DAVID J. WILLIS ATTORNEY
Copyright © 2013. All rights reserved worldwide.
Buying or Selling a Texas Business
by David J. Willis
Attorney at Law
This is an introductory-level article that discusses the basic elements of buying or selling a small business in Texas. The heart of the transaction is the Purchase and Sale Agreement, which resembles an earnest money contract in the sale of real estate. In fact, if the business owns real property, then the Agreement may also serve as a contract to convey the real property.
There is a consistent rule of thumb relating to the sale of a business: the transaction is never as simple or inexpensive as either the seller or buyer would like it to be. The complexity, due diligence burden, and professional expense (lawyer, CPA, business broker, appraiser, etc.) incurred by both sides in such transactions often substantially exceeds that which would accompany a comparably-sized sale of real estate only. Legal fees alone can range from $1,500 for simple transactions to $15,000 or more for larger, more complex deals.
The Purchase and Sale Agreement
The Purchase and Sale Agreement will, at the very least, identify the parties and the business to be sold; state whether the sale is a transfer of a company as an entity or of assets only (and then list those assets); specify the sales price and how it will be paid; provide for the deposit of earnest money; include an inspection period for due diligence; contain representations and warranties by both seller and buyer; provide protections for confidential information; specify what conditions precedent must be met for the transaction to close; and provide for remedies in the event either party defaults. Various exhibits and attachments (an inventory, a list of liabilities, a copy of the lease, copies of employee agreements, etc.) may accompany the purchase and sale agreement.
At closing, additional documents may be required, such as a deed to real property; if an asset sale, a bill of sale for inventory, FF&E (furniture, fixtures, and equipment), and other personal property; a note and security agreement if the transaction is partially financed by the seller; a deed of trust if realty is involved; an approval by the landlord for the buyer to assume the lease; customer or client list; various assignments; notice letters to customers and vendors; UCC forms; and other documents necessary to create a smooth and secure transition to new ownership.
The first step is to ascertain who will be the seller and who will be the buyer. Is the seller a sole proprietorship? A corporation? A limited liability company (LLC)? A determination needs to be made as to who actually owns the enterprise that is being transferred, who has authority to speak for and convey the business, and whose consent must be obtained (Warning: this may include spouses). If the selling entity is a corporation or LLC, then that entity will need to be in good standing with the State of Texas (Secretary of State and Comptroller) and have proper, up-to-date records that the buyer should carefully examine.
Similarly, will the buyer be an LLC? An individual or a partnership of individuals? It is often advisable to establish an entity (nowdays usually an LLC) to take title to and operate the business. This is done for reasons of liability protection as well as convenient allocation of percentage interests among those persons who are participating. If the buying entity is as yet unformed or unknown, it is a good idea for the buyer to be listed by name plus the phrase "and/or his assigns," thereby providing an opportunity to get an entity formed prior to closing of the sale.
Sale of Assets or Entity?
In buying a business, the buyer can acquire either the assets of the enterprise or the entity that owns those assets. In an asset sale, the assets to be transferred are specifically listed, as are the assets that are excluded. Ownership of the entity remains with the seller, as does the entity´s debts and liabilities – unless specific exceptions are made. In the sale of a corporation or LLC, the seller´s stock or membership interest is assigned and transferred to the buyer. Since ownership of the assets remains with the entity, a bill of sale is not required.
Buyer´s counsel generally prefer an asset purchase, because it comes without the potential for hidden or undisclosed liabilities. On the other hand, acquiring the seller´s entity may be accompanied by certain advantages such as an existing credit rating, established vendor accounts, or lines of credit at a bank. However, buying an entity significantly increases the amount of due diligence that must be performed by the buyer.
The Sales Price
As with any transaction, the sales price can be paid in cash, partly in cash and partly by third-party (e.g., bank or SBA) financing, or by means of cash plus seller financing. Certain indebtedness may also be "wrapped" or taken "subject to." In the case of third-party financing, the buyer will generally want the deal to be contingent upon obtaining financing approval. If the deal is seller-financed, the seller will want the opportunity to evaluate and qualify the buyer before giving final approval for closing the sale. If either contingency fails, then the earnest money is usually refunded, less any independent consideration paid for the inspection period.
How the sales price is divided up – i.e., between inventory, FF&E, goodwill, and the like is less a matter of legal principle than old-fashioned common sense. Caution to buyers: Do not overpay for "goodwill." Often the single most valuable assets of a business (a service business in particular) are its employees and its lease – or what remains of it.
Note that it is generally in the seller´s best interest to provide that if the business is subsequently transferred that any outstanding seller financing be paid in full (a "due-on-sale" clause). The seller should also reserve the right to inspect the business and its records (upon reasonable notice) in the future, in order to assure continued compliance with the Agreement.
Due Diligence and the Inspection Period
Nothing is more critical for the buyer than effective use of the inspection period to perform all prudent aspects of due diligence. What sorts of due diligence? The following is a basic list: "(a) physical inspections, including inspections of the business premises, inventory, furniture, fixtures, and equipment; (b) economic and financial evaluations including but not limited to a detailed examination of the books and records of the business; annual and quarterly tax returns as well as ad valorem tax records; records of utilities usage; any agreements with contractors and/or employees; financial statement of the business; (c) current credit report; (d) marketing evaluation, including examination of the customer/client list, receivables history, and related files; and (e) any appropriate environmental assessment or engineering study including performance of tests such as soil tests, phase I or II environmentals, materials tests, equipment tests, and air sampling." Depending on the nature and circumstances of the business to be sold, one could easily come up with additional items for scrutiny.
