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WHAT ARE ‘OUTSIDE IN-HOUSE COUNSEL’ SERVICES FOR FRANCHISORS?

WHAT ARE ‘OUTSIDE IN-HOUSE COUNSEL’ SERVICES FOR FRANCHISORS?

“How are you guys different from a typical law firm?”

We’ve answered this question several times recently in response to inquiries from franchisors about EntrePartner’s “Outside In-House Counsel” services. Thus, we’re including our response on our blog to help explain how we work with emerging, growing, and established franchised brands from a legal perspective.

Due to the nature of being in a regulated industry, every franchisor has ongoing and regular legal needs. This goes far beyond drafting an initial Franchise Disclosure Document and preparing annual updates. A growing franchisor is required to comply with ongoing regulatory requirements, as well as establish new systems for franchisee relationships and disputes, support its franchise sales program, comply with agreements, adopt new system standards and policies, and pursue additional growth avenues such as alternative growth structures and international growth.

Depending on certain factors, such as a franchisor’s size, industry, and growth trajectory, those legal needs can range from a standard set of projects, to a specified number of hours of legal support each month. For example, every franchisor will need a standard set of compliance documents to administer its franchise agreements, and ensure that the legal foundation to enforce those agreements against the appropriate people is in place. Additionally, a myriad of issues typically come up in day-to-day operations of a franchise program. Some specific requests that we have heard recently:

• What happens when a franchisee brings in a new partner?
• What do we do if a franchisee wants to sell or transfer its business?
• What if a franchisee wants to move its territory?
• What documentation do we need for a site approval process?
• What do we do if a franchisee misses its required opening date?
• What information can our sales team provide to a prospect?
• What terms should our vendors be required to adhere to?
• What disclaimers and terms should our ops manual and policies include?

Our team of former in-house lawyers provides the answers, and helps establish templates and systems to deal with these and other common recurring issues. Unlike most law firms, though, we provide these services through predictable flat fee arrangements or ongoing subscription agreements with discounted legal rates. Most of our clients that choose this model subscribe to a certain number of attorney hours per month at exclusive, reduced hourly rates. The more hours needed, the lower the hourly rate. While our clients appreciate the financial savings of this arrangement, equally important is the fact they get more in-depth representation. Our subscription clients may take advantage of unlimited emails and phone calls of 15 minutes or less, and a free, monthly client check-in lunch (or happy hour) meeting to discuss ongoing matters, business operations or other topics as necessary – which allows us to have deeper insight into our clients’ businesses.

We have found that this model can significantly delay the timeframe in which a franchisor needs to incur the payroll expense of a full-time general counsel. It also avoids the need to incur big firm legal rates for every question asked or document needed. Having represented many franchisors across various industries, our lawyers draw from a wide range of experience to solve both legal and business issues. Not only that – our lawyers have actually been franchisors AND franchisees, too! This allows us to offer insights beyond those provided from a purely legal advisor.

EntrePartner is founded on the belief that legal services can be provided in a different way. As entrepreneurs ourselves, we represent our clients the way we would want to be represented. First of all, we provide all services at a reasonable and predictable cost – whether that be subscription agreements, flat and capped fee arrangements, or proactive discussions with our clients about their legal budgets and corresponding value for services. In this manner, we focus on developing long term strategic alliances rather than maximizing legal fees.

Secondly, where we really excel is helping our clients translate legal advice into smart business decisions. We leverage our in-house and on-the-ground business experience to help clients avoid the common mistakes that many growing franchisors make, or reinventing the wheel with every issue. Whatever the issue, we’ve likely seen it or something like it (or are able to connect clients to the person who has), and have a first-hand awareness of where it should fall in your priorities list. We combine that actual business and operational experience with legal expertise to do what we do best: help you create, grow, and protect your franchise system.

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CAN I APPLY FOR A FEDERAL TRADEMARK REGISTRATION BEFORE I’M USING THE MARK?

When we are preparing a federal trademark application, one of the most important things we need to know is whether you are – at the time of the application – actively using the trademark in the marketplace.  If you are, we will file a use-based trademark application, also known as a section 1(a) application (corresponding to the section of the law that authorizes this type of application).  But in many cases, an entrepreneur wishes to register a mark before he or she has introduced the product or service that the mark represents. As explained below, it is possible to apply to register a mark that is not yet being used.  This type of application is known as an intent-to-use (“ITU”) application or a section 1(b) application.

