Introduction
Selling a closely held business is a complex transaction involving multiple layers of negotiation, legalities, and deal structuring. While many sellers focus on the headline purchase price, they often overlook key deal terms and negotiation topics that can significantly impact the financial outcome, future liabilities, and overall success of the sale.
This report aims to highlight the most commonly overlooked deal terms and negotiation points that sellers of closely held businesses should prioritize. By understanding these critical areas, business owners can negotiate more favorable terms, avoid pitfalls, and achieve a smoother transition.
Chapter 1: Overview of Deal Terms in M&A Transactions
When selling a closely held business, deal terms go far beyond just the purchase price. The structure of the deal, payment methods, post-sale obligations, and legal protections all contribute to the final value and the seller's risk exposure.
Key Components of a Deal:
Purchase Price: The total financial consideration the seller receives.
Deal Structure: Whether the transaction is an asset sale, stock sale, or hybrid.
Payment Terms: The timing and method of payment, including upfront cash, deferred payments, and earnouts.
Representations and Warranties: Assurances made by the seller about the company’s condition.
Indemnification: The seller’s liability for post-sale claims or issues.
Post-Sale Obligations: Employment agreements, consulting roles, or non-compete clauses for the seller.
Closing Conditions: Conditions that must be met for the deal to close.
Chapter 2: Overlooked Deal Terms that Impact Sellers
Deal Structure: Stock vs. Asset Sale
Stock Sale: In a stock sale, the buyer purchases shares and assumes ownership of the entire entity, including liabilities. This is typically more favorable for sellers, as it provides a clean exit.
Asset Sale: In an asset sale, the buyer acquires specific assets and liabilities, leaving other liabilities with the seller. Sellers often overlook the complexities and tax implications of an asset sale, which may lead to unexpected tax burdens.
Sellers should negotiate to limit the scope of liabilities transferred in an asset sale.
Tax planning is critical, as an asset sale may result in ordinary income taxes on certain assets.
Payment Terms and Deferred Payments
Many sellers focus on the total purchase price but overlook how payments are structured. Deferred payments, such as installment plans or promissory notes, may expose sellers to credit risk if the buyer cannot fulfill future obligations.
Earnouts: A common deferred payment mechanism, earnouts tie a portion of the sale price to future business performance. Sellers often underestimate the challenges of achieving earnout targets once the buyer takes control of operations.
Negotiate strong protections in case the buyer defaults on deferred payments.
Set realistic, clear, and measurable earnout targets that align with factors within the seller's control.
Include interest on deferred payments to account for the time value of money.
Working Capital Adjustments
Buyers and sellers may negotiate adjustments to the purchase price based on the target company’s working capital at closing. Sellers often overlook the importance of setting accurate working capital targets, leading to post-closing price reductions.
Sellers should carefully review working capital adjustments and set targets based on historical averages.
Understand which accounts are included in working capital, as buyers may try to shift liabilities into categories that lower the purchase price.
Indemnification Provisions
Indemnification clauses define the seller’s responsibility for covering certain liabilities post-closing, such as undisclosed legal issues or financial misstatements. Sellers often overlook how broad these provisions can be, leading to unexpected future liabilities.
Limit the scope of indemnifications to specific risks, and set caps on potential liability.
Negotiate time limits (survival periods) for how long the buyer can make indemnification claims.
Ensure exclusions for known issues disclosed to the buyer during due diligence.
Escrow and Holdback Provisions
Buyers often request that a portion of the purchase price be held in escrow for a defined period to cover any potential claims, such as breaches of representations and warranties. Sellers frequently underestimate how much of their proceeds may be tied up in these holdbacks and for how long.
Negotiate the amount and duration of any escrow or holdback. Seek to limit the amount held to a reasonable percentage of the total purchase price.
Specify clear conditions under which funds can be released from escrow, ensuring any claims must meet strict criteria.
Chapter 3: Post-Sale Obligations that Sellers Overlook
Non-Compete and Non-Solicitation Agreements
Buyers often require the seller to sign non-compete and non-solicitation agreements to prevent the seller from starting a competing business or poaching employees or customers post-sale. Sellers may not fully understand the long-term implications of these agreements, which can limit future business opportunities.
Negotiate the scope and duration of non-compete clauses to ensure they are reasonable and do not overly restrict future opportunities.
Specify geographic limits and consider how industry changes or new business models may impact the enforceability of these clauses.
Consulting and Employment Agreements
In some transactions, the buyer may request that the seller stay on in a consulting or employment capacity to ensure a smooth transition. Sellers often overlook the terms of these agreements, including compensation, duration, and the scope of duties.
Clearly define the role, responsibilities, and compensation during the transition period.
Set time limits for how long the seller is required to stay involved post-sale.
Ensure that compensation is commensurate with the level of involvement and that any post-sale roles are optional, not mandatory.
Earnout Management
Earnouts are common in closely held business sales, especially when the business’s future performance is uncertain. However, once the buyer takes control, the seller often has little influence over operations, making it difficult to achieve the performance targets that trigger the earnout payments.
Negotiate clear, measurable earnout metrics that are achievable and within the seller’s control.
Include provisions that require the buyer to operate the business in good faith and not take actions that would negatively impact earnout targets.
Consider a minimum guaranteed payment if earnout targets are missed due to factors outside the seller’s control.
Chapter 4: Legal and Regulatory Considerations
Environmental Liabilities
Sellers in certain industries, such as manufacturing or real estate, often overlook the need to address potential environmental liabilities. Even if the business has a clean record, environmental due diligence may uncover issues that become the seller’s responsibility post-sale.
Conduct a thorough environmental review before the sale to identify and mitigate risks.
Negotiate indemnification provisions that limit the seller’s exposure to post-sale environmental claims.
Tax Implications
Sellers often focus on the headline purchase price but overlook the tax consequences of the deal structure. Stock sales, asset sales, and earnouts all have different tax implications that can significantly impact the seller’s net proceeds.
Work with tax advisors to structure the deal in a tax-efficient manner.
Understand the difference between capital gains and ordinary income taxes, and plan accordingly.
Negotiate tax treatment of deferred payments and earnouts to minimize the tax burden.
Successor Liability
In asset sales, the buyer may not assume all of the seller’s liabilities. However, certain obligations, such as tax liabilities, pension obligations, or environmental liabilities, may follow the business even after the sale.
Understand which liabilities are being transferred to the buyer and which remain with the seller.
Work with legal counsel to mitigate successor liability risks and ensure a clean exit.
Chapter 5: Legal and Regulatory Considerations
Understand the Entire Deal Beyond Price
Focus on the full scope of the deal, not just the purchase price. Payment terms, liabilities, and post-sale obligations can have a significant impact on the outcome.
Work with Experienced Advisors
Engage M&A advisors, legal counsel, and tax professionals early in the process to ensure that all deal terms are fully understood and negotiated in your favor.
Limit Future Liabilities
Pay close attention to indemnification clauses, escrow amounts, and potential holdbacks to limit your exposure to post-sale risks.
Be Proactive on Tax Planning
Tax implications can significantly affect net proceeds. Work with advisors to structure the deal to minimize tax burdens and maximize after-tax profits.
Conclusion
It is important for owners to consider factors beyond total purchase price during the negotiation and sale of a closely held business. Other terms mentioned above can significantly alter the risk to the seller and ultimately impact the total net proceeds achieved during a sale. For this reason, it is important for sellers to equip themselves with advisors that can fully understand, model, and relay their analyses and recommendations on behalf of their clients.