Editor’s note: Linda Markus Daniels is a founder of and principal in the Research Triangle Park law firm of Daniels Daniels & Verdonik, P.A. TechLaw is a regular feature in Local Tech Wire.
________________________________________________________________________________________As the economy continues to recover, more businesses are likely to be bought and sold. If your business is one of these, there are certain things you should consider in determining whether you have the right potential transaction partner and whether the deal makes sense for you.

Major Issues in the Purchase Transaction

While early meetings are likely to focus on the fit of the buyer’s business with the seller’s as a merged entity, some of the fundamental issues that should be discussed are as follows:

  • What will the buyer be buying? Will the company being purchased be merged into the buyer, or will the buyer be buying only the assets of the seller? Will the buyer buy the accounts receivable or will the seller remain in existence to collect accounts receivable after the deal closes? Will the buyer assume all liability for debt?

  • What will be the medium of payment…cash, equity or debt? If it is equity, how will it be valued? If it is stock in a publicly traded company, will it be immediately sellable? If not, what arrangements will be made for registration of the shares? If it is debt, when will it be paid and are the any conditions on payment other than the passage of time?

  • How will the purchase price be determined?

  • Will anyone be required to remain as an employee or consultant, and if so under what terms? Will any part of the purchase price be tied to completion of the employment obligations? Conversely, what, if any, arrangements does the seller require to protect or provide for any of its employees?

    • Structuring Considerations

    The overall structure of the transaction is likely to be driven by tax and liability considerations. There are three basic forms that the purchase can potentially take, and each has different income tax and liability consequences, as follows:

    The first form is a sale of assets. This form is the favored method of purchase by most buyers for both income tax and liability reasons. From the tax side, the buyer allocates most of the purchase price to highly depreciable assets or to wages and noncompetition payments. In this scenario, all or virtually all of the income the seller receives will be taxable as ordinary income, i.e., at the highest tax rates. From a liability side, the buyer can (if the seller permits it) elect to purchase only specifically selected assets, leaving behind assets that could result in any liability. To be clear, the buyer would not be purchasing the seller as a company, but rather the company would remain in existence and owned by its current shareholders. Any liability not actually assumed by the buyer would remain the company’s problem.

    The second form is a sale of stock. This method is more beneficial to the seller, and probably the least favored by potential buyers. From a tax standpoint, the seller’s shareholders will receive capital gains treatment on the difference between the basis in their stock and the purchase price. The amount paid by the buyer for the stock, however, will not be deductible to the buyer. As to liability, the buyer is taking ownership of the stock which means it takes ownership of the company as it exists, including any potential liability. As a result of this situation, sellers may prefer to take a lower price if the buyer will buy stock rather than assets.

    The final form is a merger, which in its simplest form means that the shareholders of seller end up as shareholders of the buyer. In most cases this is done as a “tax-free exchange,” meaning that the seller’s shareholders are not taxed on the shares of the buyer received at the time of the exchange. Instead tax is only due (at the capital gains rate) at such time as the buyer’s stock is eventually sold. This allows the seller’s shareholders to control the timing of the tax hit if they wish to do so. The other tax and liability aspects are the same as with respect to sale of stock.

    Of course, it is important to know when the seller’s shareholders will be allowed to sell the shares received, since if they are locked up for a period of time this could result in a substantial change in the value between the closing of the sale and the time when the stock can be liquidated.

    Buyer’s Review of the Seller

    Before any business information is exchanged the parties should have a nondisclosure/nonuse agreement in place. Anyone interested in potentially buying another business is likely to be doing so because of perceived, unique aspects of that business. Disclosure of information on those aspects, including customers, could be used against the seller if the transaction is not ultimately consummated and there is nothing to prevent such an abuse of the information. In any event, the buyer will undertake “due diligence” and collect a large amount of information about the seller’s business. In general, however, the following are a sample of the types of questions that will be reviewed:

  • Who are the seller’s customers? What is the average size purchase? How much additional revenue is standardly generated from other sources such as support and maintenance? What is the attrition rate from maintenance?

  • What type of legal agreement exists with the customers? What type of warranty and indemnification obligations do you have to your customers?

  • Does the seller own all the technology it employees and consultants use, or have a valid license to use all such technology in the manner it is used? What type of agreements does it have with its employees and contractors in this regard?

  • Are there any claims pending from customers related to products sold or services rendered? Are there any current lawsuits?

  • What are the outstanding business and financial obligations of the seller? How much debt does it have, and on what terms? Are there liens on the assets of the seller? Are all taxes, including withholding taxes, paid?

  • Have all employees been paid all amounts due, including all overtime, all contributions to retirement or other benefit plans, and all amounts due for vacation or other leave time not taken?

  • What kind of employment agreements does the seller have with its employees and consultants? What are their salaries? What kind of fringe benefits do they receive, including holidays and paid vacations? Do any employees have written employment agreements, and if so do such agreements provide for severance pay upon termination or provide any restrictions on termination?

  • What does the seller’s office lease look like? What leased equipment does the seller have and what are the lease terms? Are there other contracts with third parties that are burdensome?

  • Are there any persons who might claim an ownership right in the company other than the shareholders on the stock ledger?

  • Are there any significant irregularities in the corporate structure or in compliance with required corporate formalities in the history of the seller?

  • Are there any contracts that cannot be assigned to the buyer or which require consent of the third party for assignment?

    • Seller’s Review of the Buyer

    It may seem strange, but if a seller is going to be employed by or a consultant to the buyer, to rely on the buyer to take care of its employees, or to rely on the financial stability of the buyer for further payments or to support the value of stock received in the transaction, then a careful examination of the buyer is important to the seller. Depending on how the transaction is ultimately structured, some of these issues may not be relevant, but understanding the buyer up front will still be useful.

  • How is the buyer managed? What is its management philosophy? Is the company highly centralized? Do branch offices have a lot of autonomy? Is there one overall manager with ultimate control? Is there a management group, and if so how is it selected and will the seller’s management be part of it?

  • How does the buyer handle new customers? Is the decision to accept a new customer up to the management employee who has the customer, or are decisions ultimately made by someone in the headquarters office? If so, what are the standards for accepting new customers?

  • How are professional employees/management compensated? Will the compensation of seller’s key employees be guaranteed, or would it be contingent on certain performance criteria (and if so, what are those criteria)? Would purchased “local office” be run as profit center or division with salaries being paid only out of local profits or bonuses being determined based on local profits? What benefits are provided to employees?

  • Would the buyer take all of seller’s employees or would it pick and choose?

  • What is the management style of the buyer? How do people relate to each other? What are the social expectations? How does the work product and manner of working of the buyer compare with that of the seller’s?

  • Does the buyer have a high turnover of personnel?

  • What are the financials of the buyer? (This is particularly important if the seller is going to be paid in any manner other than cash up front.)

  • What is the history of offices or divisions outside headquarters? Have other businesses been purchased and then closed/moved?

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    Daniels Daniels & Verdonik, P.A. has been serving the legal needs of entrepreneurial and high technology clients for more than 20 years. Linda Markus Daniels concentrates her practice in the representation of entrepreneurial and technology-based businesses, focusing on corporate, technology and international matters. Comments or questions can be sent to ldaniels@d2vlaw.com.