Use-Based (Section 1(a))

We file a use-based application when you are already using the trademark “in commerce.”  Using a mark “in commerce” means a bona fide use of the mark in the ordinary course of trade. If the mark is used with goods, it will be deemed to be used in commerce when, for example, it is placed on the goods, on the containers of the goods, displays associated with the goods, or on the tags or labels. Use in commerce also requires that the goods be sold or transported in commerce of a type that can be regulated by Congress, which generally means in interstate commerce or affecting interstate commerce. (Strictly intrastate commerce will not provide a basis for federal registration.) For a mark associated with services, rather than goods, the mark must be used in connection with the sale or advertising of the services and the services must be rendered in commerce.  Determining whether a mark has been used in commerce can sometimes be a complicated analysis, we can help you sort it out.

Intent-to-Use-Based (Section 1(b))

If, on the other hand, you have sincere plans to use the mark in commerce but are not yet doing so, an ITU application essentially permits you to reserve the trademark for your exclusive use in your field.  You must actually use the mark in commerce, however, before a registration ultimately will be issued.  Reserving a mark with an ITU application can be a good option since developing an brand can take time. If you are creating a brand from scratch, you may need time to design logos and packaging, order raw goods and supplies, produce the product to be sold, create a website and the like.  An ITU application provides the comfort that some other party will not be granted the rights to your mark while you are hard at work launching your business.

With an ITU application, once the trademark office “allows” your mark, we will have six months to file a Statement of Use, which is a declaration by a trademark applicant that the mark is currently being used in commerce. A governmental filing fee will also be required.  Should your mark not be used in commerce by the due date to file a Statement of Use, we can file various requests for six-month extensions of time to file the Statement of Use; a request for a six-month extension can be filed every six months, for up to three years.

For more information about trademark registration, visit our EntreTrademark site.

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IS MY BUSINESS RIGHT FOR FRANCHISING?

One of the most common questions we get from business owners is whether their business is right for franchising.  On its face, franchising can seem like an excellent way to expand utilizing the capital and talents of qualified third parties.  And for those that do it right, it is!  That said, entering into franchise relationships takes a considerable investment in time, talent, and money, and we initially have many conversations with our clients about whether they are willing to invest accordingly.

Here are some of the questions we go over with our clients when we help them consider whether franchising is the right growth strategy for them:

1.  What is your stickiness factor? We believe this is one of the biggest threshold questions that needs to be answered.  Take a moment to consider a typical franchise relationship.  A franchisee is considering getting into business, but doesn’t necessarily have the know-how to do it on their own. The franchisor teaches the franchisee everything they know about the business up front, and the franchisee thereafter pays a royalty throughout the entire term of their relationship in exchange for operating as part of the franchise system.  As years go by, it is a common feeling for franchisees to feel that they are paying a royalty for things they already know, since it has been taught to them from the start.  The best franchise systems have a common proprietary element that operators cannot get somewhere else and continues to tie the network together past the initial “honeymoon” period – whether it be a literal secret sauce (or proprietary recipe), a technology platform that allows the business to operate and is not available elsewhere, a product or series of products that have been developed for the system, or some other proprietary element.  Consider whether, outside of the brand name, your business has this stickiness factor and if not, whether you can develop one before launching!

2.  Do you have a proven model? Brands often develop as they learn over time.  Many business owners launch their first location with a set of ideas and assumptions, that they later learn may or may not have been correct.  Most entrepreneurs that we work with tell us that if they knew when they started what they know now, they would have _______ (fill in the blank: leased a bigger space, leased a smaller space, added a different service element, simplified their menu, worked with different vendors, offered a different pricing model).

This experience is exactly what franchisees are paying for when they enter the system.  That said, a good franchisor will actually build-out and test what they consider to be the actual franchise “model” location.  The model is, in a vacuum, the ideal set of circumstances that a business under the brand should have to operate – size, location, services, pricing, etc.  Although companies aren’t required to have a model location actually established to begin franchising, it certainly helps franchisors provide relevant information to their franchisees, and also have a showcase location to show and train franchisees and prospective franchisees.

