Presentation on theme: "Business Succession Planning: Ensuring Your Business Survives Into The Future Robert M. Anderson, Esq. Nexsen Pruet, LLC Estate Planning – Taxation – Corporate."— Presentation transcript:
Business Succession Planning: Ensuring Your Business Survives Into The Future Robert M. Anderson, Esq. Nexsen Pruet, LLC Estate Planning – Taxation – Corporate 205 King Street, Suite 400 Charleston, S.C. 29401 Telephone: (843) 720-1784 Fax: (843) 414-8240
What Is Business Succession Planning? Every business owner in America at some point asks questions concerning how his or her business will be handled when he or she retires or dies while still managing the business. These questions are oftentimes difficult to address involving family dynamics, business relationships, and office politics. An attorney that concentrates his or her practice in business succession planning is trained to handle these business issues and find sensible solutions for all of these questions.
Whenever you are trying to find an attorney to help you tackle a business succession planning issue you want to make sure that he or she has full knowledge of important estate planning techniques, federal and state tax laws, and corporate law. Almost always, you will want an attorney that has earned a Master of Laws or “LL.M.” degree in taxation. This indicates that he or she has undergone extensive study in taxation and is fully competent to handle the tax and financial issues that arise in business succession planning.
Outline For This Presentation Since there are so many issues surrounding business succession planning, this presentation tries to distill and organize the estate planning, corporate, and tax issues into something more manageable. This presentation tackles the issues of business succession planning in the following order— First, we will discuss and lay out a series of talking points involving circumstances that can prevent a successful business succession plan. Next, we will discuss the nuts and bolts that are involved in almost every business succession plan, including control and ownership transfer techniques and tax issues. Lastly, we will tackle the three main avenues for a business succession plan— Allowing family members to inherit the business, Offering the business interests to a business partner or employee, Selling the business interests to an outside third party.
Circumstances That Can Prevent A Successful Business Transition
Our attorneys’ experience has shown that five circumstances almost always stop a successful business transition from one party to the next. These circumstances include— Forces Outside the Business Forces Within the Business The Costs of Acquisition Make the Business Unmanageable Dividing the Business Among Everyone In a Generation Knee-Jerk Reaction Planning
Forces Outside the Business Small businesses typically do not make it past the first generation as a result of limited capital and a lack of marketability of their business interests. This is a problem unique to small businesses since large publicly traded companies, almost by definition, have unlimited access to capital and are highly marketable. Other external forces that cause small businesses to fail include— Changes in consumer taste, Advances and changes in technology, Competition from other businesses, Poor income tax and estate and gift tax planning
Forces Within the Business Sometimes, a small business is its own worst enemy. Some circumstances that cause a business to fail from the inside out include— The business successor not having enough leadership ability or experience to properly take over the business, The business successor not having enough education or skill to manage the business or to supervise over the business’s work product, The business owner and workforce’s self-satisfaction that the business can be transitioned without adequate planning
The Costs of Acquisition Make the Business Unmanageable Oftentimes business owners do not think about the welfare of their business whenever they pass the torch to a business successor Sometimes, business owners will ask for an unreasonable purchase price when selling their business to a family member or third party. If a deal is completed with an excessive price, there could be hazardous results since it will substantially change the business’s economic equilibrium and increase the costs of operating the business. Over time, the business’s expenses could not be used to support the business, going instead to the debt used to cover the business successor’s acquisition costs.
Dividing the Business Among Everyone In a Generation Many clients, out of a sense of fairness, will try to divide their business interests equally among all of their children. In many instances, this can lead to bad results— The business’s division can water down the business’s profitability, giving the children no incentive to continue the business. Worse, it might cause management problems where a share of the business goes to a child that is a ne’er-do-well and another goes to a golden child. For example, without the right business structure, the ne’er-do-well could easily make business deals that could destroy the business. Additionally, differences between the children’s personalities might cause the business to dissolve over a lack of compatibility
Knee-Jerk Reaction Planning Oftentimes a successor is chosen at the last moment due to a lack of planning and subsequent sense of urgency. After a business owner dies, becomes severely disabled, or retires, interested parties may scramble trying to find someone that they believe, rightly or wrongly, can manage the business.
