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.
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.