Closing the Deal: How to Avoid Pitfalls

You’ve invested a lot of time and money to get to this point.

There’s a Letter of Intent or Term Sheet in place with the basis for agreeing a deal. The buyer’s undertaken the Due Diligence process which on the face of it seems to have gone well. It’s "all systems go" as far as you’re concerned.

So what could possibly go wrong? Here’s the time to get focused on the detail.

You may find this frustrating when you’re so close to the finishing line, but if you miss something important it could easily prove very costly. Not just now, but potentially in the future should you be held responsible for any lingering liabilities following sale closure.

This how-to guide could easily extend to several thousand words as there’s so much detail to cover. It’s deliberately kept as a concise summary because you’re strongly recommended to take professional advice when structuring the final deal. To make sure that you get a successful outcome. There are many technicalities, and it's very easy to miss something. Not to mention legal requirements that can vary significantly from state-to-state.

Related: How to Avoid Legal Mistakes When Selling a Business

Ideally, you’ll already have used the services of an accountant, an attorney, and perhaps also a business broker, when reviewing the buyer's proposed offer in the Letter of Intent or Term Sheet. Perhaps they've also helped you with a counter-proposal addressing any specific issues in the buyer's proposal, and to look after your general interests.

Below you’ll find highlights of the main pitfalls so that you can be forewarned and better able to have an informed dialogue with your professional advisers. This guide goes hand-in-hand with the one that covers preparation of legal papers.

The following key areas are covered here:

  1. Negotiating a "win-win"
  2. Getting paid
  3. Deal closure
  4. Communications and transition

Let’s take a look at the first one:

1. Negotiating a "win-win"

Your immediate reaction to this statement may be, "why should I care if the other person wins too?"

Here are a few reasons why you should care whether your buyer is also satisfied with the final deal.

  • Let’s assume it’s a buyer’s market for businesses such as yours, so if the buyer walks away at this stage you may have to start your search all over again.
  • Most small business sales involve some seller financing, so it’s in your interests that the buyer remains financially motivated to make a success of your business.
  • It’s not uncommon for the seller to remain in the business for a period of time after the sale as part of the deal, so you both need to be comfortable with the outcome.

What does win-win mean in practice?

Well, it’s now time for both parties to stay focused on achieving a mutually acceptable Business Sale Agreement, concluded on an agreed date not too far distant. To increase the likelihood of getting the result you want, you’re strongly advised to take advice from your accountant (and attorney) before entering these negotiations.

There are a number of important considerations here:

Generally speaking it’s in the seller’s interest to sell the shares (or stock) in the business, assuming of course that you’re not a sole proprietor. This means that you can walk away completely happy in the knowledge that there can be no hidden liabilities for which you’ll be subsequently held accountable. Also the profits from a stock sale are liable for capital gains tax, which is typically levied at a lower rate than income tax.

Related: How to Sell a Sole Proprietorship

Closing the business sale deal
Closing the deal

The problem for you is that the buyer is likely to want quite the opposite. That is, to pick and choose the assets included in the deal, whilst ring-fencing their exposure to identified liabilities. The overwhelming majority of small business deals cover assets only, which is why this sale type is the primary focus of this How-to Guide.

Related: Sale of Assets vs Selling Shares

So, if you need to concede to an asset sale, you’ll certainly expect something in return. The best time to address this issue is at Letter of Intent (or Term Sheet) stage, by taking advice from your accountant and attorney, with a view to making an early counter-proposal.

One bargaining chip may be the cash amount payable at deal closure. It’s unusual for a deal to involve 100% cash.

Although it may seem counter-intuitive, there are actually pretty good tax reasons why you might not want all the deal money now in cash. This of course assumes that you’re offered firm guarantees that your seller loan will be repaid in full.

You’ll still want a significant cash sum to compensate for agreeing to an asset sale. For example, if the buyer offers 30% down payment you may want to insist on 50%.

Another negotiating chip is to push more of the purchase price into asset class categories that reduce your tax liability. This is achieved mainly by allocating as much as possible to long term fixed assets (owned for more than one year), and intangible assets including goodwill that are taxed at the capital gains rate.

The seven IRS tax classes are:

  1. Cash, including savings accounts
  2. Certificates of deposit, foreign exchange, investments or securities
  3. Accounts receivable and any debt instruments
  4. Inventory
  5. Tangible assets, such as equipment, fixtures and fittings
  6. Intangible assets, such as operating systems and processes, licenses, business web site and any intellectual property
  7. Goodwill, typically the ongoing trading status of the business and the brand name

The buyer’s preference on the other hand is to allocate the price towards tax deductible expenses or assets that can be quickly depreciated. Again a basis for negotiation, although you need to be careful because the IRS will take an interest in your valuation decisions and how apportionments are made between asset categories.

