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