you buy the assets of a corporation or LLC, you don't automatically become responsible for the debts and other liabilities of the business. You may, however, agree to assume liability for at least some of them as part of the sale contract.
It's important to understand that the assets that an entity sells to you may not be limited to physical property. You can acquire the entity's intangible assets as well, such as the company's goodwill and its trademark.
Why Sellers Usually Prefer Entity Sales, and Buyers Asset Sales
Why is the legal distinction between an asset or entity sale important if the result under either approach is that you end up owning your business? One important reason is that how your transaction is structured will affect how you write off the purchase price on your tax returns, and how the seller gets taxed. As you'll see in Chapter 3, you'll typically be able to begin getting depreciation benefits sooner if you acquire only the assets than if you buy the corporate entity or LLC. The flip side is that the seller will usually fare better from a tax standpoint selling the entity rather than its assets, because the seller will pay tax at the low long-term capital gain rate. By contrast, in an asset sale, part of the seller's tax bill may be computed at the ordinary income rate, which is higher. Sellers are especially
skittish about using an asset sale for a C corporation, since they face the distasteful
risk of double taxation.
Incidentally, this tax benefits issue is often resolved by a compromise between the seller and the buyer that's reflected in the sale price or the terms of payment. For example, you may prefer to buy a business on an asset basis so you can immediately begin to get tax benefits. The seller may have set the selling price at $500,000 based on the expectation of an entity sale and may face an additional $40,000 in taxes if there's an asset sale. To compensate, the
two of you may agree to an asset sale, with an adjusted sale price of $520,000 -- a kind of middle ground.
Another reason why you, as a buyer, might prefer an asset sale is that it gives you the valuable opportunity to pick and choose among the assets you'll acquire. You'd like to negotiate a good deal for assets you want, leaving behind (and not paying for) those that aren't valuable to you.
Finally, the treatment of existing debts and other liabilities of the business is very different in entity and asset sales. Typically in an asset sale, you're not going to be responsible for existing debts of the business, unless you agree to accept responsibility. By contrast, in an entity sale, it's assumed that all the liabilities go along with the sale -- though to make the deal happen, the shareholders or LLC members who are selling may agree to be responsible for some specified liabilities, such as a recent bank loan.
But again, as mentioned above, what's legally and financially best for you may not be best for the seller, who would probably find it most advantageous to transfer the entire corporation or LLC entity to you. That way, the seller gets favorable tax treatment, is less likely to have to keep any undesirable assets of the business, and shouldn't have to worry about paying existing business debts and liabilities. Still, even where your interests diverge, it may turn out that you have more clout than the seller when it comes to setting the terms of the deal, and you may be able to insist on an asset sale. This might be true, for
example, if the business has been on the market a long time and the seller is anxious to unload it. Or you may be willing to make an unusually large down payment.
Still, in some situations, you may decide not to strenuously resist buying a complete entity rather than only its assets. This can be especially true, for example, if the business is highly sought after, putting the seller in a very strong bargaining position. Similarly, you may be quite willing to go along with an entity sale if the corporation or LLC has a valuable lease for the space where it does business, and the lease can't be assigned to you. By buying the corporation or LLC, the entity continues to be the tenant, so you get the benefit of the lease. (This won't always work, since some landlords state in the lease that a change in ownership of the entity will be treated as a forbidden transfer of the lease and cause a termination of the lease contract.) You'll learn more on this subject in Chapter 8. For now, just be aware that an entity sale can sometimes be the most practical choice even if it doesn't seem that way on the surface.
Not all entity sales are exactly the same.
Important details may differ. For example, in buying a corporation or an LLC as an entity, you and the seller may agree that some assets will be transferred to the seller before the closing. You and the seller may also agree that the seller will assume personal responsibility for some of the existing debts of the business.Consider Forming a Corporation or LLC to Buy the Business
If you're not buying a company that's already organized as a corporation or an LLC, you might consider creating one of your own, so you can have an entity to buy, own, and run the business. Of course, if you already have a corporation or LLC and that existing entity is buying the assets of another business, creating a new entity won't be necessary.