Note that the agreed asset breakdown must not only appear in the final Business Asset Sale Agreement, but also in an IRS Asset Registration Statement. This form, named IRS 8574, must be completed and filed separately by both you and the buyer, attached to the respective annual tax returns. It's important that both IRS 8574 returns state an identical allocation of the assets sold.

It’s easier to assign a fair market value to the first five categories in the above list. This leaves a residual amount for intangible assets and goodwill, which are harder to value.

Here are a few deal options for dealing with this residual sum.

For example, goodwill may be covered through an earn-out deal, whereby a percentage of future business revenues are paid to you at agreed fixed intervals. It's common to agree a minimum and a maximum money amount in any earn-out arrangement.

Another way of allocating the purchase price to intangibles and goodwill arises where the buyer wants you to sign a Non-Compete Agreement statement. A monetary value can be agreed and assigned to this statement, which makes you liable for capital gains tax rather than income tax. The disadvantage for the buyer is that this payment is typically written off in the books over a number of years, leaving little immediate tax advantage for them in the first year.

A still further way of allocating tricky intangible asset costs is to sign a management consulting agreement. This is where you stay on in the business for a specified period of time, subject to clearly identified terms and conditions and a well-defined role. The buyer may regard this as a way to reduce business risk during transition and, if so, they'll also appreciate your expenses being tax-deductible. It’s less good for you however because these consultancy payments are subject to Income Tax. Alternatively, you could take an employment contract were this to work better for both parties (although you'll still be liable for Income Tax).

Of course, certain non-essential assets may be excluded from the sale enabling you to sell them separately elsewhere, or lease them back to the buyer to give you an ongoing income source. An obvious example is where you own the business premises.

As you can imagine there’s a lot to this subject area. That's why we strongly recommend that you speak with your accountant, as early on in the process as possible, to avoid making costly errors.

If you own a "C" corporation there's a likelihood of double taxation, where assets are charged first as capital gains, and then as income when the proceeds of the sale are distributed. To avoid this extra tax burden, you may wish to take professional advice on the benefits of changing to an "S" corporation.

2. Getting paid

Most sale deals involve some form of seller finance, or payment by the buyer in installments over a period beyond a year.

This oils the wheels of the deal as it can be difficult for a buyer to secure sufficient lender finance to buy a small business at an affordable rate of interest. Offering seller finance can make it much easier for the buyer to conclude a deal, whilst you earn a regular stream of interest payments along with the repayment sum.

The key document here is a Promissory Note which can take a number of forms. You can defer your total tax bill by spreading Promissory Note payments across several years, which may be helpful even if you’re able to negotiate a higher apportionment to asset categories taxable at capital gains tax rate. This is because there’s a rather nasty surprise tax called the Alternative Minimum Tax (AMT) which applies if you make too much overall profit in one year!

It's important to take precautions before you agree to offer a seller-financed loan.

Check out and seek assurances about the buyer’s capability of repaying you. If they’ve been refused a bank loan it’s important to find out why, particularly if they’re not deemed creditworthy. A substantial initial cash down payment reduces the overall risk, but you still need to check that the buyer has not already committed the assets of your business as security against another loan from, for example, a bank. If so, you may find yourself waiting in line to receive your payment in the event of buyer default. It's important to get a formal written warrant from the buyer to cover against this possibility.

Beware also that even if you reacquire the business assets, in the event of the buyer defaulting on your loan, there’s a danger that the buyer may have severely depleted or squandered them in the intervening period.

The best way of handling this situation is to have the buyer sign a Secured Promissory Note accompanied with personal guarantees on their private assets, for example real estate. Be careful that certain states have passed Community Property legislation requiring a spouse to also sign these documents to make them valid.

If there’s a 3rd party personal funding source involved, such as a family member or friend, then they need to provide cast iron guarantees for the amount loaned.

Another precautionary step is to request that your attorney records the Promissory Note with the Secretary of State’s office as a Universal Commercial Code statement (UCC), which makes the legal debt collection process easier should your buyer default on payments.

In the case of a stock sale you can seek to have the shares restrictively endorsed so that they don’t become the buyer’s outright property until all the debt has been repaid.

3. Deal closure

Again it’s important to stress the value of professional advice here so you don’t overlook the legalities and technicalities.

There’s actually a lot to do before you get to closing day signatures.

The setting of the closing date itself requires some thought. It may make sense to choose a month end so as to make it easier to pro rata bill payments, such as utilities and rent.

The Settlement Sheet is an important document for you to check. Here you’ll find closing day valuations and adjustments along with all the other financial details needed to close the sale, including the purchase price and costs. An independent 3rd party agent is usually used to make a physical stock check a few days before deal closure. It also shows expected closing day values for accounts receivable and any split of professional fees where it’s been agreed to share the cost.

