Many a small business person has spent years building a business from scratch, injecting fresh capital when needed and investing new sweat equity daily in order to someday establish a profitable business operation with valuable assets, cash flow and goodwill. For many entrepreneurs, the payoff is the ability to sell that business and either retire or start a new business with the fruits of his or her labors. These rewards come at the expense of a buyer, typically a first-time entrepreneur investing either substantial borrowed funds or the bulk of his or her life savings. For both seller and buyer, the stakes could not be higher.
The transfer of a business or business assets cannot be accomplished without appropriate written contracts, where small oversights in drafting can make the difference between protecting one’s investment and losing everything. It is therefore unthinkable that either a buyer or seller would enter into the transaction of a lifetime without proper legal representation. Buying or selling without legal counsel presents numerous traps and pitfalls, with potential risks far in excess of the legal fees saved by proceeding alone. While the risks of home-made business transfer contracts are too numerous to address here, a few of the more common mistakes are addressed below.
Failure to Secure the Transaction
In many cases, the buyer of the business or business assets is unable to pay the full purchase price up front, and also unable to secure financing from a lending institution. In these cases, it is usually the seller who finances the transaction by agreeing to take purchase price payments over time. Just as a home lender must secure its loan with a mortgage against the borrower’s home, so must the seller of a business or business assets secure the buyer’s obligation.
The buyer’s obligation to pay the balance of the purchase price should be memorialized with a promissory note, secured with a written security agreement and recorded with the Pennsylvania Department of State by the filing of a financing statement. These documents provide a business seller with the same security that a recorded mortgage provides for a mortgage lender – a lien against the assets being sold. With such security, in most circumstances, the business seller will ultimately be able to repossess the business assets if the buyer fails to make payments according to the promissory note. Also, if the business ultimately fails under the buyer’s management, the security agreement will permit the seller to stand first in line amongst the creditors seeking to collect from the insolvent buyer.
Without such a security agreement, the seller is no more than an unsecured creditor, standing in line with the rest of the unsecured creditors, and with no recourse available but the filing and prosecution of a lawsuit. By the time such a lawsuit runs its course, there are very often no assets left, and the unfortunate seller may find that he has lost the value of the business he worked so hard to build.
Sale of Business Versus Sale of Business Assets
When buying without the benefit of legal counsel, buyers very often fail to consider the difference between buying “the business” and buying merely the assets of the business, which can include the business name and goodwill. If the business has no outstanding debts to creditors or taxing authorities this may be a distinction without a great deal of difference. However, if the business does have debt at the time of sale, a sale of the business itself will generally obligate the buyer to pay the pre-existing debts of the business, whether he knows it or not.
It is therefore important in the negotiation of any such sale to specify in the written contract whether or not the buyer is assuming the obligations of the business. If the deal requires the seller to pay off the debts of the business from the sale proceeds, the written contracts must make specific provision for this requirement. Further, if the buyer is merely acquiring the assets of the business rather than the business itself, the buyer, through legal counsel, must determine whether those assets are subject to a security agreement held by a third-party creditor. Without making detailed provisions for these issues, a buyer can find that he has purchased much more, or much less, than he bargained for.
No business purchaser in his right mind would buy a business if the seller announced in advance that he intended to start a new business competitive with and in the same geographical area as the business which the buyer was about to purchase. Very often, however, when parties proceed with a business sale without the benefit of legal counsel, they do not include provisions to prevent the seller from competing with the buyer’s business operations. Problems generally arise months or more later, when “seller’s remorse” or the seller’s dissatisfaction with the buyer’s way of doing business prompts the seller to try to get back in the game. Without a properly drafted non-compete covenant, the buyer has no recourse to prevent the seller from once again soliciting his old customers and dramatically reducing the value of what the buyer thought he had purchased. It is therefore critically important that the issue of non-competition be negotiated and addressed in detail in the body of the parties’ sale agreement.
While the Pennsylvania courts will enforce properly drafted non-competition covenants, the courts also carefully evaluate these covenants to make sure that they are not overbroad and that they do not unfairly prevent the seller from making a living. For this reason, it is necessary that the non-compete covenant be drafted by an attorney well-versed in the relevant judicial decisions so that the non-compete covenant is appropriately limited in terms of duration and geographic area.
Seller’s Consulting Obligations
In many cases, the buyer needs the seller to remain involved in the business for a period of time, either to educate the buyer on how to conduct the business or to help the customers of the business transition to a new owner. Very often, when the seller remains on board to assist the buyer in a transition, there is a period of co-management of the business. Such short-term unions, often between people who would never choose each other as business partners, can create a great deal of friction, particularly when buyer and seller have very different ideas about how the business should be operated.
Controversies often develop and grow ugly unless the parties’ agreement carefully defines the former owner’s role in the new relationship. At a minimum, there should be written consulting provisions, perhaps in a separate consulting agreement, setting forth the nature of the consulting services to be provided, the minimum number of hours per week the consultant is to devote to the business, the extent of the consultant’s ability to refuse work, the extent of the consultant’s ability to participate in management decisions, the rate or amount of compensation to be paid for consulting services, if any, and the number of weeks or months the consultant will be obligated to provide consulting services to the new business owner.
Tax Consequences of Purchase Price Allocations
When a buyer and seller prepare a home-made contract for the sale of the business or business assets, they will, more often than not, agree upon an overall purchase price without allocating that purchase price amongst the specific assets being purchased. That is, these agreements typically contain no provision as to how much of the purchase price is allocated to equipment and fixtures, as opposed to inventory, business goodwill, accounts receivable and, in some cases, post-settlement consulting services. However, whether and how the purchase price is allocated amongst the component parts of the business assets can have very serious consequences for both buyer and seller for income tax purposes and, more particularly, for capital gains treatment. Accordingly, it is important that before a contract is signed, both buyer and seller obtain advice from their tax professionals, and negotiate an allocation of the purchase price which is then memorialized within the body of the written contract itself.
The issues and risks noted above are but a few of the pitfalls faced by buyers and sellers of a business. Risks and complications increase when the parties add other terms into the mix, such as a seller’s rights to participate in the profits of the business. Risks increase again with a real estate sale or an assignment of lease with respect to the business premises. Even without these additional levels of complexity, a wise businessperson will not attempt to navigate through these potential traps without the assistance of competent legal counsel.
The attorneys of Wolf, Baldwin & Associates, P.C. can provide the legal assistance you need to buy or sell a business in Pennsylvania. Please contact us to schedule an appointment with a lawyer from Wolf, Baldwin & Associates, P.C. today. You can’t afford not to.