The United States has experienced an entrepreneurial explosion since the end of World War II, resulting in the creation of many companies that are now owned by the World War II generation and Baby Boomers. Today, many of the fiduciaries, heirs and guardians of deceased and incapacitated entrepreneurs have to address the issue of how to get as much money out of the business as possible. The sale of a business can often result in significant financial gain, but there are also major risks for the inexperienced seller. This article will discuss some of the ways to protect the sale of a closely held business.
Taking back “paper”
The more the purchase price is paid by a deferred payment, the greater the risk that the buyer will refuse or be unable to pay the full purchase price (e.g., the business is run into the ground by a buyer who blames the seller). In many cases, a fiduciary or heir is in the worst possible position. To preserve the business of a deceased or disabled business owner, the fiduciary or heir may feel pressure to sell the business quickly, but available buyers, such as employees of the business, may have little cash to make a significant down payment. Control of the business may have to be given up, but the fiduciary must wait to see whether the buyer can properly manage the business and pay the remaining purchase price. If the business is run into the ground, the buyer may throw up his hands and say, “Here, take it back.” Unfortunately, there may be little of value to take back. Heirs may use 20/20 hindsight to question the transactional decisions of the fiduciary.
Any seller should take back as little “paper” as possible and require the buyer to furnish the seller with periodic financial statements for the business. Because a faltering buyer may be reluctant to offer evidence of problems, the failure to provide the financial statements should be a default under the promissory note.
If a promissory note is a part of the sale, the fiduciary should try to shorten the payment period (e.g., three to five years instead of 10 years) and use an interest rate that is higher than commercial rates because the risk to the seller is generally greater than the risk of a commercial loan. For example, in many cases, the buyer will not qualify for a comparable commercial loan.
Any loan should be as collaterally secured as possible. The promissory note should be secured by the equity (e.g., a pledge of corporate stock) of the buyer in the business and by a broad form Uniform Commercial Code filing on all of the assets of the business. The agreement may also allow the seller to foreclose if the business experiences a downturn (e.g., there is a 20 percent drop in gross revenue).However, many sellers are reluctant to take their businesses back, and the buyer may also use bankruptcy to forestall a foreclosure.
In addition, the fiduciary should obtain personal guaranties not only from the buyer, but also from those with deeper pockets in the family (e.g. the buyer’s father). Additional personal collateral security may also be important, such as security in the buyer’s residence.
Given that the death of the buyer may make it unlikely that the business will survive, the fiduciary should consider collateralizing the deferred payment with a life insurance policy on the life of the buyer.
Warranties and representations
Most transactions, particularly stock transactions, require the seller to provide broad warranties and representations with regard to the business and its operations. Before such a sale, the owner’s corporate or LLC shield provided a measure of protection from the liabilities the seller is now effectively assuming as a result of the warranties and representations. To protect the fiduciary and reduce claims by the buyer, the sales agreement should fully disclose any and all exceptions to the warranties and representations. Even if the seller believes there is very little likelihood that an issue will cause problems (e.g., a sexual harassment claim from three years before), is it safer to disclose because failure to disclose can result in future liability. Even if the exception has been verbally disclosed to the buyer, the agreement should document the disclosure.
The fiduciary should also try to minimize the nature of the warranties and representations to include the use of best knowledge and belief in place of absolute truth as a standard. If it was the fiduciary’s belief that there was no issue but there later turns out to be a liability issue, the use of this limitation can limit the claim to what the fiduciary believed to be true, not what was actually true. For example, the fiduciary believed the financial statements were true, accurate and complete, but the bookkeeper or disabled owner made significant errors. Moreover, such a standard shifts some of the burden of proof to the buyer to prove that the fiduciary knew the representation was false.
Finally, if the sale is to an “insider” such as to a partner or long-term employee, it would appear that the fiduciary should not have to provide as broad a set of warranties and representations. The insider should have an intimate knowledge of the business operations, and in many cases, may have a better knowledge than the fiduciary (e.g., the buyer was the president of the business for 10 years).
Most sales transactions require the seller to provide indemnities based upon the terms, warranties and representations of the sales agreement. There are a number of ways to limit future indemnity claims. These include:
- By time, such as providing that any indemnity ceases one year after the closing
- By amount, such as providing that the buyer cannot make a claim against the seller until the indemnity “pot” has reached a certain floor, such as $30,000
- By the nature of any claims, such as restricting indemnities to only certain claims, such as tax and environmental issues. Such a limitation can also occur by limiting the warranties and representations made by the seller.
Finally, to avoid having the buyer arbitrarily make indemnity claims that may be used to reduce the note payments, the sales agreement should provide for an even-handed process for making claims under the indemnity. It may also provide that the seller has a right to take over the defense of any third-party claims to ensure that the buyer does not quickly agree to an unreasonable settlement of an indemnified claim. If an agreement cannot be made between the seller and the buyer, the sales agreement may provide for binding arbitration by the parties.
In many cases, the warranties, representations and indemnities result in the seller effectively dropping the protection the seller had from the business’ entity shield. But a significant portion of the liabilities that the seller may be taking on may have been covered by business insurance. One major way to protect the seller is to provide that the buyer must maintain comparable insurance coverages to those maintained by the seller’s business and that any claims under the sales agreement must first be made against the insurance. The agreement should also provide that the insurance carrier has no claim against the seller if the carrier is required to make such payment.
Many business owners have provided personal guaranties to vendors to the business, but an executor or guardian may have no way of knowing the extent of such guaranties. For example, the disabled business owner failed to keep a copy of the documents that he signed when a vendor account was created 20 years ago. If the buyer continues to use those accounts and subsequently fails to pay the account’s balance, the estate of the business owner may still be liable. Therefore, the fiduciary should consider sending a notice to all parties with whom the business has had an account, notifying them of the sale and noting that the seller will no longer be liable for claims occurring after the date of the sale. It might also be advisable for the fiduciary to obtain a personal indemnity from the owner for any such future claims (e.g., a landlord may not agree to a release of a disabled owner’s personal guaranty).
While the cost of a competent attorney can deplete a fair amount of the sale price of the business, there are so many transactional and fiduciary risks that an uninitiated fiduciary is probably deemed to be irresponsible if he fails to consult with a competent attorney. Fiduciaries should be especially leery of brokers and buyers who try to convince them that an independent attorney is an unnecessary cost.
Given the significant number of business owners who will die or become disabled in the next 30 years, fiduciaries will increasingly have to address the risks and rewards of selling a closely held business. Failure to adequately address these issues will not only potentially deplete the value of the business owner’s estate; it will also expose fiduciaries to personal liability for breaching their fiduciary responsibilities.
John J. Scroggin, J.D., LL.M., AEP, is a speaker and author. Scroggin has written over 300 published articles, outlines and books. To be added to his free blast email system on estate and income-tax planning, contact Penny@scrogginlaw.com.