The creation of any business owner’s succession plan requires the answering of three questions— First, who should take over the control and ownership of my business? Second, how do I convey my business interests to the people I want to take over? Third, how do I manage taxes?
Who Should Take Over the Control and Ownership of My Business? Every business in America has two basic elements— Control—the control of day-to-day operations of the business Ownership—the ability for someone to receive the business’s financial benefits These elements are most apparent in a publicly traded company where control is harnessed by a company’s directors and officers. Its ownership is in the hands of its stockholders.
Generally, in small businesses, the same person or person’s have the business’s control and ownership. Although holding control and ownership together is a characteristic of a small business, there is nothing that says that they must be held together. A small business owner looking for a business successor could convey his control interests to a professional manager and convey the ownership interests to his or her immediate family Likewise, a business owner could convey his or her control interests to an employee that was intimately involved with the business while conveying all ownership interests to his or her family. Even though there is flexibility in dividing up control and ownership interests, sometimes it makes sense to hold control and ownership interests together. You should have a forthright conversation with your attorney to determine whether splitting your business’s control and ownership interests makes sense and whether you feel that each interest’s successor would competently and favorably accept those interests. This need often occurs when there is no one inside the business or within the family that could successfully take over its management or when an employee might be resentful of uninvolved family members benefiting too much from the successor’s hard work.
How Do I Convey My Business Interests To the People I Want to Take Over? Once your business successor has been chosen, the next step is to determine how to convey your business interests. Generally, when interests are conveyed to family members, the difficult issue is determining whether such transfer should be free or should take the form of a purchase. How to address this issue depends on the personal, business, and tax circumstances surrounding the situation. Almost always, business transaction that occur before the business owner’s death will be in the form of the purchase in order to give the business owner continual cash flow although he no longer owns the business.
Control Strategies for Conveying Business Interests When conveying business interests, it is important to consider control strategies, i.e. how control will be managed within the business. If the business owner is willing to give up partial ownership of the business but not all of his or her control, there are numerous structuring techniques that can be used. If a business is a corporation, voting and non-voting shares can be created. This creation would have no impact on an S election. The non-voting shares can then be distributed to the business successors. If the business is a limited liability company, the limited liability company can become manager-managed. The business owner can then be the company’s manager while partial member interests are conveyed to the business successors. If the business is a limited partnership, limited partnership interests can be conveyed to the business successors. Other control strategies include— Requiring super-majority voting for major business decisions, Implementing guidelines for the election or appointment of directors, officers, and managers, Instituting voting agreements and voting trusts.
Agreements and Plans For Maintaining Control Various agreements and plans can be used by a business owner to maintain control of the company while those taking control of the business become trained in managing it and gradually receiving control. These techniques include— Employment Agreements Nonqualified Deferred Compensation Plans Stock Option Plans Change of Control Agreements
Transferring Business Ownership Techniques for transferring business ownership should also be considered when discussing techniques for structuring control with your attorney. Some considerations for transferring business ownership include— Selling the business to children involved in the business Transferring the business to all children with only children involved in the business receiving control Transferring the business to children involved in the business and giving nonparticipating children other assets Gifting interests to instrumental children Drafting a buy-sell agreement between family members Favoring one participating child over another Ensuring participating children are competent to handle the business Ensuring retirement income if business interests are gifted Drafting a buy-sell agreement for a third party Treating Children Equally
Use of Multiple Entities Aside from control and ownership strategies, it is important to keep in mind the use of multiple entities when formulating a business succession plan. From an operational standpoint, the use of multiple entities provides asset protection to the business owners and business successors. If the right planning is done, one entity’s assets will be protected from another entity’s liability regardless of whether the entities are affiliated. From an estate and gift tax perspective, multiple entities create multiple holdings of assets. These asset holdings can then be distributed to various classes of heirs for purposes of ensuring a smooth business transition and avoiding harmful estate and gift taxes.