The important point for the buyer is to be able to terminate the agreement if the business is for any reason unsuitable for the buyer´s intended purposes, is not in satisfactory physical or financial condition, or is otherwise unacceptable for any reason. The buyer would then receive the return of the earnest money less some agreed-upon amount that provided independent consideration for the inspection period. If the results of the buyer´s inspections are satisfactory, it is common for additional earnest money to be due at that point. In fact, buyers always want to structure payment of earnest money in two parts: a modest initial amount followed by payment of additional earnest money after due diligence is completed.
Paradoxically (or so it would seem), the seller wants the buyer to have this right to terminate. Why would the seller want a reluctant buyer – particularly if the seller is going to finance him?
Attempting to cut corners in the area of due diligence often has calamitous consequences. Buyers and sellers who want to avoid legal fees may use some sort of contract off the internet (not even knowing if it is valid in Texas) and, when one party defaults, make the unpleasant discovery that legal fees to bring a lawsuit far exceed the cost of having properly documented the transaction in the first place.
Representations and Warranties
Both seller and buyer make representations and warranties, breach of which is a default under the Purchase and Sale Agreement, or at least a basis for terminating the Agreement. These "reps and warranties" can be made to survive closing, survive closing for a limited time, or not survive closing at all. Buyers want seller´s reps and warranties to be broad and extensive in time and scope; sellers naturally want to limit their ongoing liability.
Examples of typical seller´s reps and warranties include assurances of authority to enter into the transaction; good and marketable title to the assets; full disclosure of liens and liabilities; no litigation pending or threatened; and the like. A buyer´s focus is on full disclosure. A seller often wants to eliminate reps and warranties entirely and convey the business "as is" – something only foolish buyers go for. The result is usually something in between.
For their part, buyers need to assure the seller of sufficient expertise and financial soundness to fund operations and pay liabilities as they arise. No seller wants to have to take the business back and sell it a second time.
It is inevitable that confidential information about the business will be revealed during the course of the buyer’s inspection, and the seller has a right to demand that this information remain confidential - permanently. In addition to proprietary information about products, services, marketing strategy, and the like, the seller is also in possession of sensitive information about his employees and co-owners. As a result, the Agreement should include a strict covenant on the part of the buyer, enforceable by injunction if necessary, not to reveal confidential information at any time to third parties. This covenant should apply whether or not the deal eventually closes. It should also prohibit the buyer from utilizing the information in order to compete with the seller in the future.
Seller’s Covenant Not to Compete
If the transaction closes, a legitimate concern of the buyer is that the seller will set up shop nearby and continue in the same line of business. Accordingly, the Purchase and Sale Agreement should contain a covenant by the seller not to compete with the buyer. Courts have upheld such covenants so long as they are reasonable in duration and in geographical scope. What is reasonable? Like so much in the law, it depends. In the Houston area, for example, there are three main counties (Harris, Fort Bend, and Montgomery) that vie for the metropolitan area´s business. Therefore, any meaningful covenant not to compete should include these three counties.
The seller should also be prohibited from soliciting the buyer’s customers and employees in the future. This can often happen in subtle ways, so the Agreement needs to be carefully drafted.
At some point the deal must close, or the sale fails. Therefore, the Purchase and Sale Agreement should have a date certain for closing. Certain items (ad valorem taxes, receivables, and current rent, for instance) may need to be prorated. If real property is involved, the buyer should weigh the need for title insurance versus obtaining a title report or abstract of title. If title insurance is not required, closing at an attorney´s office is just as effective as closing at a title company and it may be a lot faster.
When closing at a title company, never allow the title company attorneys to prepare documents for the sale of a business. There are two reasons for this: first, they represent the title company, not the buyer or seller, and have no incentive to draft documents in anyone´s best interest other than that of the title company; and second, sales of businesses are not usually their expertise.
Every contract needs to specify what happens in the event one party fails to perform. Typically, the seller will want to provide that in the event of a default on his part, the buyer gets to keep the earnest money as liquidated damages and the agreement is terminated. Similarly, if the buyer defaults, the seller should usually be content with keeping the earnest money and moving on to the next buyer. The remedy of specific performance is not usually a practical or effective remedy against buyers, so it is not of great importance if the seller waives this.
A buyer wants more. After all, a buyer is expending more than just earnest money – the cost of effective due diligence can be many thousands of dollars and if the seller changes his mind about selling then the buyer can be substantially out-of-pocket. The Agreement should therefore provide that the buyer can recover these expenses from a defaulting seller. The buyer will also want to reserve the right to sue for specific performance, a meaningful remedy for the buyer.
If a buyer defaults post-closing (usually for not paying a seller-financed purchase money note), the seller´s remedies are generally contained in the note and security agreement and, if real estate is involved, in a deed of trust. Essentially, the seller´s remedy is to take the business back. This is usually a disaster since inventory is depleted, equipment may be missing, the lease is in arrears, and customer goodwill is down the drain. It is therefore critical that a seller choose the right buyer to begin with and get a solid down payment.
Get a Good Business Attorney
Both buyer and seller should get an experienced business/transactional lawyer and listen to his or her advice. Clients are often driven by emotions – the desperate desire to get rid of a business or an irrational determination to acquire one. Since the lawyer does not usually receive a commission, he or she has no stake in the transaction and may be the only person providing factual and objective advice.
Information in this article is proved for general informational and educational purposes only and is not offered as legal advice upon which anyone may rely. The law changes. While we respect your confidentiality, no attorney-client relationship is created by the offering of this article. This firm does not represent you unless and until it is retained and expressly agrees in writing to do so. Legal counsel relating to your individual needs and circumstances is advisable before taking any action that has legal consequences. Consult your tax advisor as well.
Copyright © 2013 by David J. Willis. All rights reserved worldwide. Mr. Willis is board certified in both residential and commercial real estate law by the Texas Board of Legal Specialization. More information is available at his web site, LoneStarLandLaw.com.