For over fifty years IBA has been professionally facilitating business purchase & sale transactions with knowledge, experience, and best practices in the Pacific Northwest. The firm predominantly represents the seller side of transactions; however, we welcome the opportunity to share our knowledge and experience with buyers. All questions are always welcome from parties at IBA. Selling or buying a business is a life-changing action and it is our opinion that making educated decisions in an environment of full disclosure benefits everyone.
Today, advice is being shared for the benefit of the buyer side of the transaction. Most business sellers want transactions where they receive 100% cash at closing. The primary reason for this is that an all cash transaction significantly mitigates any potential financial risk for a party selling a privately held company or family business. In a perfect world, where a seller has fully disclosed everything that needs to be known about a business and has integrity, this type of transaction should work out fine for everyone.
Unfortunately, we do not live in a perfect world. This creates a need periodically for a business buyer to hold a seller accountable for the promises they made in the legal documentation associated with the transaction. These promises can take three forms.
Responsibility for Trailing Liabilities
The most significant portion of a purchase & sale agreement post-closing for a buyer are the representations & warranties made by the seller. Simply put, these are statements about the current state and history of the company that were the foundation behind the price paid for the business and the buyer completing the acquisition. Examples include statements about the financial performance of the company up until closing, customer engagement, and past audits & litigation associated with the business. Problems can occur for a buyer when despite these disclosures something surfaces which is a trailing responsibility of the seller, but where it is in the buyer’s best interest to address the problem in timely manner. The purchase & sale agreement will have a vehicle, an indemnification clause, to collect any expenditure that should be allocated to the seller, but pursuit of the amount can take time, especially if a seller has relocated or is nonresponsive. Scenarios that may require timely response include product returns, warranty repairs, and/or unpaid taxes with successor liability. An example of the final item associated with Washington business sales relates to historical sales and use tax liability where, even in an asset sale, a buyer can be forced to pay an amount due by state government if they continued operating a business under the same name or employing the same business model at the same location.
These situations are places where a seller promissory note or escrow holdback can be a highly valued and useful tool for a business buyer, as they can provide for reimbursement of out-of-pocket expenses in a timely manner. In the case of an escrow holdback, the purchase & sale agreement should contain a methodology where the buyer can receive cash to cover seller responsibility, accrued expenses. For example, if a buyer purchased a manufacturing company and a product was delivered defective prior to closing where the seller was paid and the customer seeks to return or have the item repaired, the business acquirer will want to take action that will result in a happy customer. This action will result in out-of-pocket expenditure. An escrow holdback is an available pool of money that can pay back the buyer. Its advantage over a promissory note is that used funds are replenished. The situation can also be addressed with an offset clause in the seller’s promissory note. In this situation rather than money being replaced, a credit is received against the debt obligation in the amount of the expenditure.
Transition Training
One of the assets acquired along with a business is commonly direct mentorship by the selling owner on how to executively manage and operate the business model. The time period for this can run from weeks to months depending on the type of enterprise. An escrow holdback or promissory note can be used to address any damage that results to the company by a seller not honoring their legal commitment for transition training after the transaction is completed.
Non-Competition Agreement Violations
Business acquirers traditionally obtain a “safe harbor” for future operation of a business from threat of competition from the selling owner in the form of non-competition agreement. If the terms of that agreement are not honored, it is common for buyers to look for penalty enforcement from a seller promissory note or escrow holdback.
Business brokers and attorneys play valuable professional advisory roles in the transfer of ownership of privately held companies and family businesses. Traditionally, the role of the business sale intermediary is to address the business elements associated with the transaction. This domain frequently includes the financial elements from the price paid for the business to the allocation of dollars between cash, escrow holdback, and potentially a promissory note. Setting appropriate values for each requires a proper allocation of risk between the parties and quantification of what is probable and/or possible.
Short term trailing liabilities are commonly addressed by an escrow holdback. Selecting the amount requires analysis of what is likely to occur based on historical data in the 3 – 24 months following closing. For example, a retail store would likely only need a short-term period because any potential issues should surface (e.g., customer returns) in close proximity to when the sale occurred. A longer horizon may be required if products and services have extended warranty periods. One size fits all approaches should be avoided. The focus in determining the value of an escrow holdback should be based on quantifying risk specifically, not selecting a standard percentage.
Longer term and lower probability trailing liabilities are frequently addressed with rights to offset in the promissory note.
A seller promissory note can also be used to help secure bank financing or private party investment for an acquisition. The purpose of this note is the same for the bank or investor as for the buyer, to mitigate risk and ensure agreements are honored by the seller.
The overarching concept governing IBA is the “Golden Rule” of do unto others as you would like them to do unto you. It is beneficial for business brokers to facilitate having each party travel conceptually to the other side of the table and evaluate the transaction from that perspective. IBA commonly does that related to escrow holdbacks and seller financing requests from potential buyers of our clients’ businesses. It has been our experience, if the “Why” is explained most parties are willing to work together in good faith in pursuit of a commonly shared objective.
IBA, the Pacific Northwest’s premier business brokerage firm since 1975, is available as an information resource to the media, business brokerage, mergers & acquisitions, real estate, legal, and accounting communities on subjects relevant to the purchase & sale of privately held companies and family businesses. IBA is recognized as one of the best business brokerage firms in the nation based on its long track record of successfully negotiating “win-win” business sale transactions in environments of full disclosure employing “best practices”.