3.  Industry Trends and Competition.  Piggybacking off of the idea of having a proven model, good franchisors also have a brand that is differentiated in its market and poised for growth.  When considering whether to buy a franchise, franchisees will ask the franchisor why they should buy into their brand.  Whether it’s a new type of offering in the industry, or whether the franchisor has a new approach to go to market, franchisors should consider what makes them different and worth buying into.  And, since a big part of a franchisor’s success is the long-term success of a franchisee, the franchisor should also feel confident that their concept has the staying power to be successful in the marketplace, despite industry trends and changes in the competitive landscape, through the long-term franchise relationship.

4.  Are You Willing to Get Into the People Business? Franchising is about relationships. Although a contract ultimately governs the legal obligations of the parties, the majority of the relationship between a franchisor and franchisee is established by trust, communication, processes, and problem resolution.  Without these elements, franchisors are rarely successful in getting buy-in from their franchisees, and ultimately, selling new franchises.

Before franchising, the company is `first a business owner and expert in the industry in which they operate.  Their customers are the people who buy their product or service.  Many franchisors are required to shift their way of thinking to focus on their new customers – their franchisees – and concentrate time and effort on managing franchise relationships.

5.  Are You Up For Investing Into Your System? As we hopefully have hammered home in the above, launching and growing a franchise system does take an investment of capital, know-how, and talent.  In order to properly establish appropriate systems, technology, and support structures, most start-up franchisors are required to hire team members and bring on new technology and systems that come at a cost.  At a minimum, we recommend that franchisors, either internally or externally through vendors, have a plan for the following functionalities: executive leadership (overseeing and adapting the brand), franchise sales and development, marketing and advertising support, compliance, and business coaching and support.  Some of these roles may be played by the same individuals at first, but we do recommend that the franchisor establish a plan to cover these needs with individuals with the appropriate skill sets.

6.  How Is Your Endurance? Franchise agreements are typically longer-term agreements, as franchisees want to ensure they have time to obtain a return on their initial investment in establishing their business.  Common agreement terms are between 5 to 10 years, with rights to renew the agreement for ongoing additional 5 to 10 year periods.  Once a franchisor signs one of these agreements, they are contractually obligated for the long haul.  Although there are always exit strategies that franchisors can pursue, absent divesting, a franchisor will be tied to the system and the brand for the long-term.  We often counsel our clients to consider this and where they are at in their career, goals, and personal lives – and ensure that they have the stamina and energy to lead the system and perform their obligations as may be required.

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SHOULD I TRADEMARK MY BUSINESS NAME, LOGO, OR BOTH?

Whether you have a new or established business, trademarks can be an essential part of protecting what often becomes a company’s most important asset:  Its brand and goodwill.  At the startup stage, entrepreneurs often are looking for guidance on how to get the most protection without having to file multiple trademark registration applications with the U.S. Patent and Trademark Office.  So, we are often asked whether a business should register its name, logo, or both.

As a preliminary matter, it’s important to note that it’s not necessarily your company name that you are registering for trademark protection.  Rather, it’s the name used to identify you as the source of goods or services in the marketplace. Simply using a business name that identifies a corporate entity, but that doesn’t indicate the source of goods or services to a consumer, won’t cut it.

Faced with the question of whether you should register simply the word(s) associated with your goods or services (a word mark) or a logo associated with your goods or services (a design mark), the answer will almost always be a word mark, for a number of reasons.

When you register just your name, it’s considered a “standard character mark” and you’re protecting the name itself, apart from any coloring, font, or other styling of the word(s).  From a legal standpoint, registering a word mark tends to offer the broadest protection, since it prevents others from using your name, in any format or way.  So, for example, a competitor can’t use your name, but in a different style than how you use it. It’s the words themselves that are protected.  You have the exclusive right to that name in your commercial space, and you can prevent others from using the name in any manner – or  anything confusingly similar to it.

On the other hand, when you register your logo, your protection is more limited, since it covers the exact shape, stylization, orientation, and sometimes colors in that logo. Your logo may or may not include your name, but ultimately what you’re preventing others from using is your logo, or something that looks confusingly similar, not your name.