How Do I Manage Taxes? Taxes, especially estate and gift taxes, should always be discussed when developing a business succession plan. Estate and gift taxes are always considered when the plan involves handing the business over to family members. Tax wise, the overarching goal in business succession planning is to transfer the business owner’s interests to the new owner while incurring as little tax as possible. The techniques for minimizing taxes can be summarized as a series of gifting and freezing techniques. In addition to these techniques, business owners should examine certain tax statutes that may provide some tax relief.
Gifting Techniques The Annual Gift Exclusion—Under federal gift tax law, a taxpayer is able to gift $13,000 of cash or property to a donee per year without the need of reporting the gift for gift tax purposes. Under this exclusion, a business owner can remove $13,000 of business interests from his estate for estate tax purposes without having to worry about gift taxes. Using the exclusion not only takes the business interest out of the estate, it also takes any future appreciation or income associated with the business interest out of the estate. The Gift Tax Exemption—If a taxpayer gives a donee more than $13,000 of cash or property, then he or she will incur gift tax unless he or she decides to use his or her lifetime gift tax exemption. Under current law, a taxpayer can gift up to $5,000,000 of cash or property without incurring gift tax. The downside to using the exemption is that once it is used it is gone forever. Additionally, any reduction in the gift tax exemption will likewise reduce the taxpayer’s estate tax death credit which is also currently $5,000,000.
Gifts of family limited liability company and family limited partnership interests— A family limited liability company or “FLLC” is a standard LLC that includes just family members. Likewise, a family limited partnership or “FLP” is a standard limited partnership that includes only family members. Both of these business entities are valuable tools for transferring business interests or real estate to family members In the context of FLLCs, there is a manager-managed LLC where the business owner is the manager and member. The business owner then gradually gifts membership interests less than or equal to the annual $13,000 gift tax exclusion to family members. In the context of FLPs, this means there is a limited partnership where the business owner is the general partner. The business owner then gradually gifts limited partnership interests less than or equal to the annual $13,000 gift tax exclusion to family members to transfer business assets. Because the conveyed non-controlling business interests lack control and marketability, they are given lack of control and lack of marketability discounts for valuation purposes. These discounts can be as high as 45% of the initial fair market value, giving the business owner the ability to gift or sell more of his or her business to family members.
Gifts in Trust—Gifting business interests to a trust rather than directly to a family member should always be considered since in our litigious society and within modern family dynamics, business assets could easily be susceptible to lawsuits or divorce proceedings. Tax wise, trusts are beneficial for long term planning. If the trust is drafted as a generation-skipping trust or a dynasty trust, the business interests can be passed on to grandchildren or even family members of a later generation with minimal tax consequences.
Freezing Techniques Grantor Retained Annuity Trust—a grantor retained annuity trust or “GRAT” is a type of irrevocable trust where a business owner transfers some of his or her business interests to the trust but retains the right to a fixed annuity from the trust for a term of years as a result of the transfer. At the end of the trust’s term, which must occur within the business owner’s lifetime, the property held in trust will be transferred to those family members active in the business. The only value subject to gift tax is the discounted value transferred to the family members after the trust term. The gamble is that the business owner may not survive the trust’s term. If the business owner dies during the trust’s term, then the value of the assets in the trust will be included in the business owner’s estate. A GRAT freezes the value of assets by removing any future appreciation and income of the business interest from the business owner’s estate.
