As a corporate attorney as a large law firm, I worked mainly for buyers (often a private equity firm) purchasing private companies. We often saw smaller companies, without an army of lawyers, overlook issues in the purchase agreement. Here’s some of the common areas someone selling their business should look out for:
Purchase Price: How much money are you actually getting?
Earn-Out: What target do I need to reach?
Many sellers are under the impression that when they sold their business, they just get a check when the agreement’s signed and that’s that. It rarely works that way. A buyer often wants to hold back some of the purchase price and require the seller to “earn it” by hitting a certain financial goal. A buyer might say “I’m willing to pay $500,000 for your business - but only $400,000 now, and another $100,000 only if EBITDA next year reaches a certain amount.”
First, make sure that you’ll actually be able to influence the operations of the company during the earn-out period. Don’t let a buyer take over the company and intentionally miss the earn-out target so it doesn’t have to pay the entire price.
Second, make sure you put restrictions on what the buyer can do during the earn-out period. You don’t want to allow the buyer to incur a huge expense that hurts EBITDA during the earn-out period.
Materiality: What’s important and what’s not?
You’ll see “material” and “material adverse effect” everywhere in the agreement. Materiality is a strange concept. Lawyers basically invented it as a way to make sure that “foot faults” - minor slip-ups - are excluded. If the seller says “there aren’t any worker’s comp claims against us,” but then an employee comes forward with a $50 overtime claim, technically that statement is false. But if you say “there aren’t any material worker’s comp claims against us,” then you may be covered. What does “material” legally mean? No one really knows - there isn’t a clear legal standard. The purchase agreement itself will define it, and you’ll probably end up arguing a lot about what “material” means.
Representations: What’s true about your business?
Representations are a section of the purchase agreement where the seller promises, or represents, that certain facts about the business are true. Usually they cover things like “no one’s suing the business” and “the business has paid all its taxes” It ends up being a heavily negotiated section of the agreement.
Knowledge: Who knows what?
You want to make sure that only the right people are saying that these things are true. Some small businesses have investors that are family members or other investors that don’t have day-to-day knowledge of the company. They shouldn’t be on the hook if something goes wrong.
Representations: What do they know?
Lawyers like to throw in language in the representations, so read them carefully. You won’t want to say “no lawsuits against us exist” without qualification. It might be true, but what if someone is preparing a lawsuit right now and you find out the day after you sign the agreement? For this reason, you’ll want to qualify what you’re saying: “no lawsuits against us exist, as far as we know.” Also, remember materiality here: “no material lawsuits against us exist, as far as we know.”
Indemnification: What happens if something isn’t true?
Indemnification is a fancy word that covers what you’re on the hook for after you sell. For example, what happens if the IRS audits the company a year after the sale? Will you have to pay any penalties? It’s one of the most heavily negotiated and important sections of the agreement, and also one filled with the most legalese.
Survival: How long do you need to worry?
The survival period is how long after the sale you’re indemnifying the buyer. You’ll want to make it as short as possible. You’ll probably end up somewhere in the range of 12-24 months, maybe with different time periods for certain representations (like tax or environmental matters).
Deductible/Cap: How much are you on the hook for?
An indemnity deductible works like an insurance deductible, with you as the insurer. For example, if the indemnity deductible is $10,000, you won’t have to cover anything like a worker’s comp or tax claim until it’s worth $10,001. After that, you’re “insuring” or covering the cost of the claim. Likewise, the cap places a limit on how much you have to cover. This is usually a percentage of the purchase price. Buyers and sellers go back on forth on indemnity for a long time, and the mechanics can get really complicated. It’s important for the business owners, not just the lawyers, to understand it.
Materiality: What are you covering?
This is a tricky one I saw often. The buyer will often try to say something like “materiality doesn’t matter for purposes of indemnification” - basically, this strips out all the work you did putting materiality in the representations! I’ve seen this slip past a lot of expensive lawyers.
Non-Compete: What can you do after you sell your business?
The non-compete agreement is usually a separate agreement, but it’s usually negotiated at the same time. It covers what you can and can’t do after you sell your business.
Restricted Activities: What can you do?
Make sure that you can do what you want after you sell your business. Maybe another business opportunity comes up and it’s related to the business you sold - are you allowed to pursue it? This can be annoying because you might go back and forth on specific language, but it’s worth spending time on it. I had a family friend sell her online business and continue in the same industry with a brick and mortar store. Her non-compete agreement stated she couldn’t have anything online - but could she have a Yelp listing? The agreement didn’t say, so she was basically at the mercy of the buyer.
Restricted Area and Period: Where and for how long?
Make sure you’re not restricted in too big an area (“the state of California”) or for too long (“five years”). Of course it’s hard to predict what’s going to happen, but push back on this. State law often comes into play here, defining what a reasonable area and time are.
