When selling their businesses, many owners focus on the purchase price (which is obviously important), and to save some money “play lawyer” when it comes to reviewing the other provisions of the proposed deal. These owners sign a letter of intent under the assumption that they’ll later ask a lawyer to “paper up” the deal they’ve already struck.
But business owners can get themselves in trouble signing a letter of intent without getting advice from an experienced lawyer. Although the deal terms of a letter of intent are typically not legally binding, once a business owner agrees to one, it can be difficult to change the terms. At best, renegotiating a deal will create tension and bad will. At worst, a buyer may walk away, thinking that the seller is unpredictable.
There’s a lot of truth to an old adage in negotiations: “I’ll let you name the price, as long as I get to name the terms.” An experienced lawyer can structure any deal to include the purchase price the seller wants, but add so many contingencies and shift so much risk to the seller, they’ll likely never see anywhere near that price.
Here are a few things to look out for:
Contingent payment of purchase price. Also referred to as an “earn-out,” this structure increases the purchase price based on the success of the business after the closing, but it is often wrongly used when a buyer and seller can’t agree on a price. Often, they are just setting themselves up for a dispute after the closing. There are, however, two situations where an earn-out can make sense for both parties by giving a seller the opportunity to justify a higher price and giving the buyer some protection. One is when the selling owner is critical to the success of the business in the short term, such as when a buyer is entering a new geographic market. In this case, the seller has influence over the operations of the business and is motivated to see it succeed. Another is when a seller has recently made significant investments in the business (for example, expansion of manufacturing capacity or entering into a new market) and there has not been sufficient time for these investments to be reflected in additional revenues.
Holdbacks. A “holdback” is when a buyer doesn’t pay a seller the entire purchase price at closing, commonly 5-10 percent of the purchase price. Holdbacks are usually paid to the seller within 12 to 24 months after the closing unless the buyer has an indemnification claim.
Indemnification. Indemnification means that the buyer has a legal right to make a claim against a seller for a problem with the business. These provisions shift risk between the buyer and seller. An experienced lawyer will negotiate them heavily. If you agreed to specific indemnification provisions in a letter of intent, you may end up assuming much more risk than you realized.
Selling your business isn’t like selling your house. There is no standard contract, and there is no set of government-imposed provisions. Before you make any commitments, and especially once you get a term sheet, call your lawyer. If your lawyer doesn’t have experience with selling a business, find a lawyer who does.