Key Legal Documents in a Business Sale

A number of legal documents are required when conducting a business transaction. For most buyers and sellers of small businesses, this is the first time they have encountered these documents.

For a seasoned small business owner, it may seem like overkill. However, it’s worth considering the position of a buyer. Often, a small business buyer is taking out a personally guaranteed loan, attaching a lien to his or her house, and being required by the bank to execute the documents.

After all, there’s no such thing as free money, and it’s better to be safe than sorry. This post outlines some of the standard documents in a business transaction.

Negotiating a Deal

Non-disclosure Agreement

In a business sale, there is often a non-disclosure agreement that the seller and prospective buyer execute. The purpose of this document is to protect the seller. 

Most owners desire a confidential sale so as not to spook existing clients, employees, and suppliers, so an NDA is requested at the outset. 

This NDA ensures that the prospective buyer does not disclose (a) that the business is for sale and (b) any information learned during evaluating and negotiating the purchase of the business.

After all, without a non-disclosure agreement, a competitor could kick the tires of a business for sale and then turn around and poach employees and customers of the business.

Letter of Intent

The letter of intent (LOI) outlines a purchase agreement's basic terms and conditions.

Typically, this agreement is non-binding except for a few clauses:

• Exclusivity: The buyer gets to exclusively diligence the business.

• Expenses: Each party is responsible for their own expenses. If a buyer wants to use legal counsel to diligence the business, he or she is responsible for their bills. If a seller wants to pull financial statements from his or her CPA, he or she is responsible for those bills.

• Confidentiality: If an NDA has not been signed, typically, there are confidentiality clauses in an NDA that prohibit the disclosure of the potential sale.

Closing the Deal

Once an LOI has been signed by the buyer and seller of a small business, the period of being “under contract” begins. During this 30-90 day period, the buyer will perform some due diligence on the business, go through underwriting with a bank, and ultimately start negotiating the final legal documents to close the deal with the selling business owner.

Purchase Agreement

The purchase agreement contains the “juice” of the transaction. This document can run from 6 to 30 pages, depending on the attorney drafting the agreement. It will contain basic legal information, such as the parties to the contract, the price of the acquisition, and the closing date. It will also include a number of other clauses:

• Representations and Warranties: The selling owner will often provide representations and warranties to the buyer. This could range from representations as simple as “I have the right to sell this business” to warranties as complex as “I will cover any repairs to vehicles purchased for the first 90 days, provided they cost more than $15K but are capped at $125K”.

• Transition Period: If a separate consulting agreement is not included, then the purchase agreement may include provisions for the selling owner to stay on for the first 30 days pro-bono and the next 60 days at a $55/hr consulting rate.

• Jurisdiction: Should there ever be legal troubles, there will normally be an agreement on the venue in which they will be resolved. This is typically either Delaware (standard) or the state in which the transaction is occurring.

• Funding: The purchase agreement will often outline the sources in which the selling owner will be compensated for the business. This will include cash at close, any hold-back for working capital, seller financing, and earn outs.

Non-compete 

Given that most owners are selling a local small business, the buyer will want to ensure that the selling owner will not compete against him or her. The typical small business owner has built up relationships with clients for years. The strength of their relationships with clients would make it easy for them to poach the clients for a new venture.

As part of a non-compete agreement, there are typically two main terms:

• Time: For how long does the owner agree to not compete against the buyer?

• Location: Where does the owner agree to not compete against the buyer?

Typically it’s a 3-5 year non-compete in a 100-mile radius around the business. However, there may be carve outs for servicing friends and family with work. For instance, an auto shop owner may agree to not compete against the buyer for 5 years in a 50-mile radius, with the exception of doing repair and maintenance work for related family members. 

Non-solicit

Aside from customers, owners often have strong relationships with their employees. They may have hired them straight out of trade school or college. If they wanted to bring them over to a new venture, they’d be able to do so with relative success. Additionally, small businesses are only successful so far as they have great clients and great employees. Poaching employees can significantly impact the business’s ability to generate revenue and profits.

A non-solicit prevents owners from soliciting their previous employees after selling the business.

Promissory Note

Many of the transactions we see include a promissory note between buyer and seller for 5% to 60% of the purchase price. This note is commonly referred to as seller financing.

Promissory notes have a number of terms to be negotiated:

• Term: For how long is the promissory note valid?

• Interest: What is the interest rate of the promissory note? How is that interest calculated?

• Guaranty: Is the note unsecured? Is the note secured by the stock of the buyer’s entity? Is the note secured by a personal guarantee from the buyer of the business?

• Prepayments: Is there a penalty for early payments on the promissory note?

• Standby: Is the buyer allowed to make payments during the term of the bank loan?

Lease Agreement

In addition to the above documents, there will often be a lease drafted between the buyer and seller or the buyer and the landlord. This agreement should include several terms:

• Term: Ideally, the lease is for 10 years or, at the very least, has extensions until the 10-year mark. The reason for this often comes from the lender. They want to ensure that the business has a place to operate during the duration of the business’s loan payments.

• Penalty Fee: Most leases have a penalty for late payments. This penalty can be a fixed amount or percentage, or it can be compounding (e.g., “5% compounding monthly for amounts outstanding”).

• Security: Is the lease secured by the business? If so, is it subordinated below the SBA 7(a) loan?

Information posted on this page is not intended to be, and should not be construed as tax, legal, investment or accounting advice. You should consult your own tax, legal, investment and accounting advisors before engaging in any transaction.