Financing business sales; How to keep a small change from becoming an enormous headache
QUESTION: I’m considering selling my business. I had agreed on terms with a potential buyer, but at the last minute, he changed the deal and now wants me to finance a portion of the purchase price. I had already signed a Letter of Intent (LOI) to sell the business for cash, but I didn’t have an attorney when I signed it, so I don’t even know if it’s legally enforceable. Anyway, I didn’t get a deposit from the buyer, and he and the broker, who I thought was working for me, have been telling me all along that I want more than the business is worth, and that I need to be more flexible. I am not sure there is much I can do here, but I’m feeling pretty uncomfortable at this point. What do you suggest?
Answer: What you are experiencing is fairly common. If your LOI is like most, it probably is not enforceable — at least not enough to require the buyer to close a cash purchase. Nonetheless, there are a number of things you can, and should, do at this point.
Take a close look at your LOI. Most LOIs expressly state that they are not legally binding, except with respect to a few things, such as confidentiality, deposits and perhaps certain duediligence-related issues. Some, however, contain express agreements to “negotiate in good faith” or words to that effect. This can be important because some courts around the country — most notably, the Delaware Supreme Court — and in Canada have indicated that such obligations will be enforceable on a limited basis where “Letters of Intent” or “Term Sheets” have included such language, in spite of express provisions stating that they are non-binding. Even if you have no desire to pursue litigation, making it clear to the prospective buyer — or perhaps preferably, having your lawyer make it clear to the prospective buyer’s lawyer — that such a claim might be available, can add significantly to your negotiating leverage going forward. It sounds as if you are going to need it.
Start over from the beginning, not from the last conversation you had. Assuming you can’t or don’t wish to pursue a breach of duty to negotiate in good faith claim, you are going to be effectively restarting negotiations from their inception, and not from the last conversation you had with the prospective buyer. Understanding this nuance is critically important, but it is commonly overlooked, even by large and sophisticated sellers.
Let’s start with why it’s important:
- The buyer just changed one of the most important elements of the transaction — when the purchase price gets paid.
- Among other things, this creates “payment” or “receivables” risk for you as the seller, something with which I’m certain you are familiar in the context of ordinary receivables. If, for example, you were to factor (sell) your receivables, you would receive only a portion of the stated payment obligation — in part, to account for that payment risk. The buyer’s change, therefore, modifies not only the applicable risk profile, but also the value, of the transaction. This, in effect, renders it a new and entirely different transaction.
- Now, consider each of the other elements of the transaction — assets, price, vendor and customer relationships, contract transfers, timing, equipment financing, lien releases, real estate ownership and/or lease(s), etc. To varying degrees, each of these is impacted when the purchase price is paid, assuming it is. The legal and practical issues that arise as a result can take many forms. For example, if the buyer is a local competitor who later defaults, what impact might that have on your customer and vendor relationships? Will your real estate have been modified to accommodate inclusion in the competitor’s operation? Will your equipment and other assets still be there? What condition might they be in as a result? What will the employee and contractor relationships consist of? And this is just the tip of the iceberg. So, a seller-financed business sale is entirely different from a cash or mostly-cash transaction. After you have accepted that reality, you may need to persuade the buyer to do so as well.
Considerations: Fortunately, most of the above issues usually can be addressed in the legal documents if you fully explain to your attorney and accountant what has happened and immediately involve them in the negotiation and drafting of the new or revised LOI and the related purchase, sale and financing documents.
Few businesses are exactly alike, which means that negotiating your particular transaction properly is going to require consideration of a wide range of factors revolving around your business, equipment, facilities, customer base, vendor and supplier relationships, employees, contractors, financing relationships, dealership agreements (if any) and other matters.
That said, some issues tend to have broad general application with respect to revised new transactions of the type you have described. Here are a few of those issues to consider as a starting point:
- Confidentiality and return obligations. Make certain you obtain your buyer’s agreements to maintain all of your confidential information in strict confidence, return it to you — or if you specifically request that it be destroyed, destroy it and provide evidence of such destruction to you — if and when negotiations and/or the relationship terminate(s), and refrain from disclosing it to others except as necessary, and then, only to those who have agreed to similarly retain, return and/or destroy it as well. If the buyer stops paying or otherwise defaults, you are going to want him or her to retain all of your information in strict confidence for as long as possible, and to refrain from using it against you going forward.
- Increased cost. Because you are now being asked to act not only as a seller but also as a lender, you are going to need an entirely new and different set of loan documents — at least a Promissory Note, Security Agreement, UCC-1 Financing Statement and supporting corporate authorizations — to go along with the necessary sale documents, which themselves, would have been shorter and simpler in the absence of the seller-financing component. Most lenders charge their borrowers a document preparation fee in order to defray the lenders’ associated costs. Consider doing the same, or perhaps adding the estimated amount of such costs to your sale price, factoring in, of course, the potential tax effect in your case.
