A 100% cash transaction in the purchase & sale of a privately held company is the cleanest transaction financially and commonly sought by both parties in deals facilitated by IBA. In a transaction facilitated in an environment of full disclosure where trust and open communication exists this type of financial transaction is the “best case” scenario for the buyer & seller.
Unfortunately, environments of full disclosure where trust and open communication exist between the parties are not the standard in the marketplace where privately held companies & family businesses are bought and sold. The lack of these elements of “good faith” business dealings or the risk associated with their potential absence, results in a need to address the issue of potential trailing liabilities in the legal documentation and potentially financial terms associated with a transaction. Trailing liabilities can take the form of unpaid vendors or taxes, existing or contemplated litigation against the company, and/or promises or obligations made to customers or employees. A conversation with an experienced business lawyer on this subject will result in a series of horror stories about “skeletons in closets” that grabbed and in some cases devoured business buyers after acquisitions. These experiences and stories often color negotiations for attorneys & their clients, but experienced entrepreneurs know that the stories are reflective of a small percentage of total transactions and likely involved a party that did not transact business with honesty & integrity, and therefore make decisions based on the potential opportunity and not from a position of fear.
The following are the methods commonly employed by entrepreneurs buying businesses and their attorneys to address potential trailing liabilities:
1. Representations & Warranties – Every purchase & sale agreement should have a comprehensive representations & warranties section. This section of the legal document is where the seller conveys to the buyer that they have fully disclosed all relevant information; they have knowledge about or should have knowledge about, regarding the history of the business and the opportunities & threats that exist for the business in the future. This information insures that the buyer assumes ownership of the business with “open eyes” and provides a “safe harbor” for the seller, since the buyer cannot hold them accountable for an issue or threat that was known prior to acquisition if it impacts future performance of the business.
2. Indemnification – Every purchase & sale agreement should have an indemnification clause. Indemnification is the legal principle where one party is compensated for loss or damage as a result of actions by the other party. This principle is the sword behind the representations & warranties and the vehicle by which the injured party can sue the other party for financial damages to remedy the harm caused by the situation. In theory, the combination of representations & warranties and indemnification clauses should be sufficient to protect the buyer involved in a transaction if a trailing liability is identified after the transaction is completed, if the seller does not address it in the natural course of the transition of ownership. However, the mechanics for collecting the money can be complicated & expensive if the use of an arbitration, mediation, or court system is employed.
3. Escrow Holdback – A common method to address potential trailing liabilities in a 100% cash transaction is to have a portion of the transaction (commonly 5 – 10%) held in escrow for a specified period of time. The thought behind this transactional tool, is that if the seller does not willingly take responsibility for a trailing liability (e.g., an invoice incurred by the business prior to the sale that is received post sale) then following completion of some sort of authentication mechanism, the invoice can be submitted to a neutral party for either payment or reimbursement. This method provides a security instrument for the buyer of the business and, other than a deferred receipt of a portion of the proceeds of sale, should not have a detrimental impact on the seller if loose ends post sale are addressed.
4. Promissory Note – A longer term financial tool to potentially address trailing liabilities is a promissory note with a right to offset. In this situation, the seller is financing a portion of the transaction, so instead of submitting the invoice to a neutral third party like in the escrow hold back situation, after some sort of authentication mechanism, the buyer has the ability to take a principal credit against the outstanding balance of the promissory note equal to the value of the unaddressed liability, if the seller does not willing take responsibility for the trailing liability. It should be noted, that it is very common for banks to require a 10% seller promissory note when financing acquisitions, as a method of insuring that all trailing liabilities are addressed by the seller.
The key to the successful transition of ownership of a privately held business is having an environment of full disclosure where trust and open communication exists between the parties. It is also prudent for a business buyer to have legal mechanisms in place to address trailing liabilities. In most transactions facilitated by IBA, the legal mechanism creation results in legal expense and some degree of mental anguish for the parties. This is a given for transactions. There is also a high probability in a properly facilitated transaction, that the legal mechanisms to address trailing liabilities will be archived after the transaction is completed and never referenced again.
IBA, the Pacific Northwest’s premier business brokerage firm since 1975, is available as an information resource to the media, business brokerage, and mergers & acquisitions community on subjects relevant to the purchase & sale of privately held companies and family owned businesses. IBA is recognized as one of the best business brokerage firms in the nation in terms of successfully negotiating transactions that are “win-win” in an environment of full disclosure between the parties.