This isn’t meant to be comprehensive, and you should always get your own legal advice, but hopefully this helps anyone here who’s thinking about selling their business. Just being familiar with some of the issues can help a lot.
Purchase Price: How much money are you actually getting?
Earn-Out: What target do I need to reach?
Many sellers are under the impression that when they sold their business, they just get a check when the agreement’s signed and that’s that. It rarely works that way. A buyer often wants to hold back some of the purchase price and require the seller to “earn it” by hitting a certain financial goal. A buyer might say “I’m willing to pay $500,000 for your business - but only $400,000 now, and another $100,000 only if EBITDA next year reaches a certain amount.”
First, make sure that you’ll actually be able to influence the operations of the company during the earn-out period. Don’t let a buyer take over the company and intentionally miss the earn-out target so it doesn’t have to pay the entire price.
Second, make sure you put restrictions on what the buyer can do during the earn-out period. You don’t want to allow the buyer to incur a huge expense that hurts EBITDA during the earn-out period.
Materiality: What’s important and what’s not?
You’ll see “material” and “material adverse effect” everywhere in the agreement. Materiality is a strange concept. Lawyers basically invented it as a way to make sure that “foot faults” - minor slip-ups - are excluded. If the seller says “there aren’t any worker’s comp claims against us,” but then an employee comes forward with a $50 overtime claim, technically that statement is false. But if you say “there aren’t any material worker’s comp claims against us,” then you may be covered. What does “material” legally mean? No one really knows - there isn’t a clear legal standard. The purchase agreement itself will define it, and you’ll probably end up arguing a lot about what “material” means.
Representations: What’s true about your business?
Representations are a section of the purchase agreement where the seller promises, or represents, that certain facts about the business are true. Usually they cover things like “no one’s suing the business” and “the business has paid all its taxes” It ends up being a heavily negotiated section of the agreement.
Knowledge: Who knows what?
You want to make sure that only the right people are saying that these things are true. Some small businesses have investors that are family members or other investors that don’t have day-to-day knowledge of the company. They shouldn’t be on the hook if something goes wrong.
Representations: What do they know?
Lawyers like to throw in language in the representations, so read them carefully. You won’t want to say “no lawsuits against us exist” without qualification. It might be true, but what if someone is preparing a lawsuit right now and you find out the day after you sign the agreement? For this reason, you’ll want to qualify what you’re saying: “no lawsuits against us exist, as far as we know.” Also, remember materiality here: “no material lawsuits against us exist, as far as we know.”
Indemnification: What happens if something isn’t true?
Indemnification is a fancy word that covers what you’re on the hook for after you sell. For example, what happens if the IRS audits the company a year after the sale? Will you have to pay any penalties? It’s one of the most heavily negotiated and important sections of the agreement, and also one filled with the most legalese.
Survival: How long do you need to worry?
The survival period is how long after the sale you’re indemnifying the buyer. You’ll want to make it as short as possible. You’ll probably end up somewhere in the range of 12-24 months, maybe with different time periods for certain representations (like tax or environmental matters).
Deductible/Cap: How much are you on the hook for?
An indemnity deductible works like an insurance deductible, with you as the insurer. For example, if the indemnity deductible is $10,000, you won’t have to cover anything like a worker’s comp or tax claim until it’s worth $10,001. After that, you’re “insuring” or covering the cost of the claim. Likewise, the cap places a limit on how much you have to cover. This is usually a percentage of the purchase price. Buyers and sellers go back on forth on indemnity for a long time, and the mechanics can get really complicated. It’s important for the business owners, not just the lawyers, to understand it.
Materiality: What are you covering?
This is a tricky one I saw often. The buyer will often try to say something like “materiality doesn’t matter for purposes of indemnification” - basically, this strips out all the work you did putting materiality in the representations! I’ve seen this slip past a lot of expensive lawyers.
Non-Compete: What can you do after you sell your business?
The non-compete agreement is usually a separate agreement, but it’s usually negotiated at the same time. It covers what you can and can’t do after you sell your business.
Restricted Activities: What can you do?
Make sure that you can do what you want after you sell your business. Maybe another business opportunity comes up and it’s related to the business you sold - are you allowed to pursue it? This can be annoying because you might go back and forth on specific language, but it’s worth spending time on it. I had a family friend sell her online business and continue in the same industry with a brick and mortar store. Her non-compete agreement stated she couldn’t have anything online - but could she have a Yelp listing? The agreement didn’t say, so she was basically at the mercy of the buyer.
Restricted Area and Period: Where and for how long?
Make sure you’re not restricted in too big an area (“the state of California”) or for too long (“five years”). Of course it’s hard to predict what’s going to happen, but push back on this. State law often comes into play here, defining what a reasonable area and time are.
This isn’t meant to be comprehensive, and you should always get your own legal advice, but hopefully this helps anyone here who’s thinking about selling their business. Just being familiar with some of the issues can help a lot.
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