This article discusses the elements of buying or selling a small business LLC in Texas, whether the business is focused on real estate investment or otherwise. The heart of the transaction is the purchase and sale agreement (entered into in anticipation of a closing to be held later) which resembles an earnest money contract to sell real estate. In fact, if the business owns real property, then the agreement may also serve as a contract to convey that property.
It is a consistent rule of thumb relating to the sale of a business: The transaction is never as simple or inexpensive as the seller and buyer would like it to be. The complexity, due diligence burden, and professional expense (lawyer, CPA, business broker, appraiser, etc.) incurred by both sides in such transactions often substantially exceeds that which would accompany a comparably-sized sale of real estate alone.
The Purchase and Sale Agreement
The purchase and sale agreement will, at the very least, identify parties and the business to be sold; state whether the sale is a transfer of a company as an entity or of assets only, and then list those assets; specify the sales price and how it will be paid; provide for earnest money; include an inspection period for the buyer’s due diligence; contain representations and warranties by both seller and buyer; provide protections for confidential information; specify conditions precedent that must be met for the transaction to close; and provide remedies in the event either party defaults. Various exhibits and attachments (deeds, an inventory of personal property, a list of liabilities, a copy of the office lease, copies of employee agreements, etc.) should accompany the purchase and sale agreement.
If realty is involved then brokers will likely use the Texas Association of Realtors Commercial Contract – Improved Property (Form 1801) with appropriate addenda in order to make an offer on the property. Why not simply add the Non-Realty Items Addendum and use this contract to buy both business and realty? This is generally an inadequate approach unless the business is dormant and consists of nothing more than a few tables and chairs. Reason? A going business has many more variables and factors that need to be considered. Buying a business is similar in many ways to buying real estate, but nonetheless materially different in critical respects. More often than not, a standard real estate contract is just not up to the task.
At closing, documents in addition to the purchase and sale agreement will be required, for example: a deed of real property to the new owner; if an asset sale, a bill of sale for inventory as well as furniture, fixtures, and equipment; a promissory note and security agreement if there is seller financing; a deed of trust if a loan against realty is involved; approval by the landlord for the buyer to assume an existing lease; a customer or client list; various assignments; notice letters to customers and vendors; UCC forms; and other documents necessary to create a smooth and secure transition to new ownership.
The first step is to ascertain the identity of seller and buyer. Is the seller a sole proprietorship? A corporation? An LLC? A determination needs to be made as to who actually owns the enterprise that is being transferred, who has authority to speak for and convey the business, and whose consent must be obtained (this may include spouses). If the selling entity is a corporation or an LLC, then that entity will need to be in good standing with the Secretary of State and Comptroller and have proper, up-to-date records that the buyer should carefully examine as part of the due diligence process.
Similarly, will the buyer be an LLC? An individual or a partnership of individuals? It is often advisable to establish an LLC to take title to and operate a newly acquired business. This is done for reasons of liability protection as well as convenient allocation of percentage interests among persons participating. If the buying entity is as yet unformed or unknown, the buyer should be listed by name in the agreement plus the phrase â€œand/or his assigns,â€ thereby providing an opportunity to get an entity formed prior to closing of the sale.
Similarly, will the buyer be an LLC? An individual or a partnership of individuals? A joint venture of LLCs? If the buying entity is as yet unformed or unknown, the buyer should be listed by name in the contract or agreement followed by the phrase “and/or his assigns (Buyer may assign without notice to or consent from Seller)” thereby providing an opportunity to get an entity formed and membership issued prior to closing of the sale.
It is often advisable to establish a single purpose entity (SPE) to take title to and operate a newly-acquired business. Most businesses of substance merit their own, stand-alone LLC. This is done for obvious reasons of liability protection as well as convenient allocation of percentage interests among the investors participating.
Sale of Assets or Entity?
In buying a business, the buyer can acquire either the assets of the enterprise or the entity that owns those assets. In an asset sale, the assets transferred are specifically listed, as are the assets that are excluded. Ownership of the entity remains with the seller, as do the entities debts and liabilities, unless specific exceptions are made. In the sale of a corporation or LLC, the seller’s stock or membership interest is assigned and transferred to the buyer. Since ownership of assets remains with the entity, a warranty deed and bill of sale is are not usually required.