Intentionally Defective Grantor Trust—an intentionally defective grantor trust or “IDGT” is an irrevocable trust that is effective for estate tax purposes, placing assets held within it outside the business owner’s estate, but intentionally defective for income tax purposes, causing the business owner to realize income generated by the trust’s assets. Because the business interests are sold, no gift tax is triggered by the sale. Additionally, no capital gains tax is triggered since sales from a grantor trust are disregarded for income tax purposes. The technique is similar to a GRAT except there is no risk associated with the business owner not surviving the trust’s term. Like in a GRAT, assets are frozen since all future appreciation and income associated with the business interests is generated outside of the business owner’s estate.
Statutory Tax Relief I.R.C. § 303— Under federal corporate tax law, any redemption of stock in a closely held corporation is taxed as a dividend, meaning it will be taxed at ordinary income rates. I.R.C. § 303 is an exception to this general rule. So long as the corporation’s redeemed stock is included in the business owner’s estate and exceeds 35% of his or her adjusted gross estate, the redemption will be taxed as capital gains rates. Because there is a step up/step down basis in the stock when the business owner dies, the estate or heir will have no gain or loss on the sale. By giving the estate or heir tax free cash from the closely held corporation, the exception’s primary benefit is the tax free use of cash from the corporation to pay the business owner’s estate tax.
I.R.C. § 6166— Under federal tax rules, estate tax must be paid in cash within nine months of death. I.R.C. § 6166 is an exception to this rule. If a closely held business makes up more than 35% of the business owner’s adjusted gross estate, then estate taxes attributed to the business interest may be deferred for four years. During the referral period, only interest on the tax is due. After this four year period, the estate tax must be paid over a period not exceeding 10 years. Use of this exception is heavily restricted, requiring numerous qualifications. As a result, it is usually only recommended by planners as a last resort for deferring estate tax payments.
Allowing Family Members To Inherit The Business
Many clients want members of their family, usually their immediate family, to inherit their business. Luckily estate planners have a variety of tools and techniques, most of which have already been mentioned, for transferring his or her business from one generation to the next. A non-exhaustive list of the techniques utilized by estate planners include—
Estate and Gift Reduction Strategies—such as utilizing the lifetime gift tax exemption and using the annual gift tax exclusion. Discounting Business Interests—with the use of entities such as FLLCs and FLPs. Creating Private Annuities—using private annuities to reduce estate and gift taxes and give the business owner cash flow in retirement. Instituting a gifting regimen—a business owner can substantially reduce his or her estate by using the annual gift exclusion to make multiple gifts to multiple family members over time. Purchasing Life Insurance To Pay Estate and Other Transfer Taxes— life insurance is a handy tool for providing liquid assets to the estate to pay estate taxes and preserve assets held by the business. Electing An Extended Payout For Estate Taxes—if the circumstances are favorable, utilizing I.R.C. § 6166 for an extended payout for estate taxes. Opting to Have Stock Redemptions Not Treated As Dividends—if the circumstances are favorable, utilizing I.R.C. § 303 to reduce taxes.
Offering The Client’s Business Interests To A Business Partner or Employee
Oftentimes, small business owners have a problem finding someone in their family that has been engaged in their business long enough to be a suitable business successor. More often than not, when this is the case, the business owner has a protégé within the company that can take his or her place in the event of death, disability, or retirement. Typically, whenever a non-family member is the business successor in a business succession plan, it is the business owner’s intent that his or her business interests be bought by the non-family member. Therefore, in order to retain the fruits of his or her labor, the business owner will allow a business partner or employee to succeed him or her after the business partner or employee purchases his or her interest. The way this purchase is structured will depend on whether the purchaser is a business partner or an employee.
Purchaser Is a Business Partner—Buy-Sell Agreements Whenever a business partner opts to buy a business owner’s interest as part of a business succession plan, a buy-sell agreement is almost always used. In order to draft a buy-sell agreement, your attorney needs to know some elements of the business owner’s intent. First, your attorney has to know who is going to purchase the interest. Whenever the purchaser is a business partner, usually two parties are available to purchase the business owner’s interests. Either the business itself will purchase the withdrawing business owner’s interest, or the business partner will purchase the withdrawing business owner’s interest. Although many considerations go into whether the business or business partner should purchase the business interest, from a tax perspective, the business partner should always purchase the interest in order to receive a higher tax basis.