But let's say you're buying the assets of a business that's organized as a sole proprietorship or partnership and you don't now have a corporation or LLC. In that case, you face the same concerns as anyone starting a new business from scratch. If you alone own the business, you'll be a sole proprietor and have unlimited personal liability on all business debts, as well as any court judgments that are entered against the business. Likewise, if you and one or more other people own the business, you'll have a partnership and each of you will have unlimited personal liability for business debts and business-related court judgments. This means that with either a sole proprietorship or partnership, your personal bank accounts, your investments, and even your home will be at risk for business debts.
By contrast, if you form a corporation or LLC to own and run the business, you'll reduce the scope of your personal liability and that of your co-owners. For example, you won't be personally liable for the actions of employees or for business loans that you didn't personally guarantee. Because the cost of creating a corporation or LLC is fairly low and the paperwork burdens are minimal -- especially with an LLC -- many small businesses choose to set up one of these limited liability entities. Before you do, though, you should also become familiar with how taxes are computed and learn whether there are other benefits available that make a corporation or LLC an attractive choice.
You can safely defer your decision on whether or not to form a corporation or LLC.
You can, for example, negotiate a deal for the purchase of assets and then form the entity before you sign a sales agreement. Or you can even wait until after the closing, create a corporation or LLC at that time, and then transfer the assets to the new entity. But while timing is not crucial, it does pay to begin considering this issue early on.
For an in-depth look at the pros and cons of the various types of business entities: see Legal Guide for Starting & Running a Small Business, by Fred S. Steingold (Nolo).Be Clear on What You'll Buy and What the Seller Will Keep
You and the seller may agree to an asset sale. (This will always be true when you purchase a sole proprietorship or partnership. It may or may not be the case when you purchase a business that's run as a corporation or LLC.) In an asset sale, you'll want the sales agreement to state very clearly all of the assets you're buying. This may seem obvious, but a surprising number of sales agreements simply say the seller is selling, and the buyer is buying, "all the assets of the XYZ business." Including a specific list in the sales agreement is good common sense even if the seller plans to transfer every last asset to you. But a list is especially important if the seller will be keeping some of the assets, such as cash, accounts receivable, or perhaps even a desk and chair the seller has grown attached to.
Or maybe the seller is going to license to you -- rather than sell to you -- some item of intellectual property like a proprietary formula, copyright, or patent.
Attorney Fred S. Steingold practices law in Ann Arbor, Michigan. An expert on small business law, he represents and advises many small businesses. He is the author of Legal Guide for Starting & Running a Small Business and The Employer's Legal Handbook. His monthly column, "The Legal Advisor," is carried by trade publications across the country.
Your Companion for Buying a Business
Is This Book for You?
Will You Need to Hire Lawyers, Accountants, or Other Professionals?
Overview of the Process
1. Thinking About Buying a Business
Which Kind of Buyer Are You?
Three Ways to Become a Business Owner
The Basics of Buying a Business
Key Steps in Buying a Business
2. The Key Legal Issues in Buying a Business
Understand the Differences Between Buying a Business Entity and Buying Just Its Assets