Buyers’ counsel generally prefer an asset purchase because it comes without the potential for hidden or undisclosed liabilities. On the other hand, acquiring the seller’s entity may be accompanied by advantages such as an existing credit rating, established vendor accounts, or lines of credit. However, buying an entity may significantly increase the amount of due diligence that must be performed by the buyer.
The Sales Price
As with any transaction, the sales price can be paid in cash, partly in cash and partly by bank or SBA financing, or by means of cash plus seller financing. Existing indebtedness may also be wrapped or taken “subject to.” In the case of third-party financing, the buyer will want closing to be contingent upon obtaining financing approval. If the deal is seller-financed, the seller will want to evaluate and qualify the buyer before giving final approval for closing. If either contingency fails, then all or part of the earnest money is usually refunded, less any independent consideration paid for the inspection period.
How the sales price is divided up—between inventory, furniture, fixtures, and equipment, goodwill, and the like—is less a matter of legal principle than old-fashioned common sense. Caution to buyers: Do not overpay for goodwill. Often the single most valuable assets of a business (a service business in particular) are its employees and its lease, or what remains of it.
It is generally in the seller’s best interest to provide that if the business is subsequently transferred, any outstanding seller financing must be paid in full (a due-on-sale clause). The seller should also reserve the right to inspect the business and its records to assure continued compliance with the purchase and sale agreement.
Due Diligence and the Inspection Period
Nothing is more critical for the buyer than effective use of the inspection period to perform prudent due diligence. What kind? The following is a basic list excerpted from a purchase and sale contract:
(a) (a) physical inspections, including inspections of the business premises, inventory, furniture, fixtures, and equipment; (b) economic and financial evaluations including but not limited to a detailed examination of the books and records of the business; annual and quarterly tax returns as well as ad valorem tax records; records of utilities usage; any agreements with contractors and/or employees; financial statement of the business; (c) current credit report; (d) marketing evaluation, including examination of the customer/client list, receivables history, and related files; and (e) any appropriate environmental assessment or engineering study including performance of tests such as soil tests, phase I or II environmentals, materials tests, equipment tests, and air sampling.
Depending on the nature and circumstances of the business to be sold, one could easily come up with additional items for scrutiny.
The important point for the buyer is to be able to terminate the contract prior to expiration of the inspection period, if the business is unsuitable for the buyer’s intended purpose, is not in satisfactory physical or financial condition, or is otherwise unacceptable for any reason. Timely termination allows the buyer to receive the return of the earnest money less the inspection consideration. If the results of the buyer’s inspections are satisfactory, it is common for additional earnest money to be due at that point. In fact, investors should generally want to structure payment of earnest money in two parts, even in purchases of rental houses: a modest initial amount followed by payment of additional earnest money after due diligence is completed.
Paradoxically, or so it would seem, the seller wants the buyer to have a right to terminate. Why would the seller of a business want a reluctant buyer, particularly if the seller is going to finance him?
Attempting to cut corners in the area of due diligence can have calamitous consequences. Buyers and sellers seeking to avoid legal fees may use some sort of contract off the Internet, not even knowing if it is valid in Texas, and when one party defaults, make the unpleasant discovery that litigation costs far exceed the expense of having properly documented the transaction in the first place.
Representations and Warranties
Both seller and buyer usually make representations and warranties (“reps and warranties”), breach of which is a default or at least a basis for terminating the agreement. Reps and warranties can be made to survive closing, survive closing for a limited time, or not survive closing at all. Buyers want the seller’s reps and warranties to be broad and extensive in time and scope; sellers naturally want to limit their ongoing liability, preferring that reps and warranties expire at closing and merge into the closing documents, thereby putting a period on liability.
Examples of typical seller’s reps and warranties include an assurance of authority to enter into the transaction; good and marketable title to the assets; full disclosure of liens and liabilities; no litigation pending or threatened; and the like. A buyer’s focus is on full disclosure. A seller often wants to eliminate reps and warranties entirely and convey the business “as is”—something only foolish buyers go for. The result is usually a compromise.
For their part, buyers need to assure the seller of sufficient expertise and financial soundness to fund operations and pay liabilities as they arise. No seller wants to have to take a business back and sell it a second time.