So, while generally speaking, a word mark offers more protection than a design mark, there are circumstances where it will make more sense to register a design mark than word mark. Most commonly, you may be unable to obtain a word mark for a number of reasons, including:

  • – The name is descriptive
  • – The name is geographically descriptive or deceptively misdescriptive
  • – The name is a surname
  • – The name is common or creates a likelihood of confusion with another mark

When one or more of these factors are present, posing a challenge to registering a word mark, a design mark can be a good fallback option to at least protect the logo or other important aspects of the mark.

If your budget allows it, the best strategy usually is to register both your name and logo. Every situation is unique, however. If you have more questions about this topic, we’d love to hear from you. You can contact us here or tell us more about your mark through our EntreTrademark service.

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DO I NEED AN ATTORNEY TO FORM A COMPANY IN MINNESOTA?

One of the most common questions that we get from our clients, contacts, family, and friends, is whether they should engage an attorney to help them start their company. There are some firms that tell their clients, no matter what, that they should engage an attorney to form their limited liability company or their corporation, and often at a high price.

At EntrePartner, we always strive to help our clients find ways to save on legal fees when the situation warrants it and the risk is low.  So, here’s the honest answer we would tell our dearest relative to steer them in the right direction.

If you are a solo entrepreneur, starting an entity primarily for local operation (within the State of Minnesota, for example), and don’t plan to conduct any external fundraising, you can file an application for your entity yourself through an online process.  The Minnesota Secretary of State provides a relatively simple to use online process that will guide you through the process.  To do so, you will need to determine whether to form a limited liability company (LLC) or a corporation (or s-corp). In this scenario, 90% of our clients form an LLC, but this can be quickly confirmed through a quick call to your accountant.  You will also need a business address within the State of Minnesota to receive notices and where third parties may serve you with documents, if the need arises.

If you go this route, you will need to visit the Minnesota Secretary of State’s website and do a quick search with the intended name of your entity, to make sure there isn’t anything confusingly similar that exists already.  It is a good idea to search different variations of your proposed entity name, including specifically searching each word that is part of it, and variations on spelling, to make sure that you find all existing options.  Once you come up with the appropriate name, you can answer the online questions and pay the initial entity filing fee right on the website.

All of that said, if your entity has more than one owner, we do recommend that you utilize the services of an attorney.  You will want to ensure that ownership is properly issued to each party, and that an operating agreement is put into place that outlines the rights and responsibilities of each owner as to one another and to the company.  For example, many typical scenarios involve a financial partner and a sweat equity partner – and the organizational documents of the entity should outline the rights and responsibilities of each role to ensure that the company has the proper capital promised and that the sweat equity partner delivers on their obligations in exchange for ownership.  We have helped many clients who did not have a proper agreement in place with their partner from the start, and who later found that there were significant miscommunications or lack of follow-through on the obligations of each partner causing significant stress to the company and to the partnership.

In addition to the above, an operating agreement covers the following:

– How will decisions for the entity be made?

– How are majority, or minority, owners protected?

– How are monetary and capital requirements of the company handled?

– How will distributions be made?

– How and when can an owner transfer their interest to a third party?

– What happens if an owner dies or becomes disabled?

– Is insurance appropriate for future business planning?

– Should owners be subject to a non-compete?

None of the answers to these questions are standard for all parties, and as such, an attorney should help you ensure your particular needs are considered and addressed.  EntrePartner offers a complete formation package for entrepreneurs who need help with setting up their entity properly, and you can learn more about that package here. We’d love to hear from you!

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IS A FEDERALLY REGISTERED TRADEMARK WORTH IT?

Starting a new business can seem like an overwhelming and never-ending series of decisions and expenditures.  So any savvy business owner will, of course, look to prioritize the “needs” from the “wants.”  One of the most common questions we hear from clients – especially those at the start-up stage – is whether federal trademark registration is worth pursuing.

New business owners often spend a great deal of time finding the perfect name for their business, not to mention making a monetary investment in a good design for their brand.  Entrepreneurs often have a vague sense that a registered trademark can be important, but are not always familiar with the underlying reasons.