- Guarantees. Attempt to obtain personal and corporate guarantees of all, not just payment, obligations of the buyer from as many of the principal players as possible, including the individual owners of the buyer as well as, where applicable, any corporate owners and/or affiliates (i.e., separate corporations or LLCs owned or controlled by some or all of the same owners) of the buyer — including for example, any separate but affiliated business entity(ies) which might also be local competitors.
- File liens. You will, of course, want to file liens — reflected in UCC-1 Financing Statements — on as many of the personal non-real-estate assets you sell as part of your business as possible. In addition, consider getting a security agreement signed by each of the guarantors as well, and then filing UCC-1s on their assets. Why? Because among other things, foreclosures can be difficult and time consuming, particularly when someone files bankruptcy. If and when the buyer defaults, you will want to have as many options available as possible when you consider pursuing your default-related remedies. If things go downhill for the buyer after closing, the assets you sold may be gone or badly deteriorated by the time you get them back. Recovering in full may therefore require seizing any number of other assets. You will only have the legal right to do so if you have taken a valid security interest in those assets — and even then, many of those may be subject to superior liens and consequently, unavailable. Because it is virtually impossible to know when a buyer might default and what assets might, by that time, be available, take as much security as you can now.
- Cross-defaults. Make a default by any one or more of the buyer(s) and/or guarantor(s) under any of the transaction-related documents a default under, at your option, any one or more of the other agreements related to the transaction. For example, if you own the real estate but will not be selling it to the buyer and/or one of the buyer’s affiliated entities as part of the sale (i.e., you plan to lease the real estate to it/ them), making the buyer’s default under the seller-financing Promissory Note also a default under the real estate lease, can not only make it easier for you to foreclose, it can also add a great deal of motivation for the buyer to pay you in the first place — particularly if your real estate is also located in a state that grants the real estate owner a landlord’s lien on the tenant’s personal property.
- Interest rate/adjustments. As of the date this article is being written, interest rates are at historic lows. Given the vast infusions of liquidity into the economy, one has to assume that it is only a matter of time before inflation, and shortly thereafter, interest rates, begin to rise. For those of you who remember the 1980s, the average 30-year fixed rate real estate mortgage, which today is about 2.5 percent, reached 18.45 percent in 1981 and remained in double digits through most of the ensuing five years. Therefore, any extended financing you provide should start with a reasonable rate of interest for a business sale, which today usually is between about 6 percent and 13 percent, depending on the creditworthiness of the buyer, the value of the collateral and any additional security the buyer might be able to offer, such as guarantees and/or additional collateral, and contain an adjustment mechanism that enables the interest rate you charge to periodically adjust upward based on the then-current levels of interest rates and/or inflation.
- Deposit(s). Requiring a deposit from the buyer before proceeding further with negotiations can be an extraordinarily effective means of motivating the buyer to proceed to closing; the buyer’s obvious alternative being to walk away from the deposit. Particularly where, as here, the buyer has already changed the rules in such a way as to require restarting the entire negotiation and documentation process, requiring a substantial deposit — at least enough to cover your anticipated attorneys’ and accountants’ fees — is certainly warranted. In this regard, be careful of refund rights, which buyers and their attorneys may feel compelled to make expansive — do not be surprised if they start with arguing that the buyer’s refund right should be unlimited if the transaction fails to close. From your standpoint, you will want the deposit to be as nearly as possible to non-refundable.
About your exorbitant price. Do not worry about what the buyer or the broker says about the sale price. Remember, both have very different, but very much aligned, incentives to tamp down the sale price. The buyer’s is easy to understand — he wants to pay a reduced price; the broker’s is less obvious, but not difficult to calculate. Consider that even if the broker is ostensibly working for you, his commission will constitute only a small fraction of the sale price. So, if for example, that commission is 5 percent, then an increase of let’s say $500,000 in the sale price of a $5 million business is only going to increase the broker’s commission from $250,000 to $275,000. That means, of course, that the broker doesn’t stand to gain a great deal by arguing for a higher sale price and perhaps risking a buyer’s walkaway — versus getting an easier deal done at a reduced price.
So, although some brokers can be extraordinarily valuable with respect to their contacts, take what they say regarding pricing with a very large grain of salt, and make up your own mind — remembering also that the coronavirus (COVID-19) pandemic has had nowhere near the effect on pricing of equipment companies we all feared it would a year ago. In this particular case, in the absence of some specific reason for reducing your price, I see nothing to indicate that your broker’s admonishment regarding your price should be given any credence and, in fact, as previously mentioned, you actually may want to increase it somewhat in order to account for your additional cost and risk. Again, you would probably do well to also require a deposit and some additional collateral/security before proceeding further. If the choice is between making your broker or your wife happy, I would advise you to pick your wife.