NL 13

Step 11: Documentation and Negotiating the Details

Surprise! The LOI (Letter of Intent) did not tie down all the issues and details of the transaction. The remaining issues are negotiated and the entire transaction is recorded in the Definitive Agreement. (You may hear this agreement called: Sales/Purchase Agreement, Sales Contract, or Sales or Purchase Agreement.)

I will touch on some of the important issues that usually come up, but keep in mind that there could be many more issues that might apply to a particular transaction.

Many Documents

In addition to the basic Definitive Agreement document with its many exhibits, there can be a Security Agreement, Covenant Not to Compete, Consulting Agreement, Management Agreement and others depending on the particular transaction.

The Security Agreement itself can have subsidiary documents such as Stock Pledge, UCC-1 Financing Statement, Personal or Corporate Guarantee, Deed of Trust, Mortgage or other security instruments.

Transfers of rights also require documentation, such as Stock Certificates, the Assignment of Lease, the Release of Personal Guarantees, the transfer of certain Licenses and the approval of government entities.

In addition, there can be several subsidiary documents involved such as Compliance Certificates, Corporate Minutes, Corporate Resolutions, Escrow Instructions, Opinion of Seller's Counsel, Sales and Employment Tax Releases and possibly side letters.

Don't be surprised if the documentation for the sale is a stack of papers one to three inches thick.

Much More Negotiating to Do

In Step 8: Negotiating the LOI, I recommended that the letter of intent be non-binding. Technically, this means that all the terms are open for renegotiation until the Definitive Agreement is executed. Usually, the basic understanding as defined in the LOI survives to become the basis for the Definitive Agreement.

However there are a myriad of issues not covered in the LOI that have to be negotiated before the Definitive Agreement can be signed. Some common issues that come up at the are:

Stock vs. Asset Sale.

There are serious tax consequences to the seller and buyer if the transaction is changed to an asset sale instead of a stock sale or vice versa. It is likely that a change from stock to an asset sale will increase the seller's taxes and will decrease the buyer's taxes. If you agree to a change, make sure you are not decreasing your after tax return from the sale.

Renegotiating the Purchase Price.

The buyer may try to renegotiate the total purchase price based on the results of the due diligence investigation. You need to evaluate whether the business is really worth less or if this is a smoke screen. If it is worth less to the buyer, are you willing to take less?

Timing of the Payments.

The LOI is usually specific about the amounts to be paid, but not necessarily precise about the timing of payments. Is it monthly or quarterly? Are the payments in advance or arrears? Does payment on the first of the month mean receipt or dispatch of the check? If the contract says the first of the month, does the payer have a 10 day grace period? Are there late payment penalties?

Allocations.

The buyer's accountant wants to allocate more to the Consulting Agreement and less to the Covenant Not to Compete. For the buyer, this means a faster write-off, because Consulting Agreement payments can be expensed as paid while Non Compete payments must be amortized over 15 years.

To the seller, who will recognize the payments as income as received, it wouldn't seem to make much difference--but it does: Consulting Agreement payments will be taxed like earned income (through IRS Form 1099 reporting), with Social Security and other employment taxes which have to be paid on the 1099 receipts. Employment taxes are 15% or more, depending on the tax bracket. Covenant Not to Compete is unearned ordinary income, so no employment taxes are due.

All allocations have to be reasonable to stand up to IRS scrutiny. It is not reasonable to have a 10 year non compete for a 80 year-old man; nor is it reasonable to have consulting allocations that work out to $2,000 per hour for the seller's consulting services.

Seller Warranties and Representations.

The LOI said "usual warranties and representations." The buyer and seller may have differing opinions as to what the word "usual" means.

The seller warrants that all information given the buyer is true. The buyer warrants that all information given the seller is true.

Usually, the seller's warranties are the most significant. For instance: The buyer's attorney will insert a warranty to the effect that all equipment is in good working order. Very seldom is that statement completely true. Probably, some equipment is not working well. The seller should to append a schedule of exceptions to each rep and warranty to protect the seller from later claims.

To forestall later bickering, the seller should negotiate a "de minimus" dollar amount of responsibility for the reps and warranties. For example, "Seller shall not be liable to Buyer on any warranty, representation or covenant made by Seller in this agreement, or under any indemnities in this agreement, regarding a single claim, loss, expense or obligation or any other liability that does not exceed $5,000."

The agreement should also set a time limit (say two years) after which the representations, warranty and indemnity obligations expire.

Contingencies to Closing.

One of the most significant contingencies is the buyer's financing. Some buyers don't want the seller to know their financing arrangements. However, if there are any downstream payments to the seller, the seller must know about and approve the buyer's financial arrangements. The third party lender may preempt some of the Sellers rights in the transaction. I've seen banks ask for the return of any note payments to the seller in case of a default. This approval should be a part of the seller's contingencies to closing.

Security.

The buyer and seller defined the financial security arrangements in the LOI.

What the LOI usually doesn't define are the details of a default, or even, "What is a default?" All of this must be negotiated and documented in the Definitive Agreement.

When there is a Note or any post closing payments, the parties need to consider: What is the definition of default and what are the procedures to cure it? How long after a payment is due before there is a default? How must the seller give default notification? How long after notification does the buyer have to cure the default? If there is a Stock Pledge, what happens if there is a default that is insignificant in comparison to the value of the stock. Are there other default conditions, such as bankruptcy, lack of proper maintenance, lapsed insurance, or non-payment of rent? If the seller is in a second position on any of the collateral, does the first have to approve? Can the seller re-assume the facilities lease in case of foreclosure and getting the business back?

In my experience, the negotiation of the default provisions are unpleasant for both the buyer and seller. The seller doesn't want to dwell on not getting paid and the buyer doesn't want to think about losing the business. But default provisions are essential; don't gloss over them. They may determine whether or not you get paid fully.

Covenant Not to Compete.

There are three issues in any covenant not to compete: Term, geography, and scope, and these must all be reasonable.

Non compete agreement terms can range from 6 months to 10 years, depending on the age and knowledge of the seller and the needs of the buyer.

Geography might be from the local city to the entire world, depending on the business and product line markets. It usually limited to the company's current geographic market area.

Scope might be from a single product to entire product lines or entire customer industries.

These issues must be resolved to protect the buyer from competition from the seller, while not unduly restricting the seller's future activities.

Consulting Agreement and Management Agreements.

The Consulting Agreement and Management Agreements must be realistic. The IRS expects consultants or managers to be consultants or managers and to be paid a reasonable fee or reasonable salaries for the work that they do.

The seller and buyer need to decide what work there is to be done, define the scope and the time to do it.

Definitive Agreement Boiler Plate.

The general provisions in the Definitive Agreement are called boilerplate. They include arbitration, jurisdiction and notification provisions that could become highly critical in case of a default. Be sure they provide you reasonable protection.

I have given you a flavor of some of the issues that have to be negotiated before the Definitive Agreement can be completed and executed. Many times, for a retiring seller of a mid-sized business, the Definitive Agreement is the single most important document executed in a lifetime. Don't slight it. Spend the time and energy to understand the subtleties of it, and make sure you have competent, experienced team to help you in negotiating it.