Deal Structure
By Jason Watson (Google+)
Posted September 2, 2014
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You will probably need an attorney’s advice for your purchase agreement, but here are some highlights to get the creative juices flowing.
Revenue Guarantees, Holdbacks
Many times, especially in service oriented businesses, a buyer is purchasing future cash flows. Therefore if revenue drops off during transition and subsequent ownership transfer, the value of acquisition is reduced. A buyer should protect him or herself by including a revenue guarantee from the seller.
The contract should define the period of time, the guarantee amount and the modification of purchase price. In a contract with seller financing, a reduction in loan balance or debt forgiveness would essentially reduce the purchase price. In cash deals, it is smart to keep a portion of the purchase price in the holdback escrow account. A holdback is where funds are held until certain milestones or obligations- very useful for revenue guarantees, warranty work, work in progress, and any other unknowns.
A buyer could protect themselves with a pay-as-you-go plan. Again, this is useful in a service oriented acquisition where revenues collected are then turned over to the seller using a gross revenue factor.
Seller Financing
A buyer wants the seller to have some skin in the game or dog in the fight, or whatever euphemism you like. And, many SBA loans want this as well. It adds motivation for the seller to ensure the buyer’s success during transition.
Due Diligence
Due diligence is a big deal, and it varies by the size of the contract. Sellers have been known to frontload projects or simply inflate sales in an attempt to look attractive to suitors. There are two quick ways to discover that a buyer might have a problem which warrants deeper investigation.
First, tax returns should be reviewed. If the most recent tax return’s income is substantially higher than the first two in a three-year look back, you might have a seller inflating the numbers. Remember, as a business owner you want to minimize your tax consequence so a tax return can be a good litmus test of a business’ income. Second, a quick tally of deposits should get close to the income numbers on a tax return. Yes, a seller could trickle cash deposits into the bank account to inflate numbers. But when you combined these two quick reviews you can get a good idea of how the business performs.
After that, the sky is the limit on the things a buyer should review. Employment contracts, vendor contracts, title searches and encumbrances, technology of the business, etc.
Work in Progress
Who will be responsible to complete projects that straddle the closing of the sale and purchase? What percentage of completions are agreed upon? How will the revenue collected be assigned and used in revenue guarantee calculations? Any prepayments, deposits or retainers?
Similar to work in progress, or WIP as accountants say, is warranty work. How is that handled? These are all questions that need to be broached, discussed and agreed upon.
Lawyer Stuff
Representations and warranties are attorney nomenclature that need to worm their way into a decent contract. Representations are things that you believe to be true or those things that a reasonable person would expect you to represent as true. Warranties are things that you are guaranteeing to be true, which is a much higher standard. Don’t fret over this stuff too much, your attorney will hammer it out.
Indemnification, damages and arbitration are some more terms that you’ll find in a contract to protect all the parties’ interests.
Non-Compete Agreements
While non-compete agreements or covenants not to compete continue to get litigated with limited success for the buyer. There are three elements that routinely cause these agreement to get tossed- restricted activities being too vague, restricted are being too broad and time period being too long. In addition, a non-compete agreement cannot prevent someone from earning a living in their chosen profession. On the following page is some language that was used in a purchase contract of a service oriented company-
For good and valuable consideration received as part of this Agreement, Seller herein agrees that for Five (5) years after Closing (the “Restricted Period”), Seller shall not engage in any Competitive Activity, being the current activity of the Seller, within a 100 mile radius of Anytown USA (the “Restricted Area”). During the Restricted Period in the Restricted Area, Seller shall not, except insofar as the restrictions are for the benefit of Buyer:
1. Canvas, solicit, or accept any business from any present, clients or new clients of Seller, unless actions are in attempt to gain business for Buyer’s sole benefit;
2. Give any other person, firm, partnership, or corporation the right to canvas, solicit, or accept any business for any other firms from any present or past clients of Seller;
3. Directly or indirectly request or advise any present or future clients of Seller to withdraw, curtail, or cancel its business with Buyer;
4. Directly and indirectly disclose to any other person, firm, partnership, or corporation the names of past or present clients of Seller;
5. Solicit, induce or attempt to influence any employee, independent contractor or supplier of Buyer to terminate employment or any other relationship with business of Buyer or the prior business of Seller.
Seller acknowledges that the restrictions contained in the foregoing sections, in view of the nature of the business in which Buyer is engaged, are reasonable and necessary in order to protect the legitimate interests of Buyer, that their enforcement will not impose a hardship on Seller or significantly impair Seller’s ability to earn a livelihood and that any violation thereof would result in irreparable injuries to Buyer. Seller therefore acknowledges that, in the event of Seller’s violation of any of these restrictions, Buyer shall be entitled to obtain from any court of competent jurisdiction preliminary and permanent injunctive relief as well as damages and an equitable accounting of all earnings, profits and other benefits arising from such violation, which rights shall be cumulative and in addition to any other rights or remedies to which Buyer may be entitled.
Ok. Don’t run out, copy and paste this into your contract and think you are good to go. Every deal and every jurisdiction will require tweaks here and there, but you get the general idea. Basically it will be hard for a buyer to prevent a seller from competing for a livelihood, but a buyer can prevent a seller from poaching their previous clients. Talk to an attorney.
Small Business Administration Loans
The SBA does a wonderful job of providing people with loans for startup and business acquisition purposes. The terms are extremely favorable yet the fees can be a bit high (2-4% of loan value). The SBA uses approved lenders such as Wells Fargo to put deals together, and the process can take 12-16 weeks. Yes, they advertise 8-10 weeks, but in our experiences with consulting on other business acquisitions the process is longer.
Common deals are an 80-10-10, where the SBA lends 80%, seller finances 10% and the buyer brings 10% as a down payment. If there is real estate involved, the SBA really shines since they will finance 50% and a local lender can finance 40% in the first position. This is huge- the SBA is kicking in 50% but taking a junior creditor position. Any local bank would love this arrangement since they are guaranteed to get paid first and paid in full on any default.
SBA loans on business acquisitions is 10 years and current rates are in 5% to 6% range, which is fantastically good. SBA loans on real estate (such as office buildings or commercial space) is 20 years with current rates in the 4.5% to 6.0% range. That too is incredible. If the deal involves both business assets and real estate, then the SBA at times will blend the terms based on the prorated loan amounts. For example, if 33% if used for business assets and 67% is used for real estate, the term might be 17 years with an equally blended interest rate.
SBA deals vary across the board, but they are usually good deals if you can stomach the slow, arduous underwriting and processing. As an aside, there is a fast-track program for deals under $150,000.
Entity Structure
As alluded to earlier most business acquisitions will be an asset sale and purchase. Therefore, you’ll need an entity to perfect the terms of the contract. LLCs, partnerships, S Corps, C Corps, etc. all have their place and consultation with WCG (formerly Watson CPA Group) will be beneficial in determining the best plan.
If your transaction involves real estate, typically we suggest that a holding company owns the real estate and another operating company owns the business assets. Accountants, attorneys and lenders all like this arrangement from all the angles you would expect- taxes, liability and underwriting. Again, we can help.
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