Consider Forming a Corporation or LLC to Buy the Business
Be Clear on What You'll Buy and What the Seller Will Keep
Pay Special Attention to the Transfer of Intellectual Property
Know the Legal Consequences of Not Making Installment Payments on Time
Assure That There Are No Liens on Business Assets
Protect Yourself From Competition by the Seller
Limit Your Legal Liability for Past Obligations of the Business
Comply With State and Local Laws That May Affect Your Purchase
3. Tax-Saving Strategies
Understanding Business Write-Offs
Buying Assets vs. Buying the Entity
Allocating the Purchase Price in an Asset Sale
Writing Off Purchase-Related Expenses
4. Finding the Right Business for You
Before You Begin
Attractive Businesses May Be Nearer Than You Think
You May Be a Strategic Buyer
Finding a Business by Word of Mouth
Finding a Business Through Advertising -- Yours and Theirs
Business Brokers Can Help Find Sellers
What Sellers Want to Know About You
5. What's the Business Worth?
There's No Universal Pricing Formula: Many Factors Affect Price
Sales of ComparableBusinesses
The Asset-Based Approach
The Income Valuation Approach
Industry Formulas and Rules of Thumb
How Appraisers and Other Experts Can Help You Decide on a Fair Price
Putting Together All the Information
6. Working With Lawyers, Accountants, and Brokers
Getting Ready to Buy
7. Financing Your Purchase
Lump Sum Purchase
How Sellers Try to Protect Themselves in an Installment Sale
Show Me the Money: Where You Can Get Funds for a Lump Sum Purchase or Hefty Down Payment
The Difference Between Loans and Equity Investments
8. Structuring Your Purchase
Asset Sale vs. Entity Sale
The Seller's Future Role
Restrictions on the Seller: Noncompete Agreements
The Future of Key Employees
9. The Investigation Stage: How Buyers and Sellers Check Each Other Out
Your Investigation of the Seller's Business
Paperwork the Seller Should Provide
The Role of Confidentiality Agreements
Information to Garner From Other Sources
Why and How the Seller May Check You Out
10. Drafting a Letter of Intent
Why Use a Letter of Intent
What to Put in Your Letter of Intent
Why You Should Only Sign a Nonbinding Letter of Intent
Format for a Letter of Intent
Preparing the Sales Agreement
11. Preparing the Sales Agreement and Other Legal Documents
Overview of Your Sales Agreement
Related Legal Documents
Well-Drafted Documents Are Crucial
Preparing Your Sales Agreement and Related Legal Documents
How to Prepare Attachments to Your Sale Agreement
Steps in Finalizing Your Sales Agreement and Other Documents
Amending Your Sales Agreement
12. Who's Selling, Who's Buying -- And What Is Being Purchased
Naming the Parties
Identifying the Business and What You're Buying in an Asset Sale
Identifying the Business and What You're Buying in an Entity Sale
13. The Sales Price and Terms of Payment
Sale Price: Asset Sale
Inventory: Asset Sale
Dealing With the Purchase of Accounts Receivable: Asset Sale
Sale Price: Entity Sale
Payment at Closing
Security for Future Payment: Asset Sale
Security for Future Payment: Entity Sale
14. Dealing With Liabilities and Representations
Liabilities in an Asset Sale
Liabilities in an Entity Sale
Representations: What They Are and Why They Matter
15. Payment for Noncompete Agreements and Consultant Deals
Seller's Agreement Not to Compete With the Business After the Sale
Seller's Agreement to Work for Your Business After the Sale
Current Employees of the Business You Are Buying
16. Other Important Legal Language for the Sales Agreement
Dispute Resolution Clause
Technical Contract Clauses
Additional Optional Clauses
17. Signatures on a Sales Agreement
Required Signatures for Sole Proprietors on a Sales Agreement
Required Signatures for an Entity on a Sales Agreement
A Spouse's Signature on the Sales Agreement
Signature Clause in a Sales Agreement
Typical Formats for Signing a Sales Agreement
Accepting Personal Responsibility for Commitments in a Sales Agreement
Signing the Sales Agreement
Preparing the Promissory Note and Other Sales Documents
18. Promissory Notes and Other Installment Payment Documents
The Promissory Note
The Security Agreement
The UCC Financing Statement
Escrow Agreement for Entity Sale
19. Bill of Sale, Lease Assignment, and Other Documents for Transferring the Business
Bill of Sale: Asset Sale
Bulk Sales Compliance
Assignments in an Asset Sale
Transferring an Entity
Assignments in an Entity Sale
Your Entity's Approval of a Business Purchase
20. Documents for Noncompete and Future Work Commitments
Covenant Not to Compete
Contract for Employment
Contract for an Independent Contractor
Closing the Deal
21. Preparing for a Smooth Closing
Where and When to Hold the Closing and Who Should Attend
Documents for Transferring Assets
Documents for Transferring an Entity
Handling Last-Minute Problems
22. Running a Small Business: Some Legal and Tax Basics
Safe Business Practices for Your Corporation or LLC
Insuring Your Business
Negotiating a Favorable Lease
The Road to Success
A. How to Use the CD-ROM
Installing the Form Files Onto Your Computer
Using the Word Processing Files to Create Documents
Using Government Forms
List of Forms on the CD-ROM
B. Sample Sales Agreements
Sample #1: Asset Sale of a Restaurant by One Sole Proprietor to Another
Sample #2: Entity Sale of a Bookstore by the Two Shareholders to an Individual
Sample #3: Asset Sale of a Landscaping Business by a Single-Owner LLC to a Partnership
IRS Form 8594, Asset Acquisition Statement and Instructions
UCC Financing Statement and Addendum