This article discusses the elements of buying or selling a small business in Texas, whether the business is focused on real estate 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.
There 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, and professional expense (lawyer, CPA, business broker, appraiser, etc.) incurred by both sides often substantially exceeds that which would accompany a comparably-sized sale of real estate alone.
The process has three main parts: negotiation and execution of the purchase and sale agreement; the inspection period for buyer due diligence and obtaining financing; and closing.
PURCHASE AND SALE AGREEMENT
Basics of the Agreement
The purchase and sale agreement will, at the very least, identify the parties and business to be sold; state whether the sale is a transfer of 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 parties; provide protections for confidential information; specify conditions precedent that must be met for the transaction to close; and provide remedies for default. Various exhibits and attachments (deed, an inventory of personal property, a list of liabilities, the office or building lease, copies of employee agreements, etc.) will accompany the purchase and sale agreement.
If realty is involved, one occasionally sees real estate brokers use the Texas Realtors Commercial Contract—Improved Property (TXR 1801) combined with the Non-Realty Items Addendum (TREC OP-M) in order to construct a rough business purchase and sale agreement. This is 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. A standardized contract intended to convey only real estate is just not up to the task.
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, 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—or it will not be legally able to do any kind of business at all.
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 purchase and sale agreement should be made expressly assignable to the new entity. This provides an opportunity for the buyer to get an entity formed and membership issued prior to closing.
It is usually advisable for the buyer to establish a single purpose entity (SPE) to take title to and operate the 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 allocation of percentage interests among participating investors.
Sale of Assets or Entity?
The buyer of a business can acquire either the assets of the enterprise or the entity that owns those assets—or perhaps a creative combination of both.
In an asset sale, the assets to be transferred are specifically listed, as are the assets that will be excluded. Ownership of the entity remains with the seller as do the entity’s debts and liabilities unless specific exceptions are made.
In an entity sale, the seller’s stock or membership interest is assigned and transferred to the buyer. Since ownership of assets remains in the name of the entity, a warranty deed and bill of sale are not usually required.
Buyers usually prefer an asset purchase because it comes without the potential for hidden or undisclosed liabilities. On the other hand, acquiring the seller’s entity can have certain advantages—an existing credit rating, established vendor accounts, lines of credit, and so forth. An entity purchase can significantly increase the amount of due diligence required of the buyer.
If assets to be transferred are going to be listed in the purchase and sale agreement then debts to be assumed (and excluded) should be listed on a separate exhibit.
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 common sense. Often the single most valuable assets of a business (a service business in particular) are its employees and its lease.
If seller-financing is provided, the seller will want to include provisions to protect his ongoing interests. This would include the right to inspect the business and its records from time to time to assure that its operations and value are being maintained. The seller will also want a due-on-sale clause in the security instrument permitting acceleration of the seller-financed note if the business is later sold to someone else.
Representations and Warranties
Both seller and buyer usually make representations 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; currency of liens and liabilities; no litigation pending or threatened; and the like.
A buyer’s focus is on full disclosure of material facts, conditions, and circumstances—so a buyer will seek representations and warranties from the seller providing for access and full disclosure.
Most sellers would prefer to eliminate representations and warranties entirely and convey the business “as is, where is.” The result is usually a compromise.
If there is seller financing, a buyer will 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.
The purchase and sale contract should specify what happens in the event one party fails to perform. Remedies should be specified and, if appropriate, limited.
Typically, a seller wants to incur minimal liability if he defaults. Sellers prefer that the buyer receive return of the earnest money as liquidated damages and the agreement terminates.
As for buyer default, the buyer usually wants the seller to be content with keeping the earnest money and moving on to the next buyer. Accordingly, buyers should seek to strike specific performance as a seller remedy.
Some buyers will want more in the way of remedies against a defaulting seller. After all, a buyer is expending more than just earnest money. The cost of effective due diligence can be many thousands of dollars. If the seller changes his mind and decides not to close then the buyer may be substantially out-of-pocket. A careful buyer will want the purchase and sale agreement to provide for reimbursement of these pursuit costs. The buyer will also want to reserve the right to sue for specific performance.
If the transaction is seller-financed and the buyer subsequently defaults, the seller’s remedies will be contained in the note and security agreement executed at closing. In most such scenarios, 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.
Protecting Confidential Information
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 may also be in possession of sensitive information about employees and co-owners.
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 same market in the future.
Buyer Due Diligence
Nothing is more critical for a buyer than effective use of the inspection period to perform thorough due diligence. The following is a basic list:
(1) physical inspections, including inspections of the business premises, inventory, furniture, fixtures, and equipment;
(2) examination of books and records including receivables history and related files; annual and quarterly tax returns as well as tax records; records of utilities usage; existing agreements with vendors, contractors, and employees; and a financial statement of the business;
(3) business appraisal;
(4) current credit report;
(5) evaluation of the customer or client list;
(6) environmental assessment.
Many more items can be added to this list depending on the nature and circumstances of the business to be sold.
Buyer’s Option to Terminate
A buyer will want to be able to terminate the contract prior to expiration of the inspection period if the business is unsuitable for the buyer’s purposes, 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 independent consideration for the inspection. If the results of the buyer’s inspections are satisfactory, it is common for additional earnest money to be due at that point, after due diligence is completed.
At closing, documents required may include 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 the 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.
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.
When closing at a title company, it is generally not advisable to allow the title company attorneys to prepare documents for the sale of a business. There are three 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 within their expertise; and third, they will likely draft brief minimalist documents that may not comprehensively address all parties’ concerns.
Seller’s Covenant Not to Compete
A legitimate concern of the buyer is that the seller may set up shop nearby and continue in the same line of work, so the purchase and sale agreement will often 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 probably include these three counties.
The buyer will also want the seller to be prohibited from soliciting existing customers and employees. This can happen in subtle ways so closing documents need to be carefully drafted to encompass both direct and indirect action of this sort.
Get a Good Business Attorney
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. This is a bad strategy. It may result in the unpleasant discovery that litigation costs far exceed the expense of having properly documented the transaction in the first place.
Both buyer and seller should get an experienced business transactions lawyer and listen to his or her advice. Clients may be 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 may be one of the few participants in the process offering 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 © 2023 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.