It is worth noting that certain trademark rights arise just from using a trademark “in commerce” – which essentially means you are legitimately doing business under your name and logo. These automatic rights are known as common law trademark rights, and they result from your use of a name and not from any statute, rule, or registration. Common law trademark rights have been developed under the judicial system (rather than by a legislative body) and are governed by state law.  The great thing about common law rights is that they are automatic and you gain them simply from using your mark in commerce. The drawback is that common law rights are limited to the market where you actually do business. So, someone in another state could use your business name and you may have no recourse.  This can get to be sticky when you are marketing your goods or services through the Internet.  To claim rights in a certain location, you may need to prove actual ongoing sales to customers in that area or otherwise show penetration of that market.

Because of this limitation of common law trademark rights, we often recommend that our clients federally register their trademarks.  One of the most important advantages to a federally registered mark is that it gives the owner an exclusive nationwide right to use that mark.  Other advantages of owning a federal trademark registration are:

– the right to use the federal registration symbol ®

– public notice of your claim of ownership of the mark, so others can learn about your rights before they use your name in a way that would violate your rights

– the ability to bring an action concerning the mark in federal court, and the ability to recover damages, lost profits, attorney fees and costs that result from the trademark infringement

– the use of the U.S. registration as a basis to obtain registration in foreign countries

– the ability to record the U.S. registration with the U.S. Customs and Border Protection (CBP) Service to prevent importation of infringing foreign goods

The bottom line is that trademark registration is an investment.  The initial cost (and hassle) is relatively minor, but the protections that come with registration can be invaluable down the road as your brand accumulates goodwill.  If you are an entrepreneur considering registering a trademark and you have questions or want further information, we’d love to hear from you. You can contact us here or tell us more about your mark through our EntreTrademark service.

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THE (NEARLY) COMPLETE GUIDE TO BUYING A BUSINESS & A FULL-TIME JOB

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Scenario: You’re one of a handful of employees at a small bakery, Maddy’s CakeBake, LLC, where you’ve worked closely with the owner Maddy for a couple years.

Maddy owns 100% of the LLC ownership interests, and the company owns all the assets associated with operating CakeBake. One-third of its revenues come from a brisk daily walk-in business where customers order beautiful cupcakes for celebrations and cheat-days. The other two-thirds of revenues are driven by the gourmet wedding cake business that CakeBake operates out of the same kitchen, mainly for weekend events.

While the walk-in counter offerings play an important role in keeping the company’s name in the public eye, the real brand value comes from the wedding cake business. And, the real value in the wedding cake business comes from the goodwill associated with Maddy, whose name is on the business. People call in from the entire state, often paying substantial deposits to reserve her expertise for their special occasion. While all employees help with walk-in counter service as needed, only a select few (including you!) are allowed to assist with wedding orders. You, in particular, have been at the bakery long enough that Maddy often trusts you to handle smaller-dollar clients alone, with only minimal oversight.

The walk-in business requires daily staffing and upkeep for the storefront location, and significant advertising spend to make the bottom line work. It is subsidized by the premium prices that Maddy can charge for her beautiful cakes designs. By contrast, the wedding cake business requires very little in the way of advertising spend; most new customers are referred by friends and family who hired CakeBake for their wedding cake.

Recently, Maddy has mentioned to you that she is planning to step back from the business. She is proud of what she’s built so far, but has recently committed to spending more time with her young children. Although she feels an obligation to all her employees, she approached you as the only person she would trust to carry on the business she built. If you are not interested in taking over the company, she will probably just close up shop. It’s the end of wedding season now, which means the next few months will bring lots of operating costs without much related business income. That make this the perfect time to either transfer ownership or just close up shop.

At present the two of you have come to a handshake deal for some of the terms of a business purchase, but you’re unsure what to do next. You are in touch with the current landlord. Maddy has agreed to be available as an advisor for the first 12 months. The bank says it would consider lending you some money to buy the business, but you haven’t yet nailed down even the essential price or payment terms.

Although you consider yourself an expert on making cakes and cupcakes, you don’t have the first idea about how to run the business side of things. When you confess to the banker that you are feeling overwhelmed, he suggests a lawyer might be able to talk you through the basics of a business acquisition like this. When you Google “How to buy a small business…” – this blog series post pops up…

This fact pattern should help illustrate some of the common issues that people considering buying an operating business encounter. The rest of this post gives the 30,000-foot view–and some of the 10,000-foot-details–of the legal landscape you’ll encounter when considering buying a small business.