It’s normal to set a further date around two weeks after deal signature to conduct a final financial reconciliation and purchase price adjustment.

Much of this pre-closure time is spent checking detail. After all, you don’t want to see the deal held up due to a last minute hitch. Aim to make closure day a mere formality, perhaps even with a little ceremony at handover time.

You’ll rely heavily on your accountant and lawyer to draw up the correct documentation, such as the Business Asset Sale Agreement (or Business Stock Sale Agreement if it’s a deal for shares), but in the end it’s your responsibility to check the content carefully before you sign. If you agree with the buyer to share documentation costs then one of the attorney’s could be asked to do the initial draft, subsequently checked by the other party’s attorney.

The Business Sale Agreement will also include amendments for any negotiated changes arising from Due Diligence.

Some of the other items you’ll need to check are:

  • Settlement Sheet, which will be drawn up by the appointed 3rd party escrow agent, if you appoint one to hold and release the buyer’s deposit at closure;
  • the various official asset transfer documents including the Bill of Sale, leases and titles to tangible and intangible business assets such as intellectual property (if any);
  • Promissory Notes, along with supporting security documents;
  • buyer’s arrangements for ongoing business insurance from the date of asset transfer, particularly important if you’re offering seller finance;
  • outstanding obligations requested by the buyer in the Letter of Intent or Term Sheet.

It’s not untypical for official closure to take place at your attorney’s office where you’ll require the presence of all those needed to sign the various sale documents presented.

As well as witnessing the signatures, your attorney will help prepare you for the big day, and guide you and the buyer through all the documents that need signing.

4. Communications and transition

You’ll still have some tidying up to do, irrespective of whether you’re staying on with the business in some capacity during transition.

In particular it’s about meeting your commitment to ensuring business operations as usual with a smooth transition to the new owner. The customer, supplier (and any distributor) lists need handing over to the new owner as well as manuals, keys and access codes, and your contact details for forwarding correspondence.

You need to make sure that:

  • all wages and outstanding bills are paid (tax and otherwise), with relevant tax forms filed with the appropriate authorities;
  • business bank accounts and credit cards are closed;
  • utility accounts and insurance policies are either closed or transferred;
  • notice is served on the property lease where it’s not being transferred;
  • assets not part of the sale are reclaimed (and distributed where necessary);
  • county and state permits and licenses are cancelled;
  • the IRS employer account number is closed.

Crucially, in an asset sale you need to close your business as a trading entity. If it’s a stock sale the business entity remains intact and is transferred to the new owner.

As a sole proprietor you just need to make sure that all outstanding bills and taxes are paid and the business will automatically be deemed closed.

If the business operates as a corporation or LLC it’s not quite as straightforward, with a number of steps required for business dissolution (again it’s best to check details with your attorney).

  1. Firstly, a vote is required by the board, partners (or members) to formally dissolve the business.
  2. Then dissolution form IRS 966 must be sent to the IRS within 30 days of the vote.
  3. Lastly it’s necessary to file articles of dissolution with the Secretary of State’s office in the states where your business is registered as an entity, starting with your home state (once again requirements differ state-by-state so you need to check with your attorney to ensure compliance).

Communication is always a key issue particularly at this sensitive pre and post sale closure time.

That’s one reason why before you announce the sale it’s important to ensure that all accounts receivable are collected!

The priority is informing those employees who don’t already know the situation. You may have already prepared a written statement along with the buyer in case news should leak out accidentally.

This can form the basic content for a face-to-face staff briefing with the buyer present. Introduce him or her in a positive way, explaining why you’re moving on, and requesting that the information remains confidential until other key players have been informed.

You may want to leave the meeting so that the buyer can start the process of taking up the reins of authority as the new boss. This gradual transformation process must continue should you stay in the business during the early stages of new ownership transition.

Next identify your most important customers, suppliers, distributors and associates and contact them personally with the news, ideally face-to-face. Again keep the news about the future positive. If you meet key contacts, it may be good to take the new owner along with you.

As you move down the priority contacts you’ll increasingly use the telephone method. On the supplier side be sure to reassure creditors that they’ll get paid. The remainder on the extended list can be covered with a personalized email sent via blind copy distribution.

Keep all written communication consistent and positive with a short biography of the buyer, ideally accompanied by a good quality photograph. If you’ve prepared a news release for local media it’s a good idea to attach it to the email so as to provide more details, including a hint of the bright future ahead.

If you’re staying on in the business for a while it’s your main job to lend support to the buyer in the transition process.

Once the job is complete, and you’re no longer needed, the new owner will probably want to see less and less of you on site. They may even terminate your management agreement early, often within 6 months of the takeover.

It’s then that you can fully relax and go on to pastures new, particularly if you’ve cast iron guarantees on any seller loan you made!

Related: The 6 Legal Steps to Completing Sale of a Business

Published by ExitAdviser


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