Confidential information about the business will likely be revealed during the course of the buyer’s due diligence, and the seller has a right to demand that this remain permanently confidential. In addition to proprietary information about products, services, marketing strategies, and so forth, the seller is also in possession of sensitive information about employees and co-owners. As a result, the purchase and sale agreement should include a strict covenant on the part of the buyer, enforceable by injunction if necessary, not to reveal confidential information at any time to third parties. This covenant should apply whether or not the deal eventually closes. It should also prohibit the buyer from utilizing the information in order to compete with the seller in the future.
Seller’s Covenant Not to Compete
If the transaction closes, a legitimate concern of the buyer is that the seller may set up shop nearby and continue in the same line of work. Accordingly, the purchase and sale agreement should usually contain a covenant by the seller not to compete with the buyer. Courts have upheld non-compete agreements so long as they are reasonable in duration and in geographical scope. What is reasonable? Like so much in the law, it depends. In the Houston area, for example, there are three large counties (Harris, Fort Bend, and Montgomery) that vie for the metropolitan area’s business. Therefore, any meaningful covenant not to compete would include these three counties.
The seller should also be prohibited from soliciting the buyer’s customers and employees. This can happen in subtle ways so the agreement needs to be carefully drafted to encompass both direct and indirect action of this sort.
At some point the deal must close or the sale fails, so there should be a date certain for closing. Certain items (ad valorem taxes, receivables, and current rent, for instance) may need to be prorated. If real property is involved, the buyer should weigh the need for title insurance versus obtaining a title report or abstract of title. If title insurance is not required, closing at an attorneyâ€™s office is just as effective as closing at a title company and it may be a lot faster.
When closing at a title company, it is not advisable to allow the title company attorneys to prepare documents for the sale of a business. There are two reasons for this: first, they represent the title company, not the buyer or seller, and have no incentive to draft documents in anyone’s best interest other than that of the title company; second, sales of businesses are not usually their expertise; and third, they will likely draft minimalist documents that may not address all concerns of buyer and seller.
Every contract should specify what happens in the event one party fails to perform. Typically, the seller will want to provide for minimal liability if he defaults—the buyer gets to keep the earnest money as liquidated damages and the agreement terminates. Similarly, if the buyer defaults, the seller should be content with keeping the earnest money and moving on to the next buyer. The remedy of specific performance is not usually a practical or effective remedy against buyers, so it is of no great importance if the seller waives it.
A buyer wants more. After all, a buyer is expending more than just earnest money. The cost of effective due diligence can be many thousands of dollars and if the seller changes his mind about selling then the buyer may be substantially out-of-pocket. The agreement should therefore provide that the buyer can recover these expenses from a defaulting seller. The buyer will also want to reserve the right to sue for specific performance, a meaningful remedy for a buyer.
If a buyer defaults post-closing (usually for not paying a seller-financed note), the seller’s remedies are contained in the note and security agreement and, if real estate is involved, in a deed of trust (or a combined deed of trust and security agreement). Essentially, the seller’s remedy is to take the business and property back. This is usually a disaster since inventory is depleted, equipment missing, the lease is in arrears, and customer goodwill is down the drain. It is therefore critical that a seller choose the right buyer to begin with and get a solid down payment.
Get a Good Business Attorney
Both buyer and seller should get an experienced business transactions lawyer and listen to his or her advice. Clients are often driven by emotions—the desperate desire to get rid of a business or an irrational determination to acquire one. Since the lawyer does not usually receive a commission, he or she has no stake in the transaction and may be the only person providing factual and objective advice.
Information in this article is provided for general informational and educational purposes only and is not offered as legal advice upon which anyone may rely. The law changes. While we respect your confidentiality, no attorney-client relationship is created by the offering of this article. This firm does not represent you unless and until it is retained and expressly agrees in writing to do so. Legal counsel relating to your individual needs and circumstances is advisable before taking any action that has legal consequences. Consult your tax advisor as well.
Copyright © 2019 by David J. Willis. All rights reserved worldwide. Mr. Willis is board certified in both residential and commercial real estate law by the Texas Board of Legal Specialization. More information is available at his website, LoneStarLandLaw.com.