Why Even Hire a Lawyer When Buying a Small Biz?

The obvious starting question here is, “Do I need a lawyer at all?”. In many cases, the smaller value of the company–and thus the smaller purchase price–makes hiring a lawyer seem cost-prohibitive. And we don’t disagree that there are plenty of things you can handle perfectly fine without a lawyer’s input; after all, you didn’t get to this position without some savvy and know-how of your own.

That said, chances are you don’t encounter these types of issues every week like we do. Because you’re often putting your own assets (like your home) on the line in order to finance the purchase, the worst case scenario here can start to look pretty ugly. Experienced legal counsel can help you avoid costly but totally preventable missteps during the purchase. If spending a fraction of the deal funds on legal fees now could keep you from losing 100% of your savings and home equity over the next few years (and might help you earn more in the meantime), why wouldn’t you?

Leveling the Playing Field

The outgoing owner has a level of sophistication not only in this business, but also in business in general. Even with a smaller, friendly deal like in our example above, it’s possible that you’d overlook or breeze through deal terms that could return to haunt you later. So even if you have a good working relationship, do your homework by reading this list to make sure that you are speaking the same language.

[Lawyer Caveat: People write entire books on each of these topics. We won’t know your deal exactly until you reach out to us. This list is designed to give you a basic working knowledge of some major areas that you should be discussing as part of the purchase.]

1. Stock Purchase vs. Asset Purchase

For reasons which are explained more fully below, it makes tons of sense to start from the position that you’ll be buying all the assets of the company, and NOT Maddy’s LLC ownership interests. This means that you’d buy all the physical assets of CakeBake – the cake pans, kitchen mixers, display cases and coolers, delivery vehicle, inventory of sugar, butter, flour, etc. You’d also buy all the “intangible” assets (i.e., stuff you can’t physically lay hands on) – rights to use the CakeBake name, any trademarks associated with the brand, any remaining lease rights, transferable insurance policies, and the contract rights for orders and deposits for next wedding season. The key factor here is what you explicitly AREN’T buying – that is, any of the liabilities (that you don’t otherwise want, of course) that would arise from the previous owner’s operations.

Remember, the whole reason you’d purchase a business instead of starting a new one from scratch is that you get something with established market presence that’s ready to operate on day one. There are basically two ways to accomplish this goal.

First, you could give money to the owner in exchange for her ownership interests in the company. This is the instinct of most folks, probably based on a familiarity with how stocks are traded in the market. However, this leaves the possibility of unknown and unanticipated liabilities popping up post-sale.

In our example, this could look like a dissatisfied former customer from the recent wedding season returning with a claim for reimbursement of some of their money. Since you would now own the entity that signed the contract with that customer, you’d be on the hook for any payment owed. Seems unfair to you, who had no ability to control the situation in the first place, no? All other things being equal, you’d rather not have potential liability hanging around from when the previous owners were in charge, right?

Enter the asset purchase agreement. This is the structure we almost always default to when first considering a business acquisition. In this structure, the buyer offers to purchase all the assets of the business, which can include tangible assets (think furniture, fixtures, and equipment), intellectual property (including trademarks, copyrights, patents, and trade secrets), interests in real estate (deeds and/or leases), and any contracts already in play (assuming they can be assigned to a new entity).

The buyer then forms a new entity for the transaction, and buys all the assets while specifically stating that it is buying none of the liabilities of the old business. This is the key advantage of the asset purchase over the stock purchase — getting to pick and choose which liabilities the buyer is willing to take on. In our example, the new owner would have the opportunity to buy the existing contracts for next season’s wedding cakes and the remaining rights under the bakery’s lease, without having to worry about, say, slip-and-fall claims from a customer that happened years before the business sale.

There are exceptions to this general rule, of course. As an example, a landlord may allow a new owner to assume the responsibility for paying rent instead of signing a new lease. The obligation to pay rent is technically a liability, but it is one that a new owner might prefer for the convenience of staying in the same location. You might also only be in a position to buy part of the business assets; in that case, a full asset purchase isn’t possible. Some other exceptions involve intricate tax considerations and specialized intellectual property concerns. These are beyond the scope of this short article, but a consultation with an experienced attorney (like us) can help steer you toward the right answers.

2. Financing

Of course, when becoming a business owner, one of the most important pieces of the puzzle is how to pay for it. This assumes you’ve determined the company’s value, a subject elaborated on below.

For a buyer whose largest purchase to date is their home, and who does not have enough cash on hand for the whole price, they might assume that their only option is one large bank loan to cover any shortfall. Banks are certainly willing to discuss traditional loans for business acquisitions, and there are special programs (like SBA loans) tailored for these relatively smaller dollar situations. Similarly, wealthy individuals in a buyer’s network (or not, in some cases) can provide access to capital on favorable terms.

However, our general advice is to insist on at least some “seller financing.” Paying via a lump sum upfront lets the seller off the hook immediately, shifting all the risk that the business doesn’t continue to perform as advertised onto the buyer. (Of course, if you’re a seller reading this, that’d be a desirable position to take!) Thoughtfully combining multiple financing options is part of many successful small business deals.

On the other hand, insisting that the seller’s payout remain tied to the ongoing success of the business gives the buyer someone else to share the burden of a bad week/month/year. It’s important to remember here that one of the core assumptions in valuation for a business for sale is that it will continue to generate similar revenues in the future. If that assumption is faulty because of intentionally undisclosed material information, the buyer could sue for fraud. But, that means an expensive legal fight for an already struggling business. The easier way to share the fallout of even an innocent misrepresentation is to make the seller your “partner” by conditioning their payout on the business’s continued success.

There are a few ways that seller financing can work in our example scenario. Each of the first two examples assumes the deal is structured as an asset purchase instead of a stock sale.

First, and probably most familiar to first-time biz buyers, is a simple loan by the seller. Using our hypothetical scenario, it would look like this: you and Maddy would agree on a final price, likely with some small down payment. For the balance of the funding, Maddy would agree to accept periodic payments with some level of interest.

Often the payoff arrangement looks exactly like your home mortgage — in exchange for a promise to pay a little bit each month over time, the lender (here, the seller) demands a “security interest” in all the assets that she is selling to you. Your failure to make payments on time will give Maddy the right to protect her interests by foreclosing on the note and reclaiming enough of the assets. In the simple* worst case scenario here, the business fails and the seller/lender gets to take back all the assets in repayment of the debt they are owed, but the buyer shuts down the business but does not* lose their home.

[*The more complex reality is that lenders often require a personal guaranty to secure repayment of a loan like this. We will discuss guaranties more fully later on, and they unfortunately increase the risks to a borrower’s personal, non-business assets.]

A second common way to arrange seller financing is via an earn-out. Earn-outs are similar to seller loans, in that the seller agrees to accept smaller-ish amounts over a set period of time, instead of the entire lump sum upfront.

However, earn-outs differ from loans in that the payments actually fluctuate with business performance, as measured by some earnings metric (think: EBIT, EBITDA, NOI, etc.). This protects the buyer if the business doesn’t perform or grow as advertised; it can also be attractive to sellers, who will be able to share in any upside should the business become even more successful post-sale. Because the payments are based on the particular earnings metric, it becomes critical to define it carefully at the outset.

There are a variety of ways to tailor an earn-out to a particular deal. Earn-outs can include floors and ceilings for each payment, to protect either side from unexpectedly large fluctuations. They can also be time-limited, where the buyer only has to make a certain number of payments regardless of performance. In addition, earn-outs for cyclical businesses can include “catch-up” provisions, which even out payments over time. In any of these circumstances, earn-outs can be the main financing method, or merely one of several complementary options.

Third, a buyer could accomplish transition in ownership by doing periodic redemptions (~buybacks) of the owner’s stock. This is option can be particularly attractive for an employee that already holds some ownership interest in the company and/or will need substantial support from the selling owner before they can run the business solo. A financing structure involving redemptions will set some periodic dates when the outgoing owner will sell back some portion of their ownership interest for an agreed price. Similar to earn-outs, the price can be based on an earnings metric to protect the buyer (from underperformance) or reward the seller (for overperformance).

Clearly, business-purchase financing methods and mix are myriad (yay, alliteration!). Lawyers are valuable not only in counseling, but also in protecting your interests during the implementation.

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