Second, your attorney has to know whether the business owner would like his or her interest’s purchase within the business to be mandatory or optional. Generally, a list of triggering events are placed into the buy-sell agreement calling for the mandatory or optional purchase of the business owner’s interest depending on the circumstances surrounding the purchase. Lastly, the attorney has to know the value of the business owner’s interest. The value of the business owner’s interest will determine the purchase price for the business partner. Typically, the business interest’s value is determined by appraisal, by formula, or by an agreement between the parties. The method used will depend on the circumstances surrounding the sale and the interests of the parties.
There are two main purposes for having a buy-sell agreement— First, a buy-sell agreement should be drafted to create a worth while and efficient exit plan for the withdrawing business owner. Whenever a buy-sell agreement is made as an exit strategy, special steps should be taken in determining the fair market value of the business owner’s business interests. An appropriate fair market value is usually determined by an appraisal or a formula that takes into account the business’s earnings. In order to protect the business and ensure that it has cash flow to meet its other obligations, the costs of the purchase can be paid over time and restrictions on the amount of each period payment can be implemented. Second, a buy-sell agreement should be drafted to assist the business partner’s acquisition of the business owner’s interest. The buy-sell agreement does this by designating the method used to determine the business interest’s value. Generally, a low, yet reasonable, fair market value, such as book value, can be selected to reduce acquisition costs.
Whenever a buy-sell agreement is drafted, it is important to realize how life insurance can be an effective tool. If the business or persons within the business are to buy the business owner’s interest upon his death, life insurance is typically the vehicle used to pay for the purchase. The premiums of the life insurance policy used to purchase the interest are usually paid for by the business.
Purchaser Is an Employee of the Business Different business succession planning is used when an employee, rather than a business partner, purchases the business owner’s interests. Typically, there are four avenues for transferring a business interest from a business owner to an employee— Long-Term Buy-Sell Agreements Short-Term Buy-Sell Agreements Practice Continuation Agreements Employee Stock Ownership Plans
Long-Term Buy-Sell Agreements Many business owners opt for implementing a long-term buy- sell agreement for the purchase of their business interests, drafting agreements that arrange for the purchase upon the occurrence of a distant triggering event. This strategy, however, can be hazardous. Circumstances may change during the course of the agreement, making its application unfair to one of the parties. Although circumstances may not change, the employees or agents that have agreed to buy the business interests may back out of the deal, creating their own business to compete with the business owner or the business owner’s heirs. Even if the business owner or the business owner’s heirs rely on an agreement with strong covenants not to compete, enforcing it can be problematic since the costs of litigating such a suit can be expensive and time consuming. Therefore, employees typically have a lot of leverage to affect the terms and enforcement of long-term buy-sell agreements.
Short-Term Buy-Sell Agreements Unlike long-term agreements, employees do not have significant leverage to affect the deal under a short-term agreement. With a shorter timeframe, the business succession structure should be similar to the sale of the business interests to an outside third party (discussed in greater detail later in the presentation). Short-term agreements, however, do have their drawbacks. The arrangements are typically seller financed. The employees purchasing the business interests usually have little assets. Therefore, although short-term agreements place the parties at an equal footing, the agreement should be carefully drafted to account for the fact that the purchase price will be paid from the future cash flows of the business being purchased.
Practice Continuation Agreements Many professional associations, such as bar associations and medical associations, have a network of professionals that absorb the practice of a fellow professional that has passed away. For professionals, practice continuation agreements may be used to provide continued payments to the deceased professional’s surviving spouse for a term of years. The payments are usually derived as a percentage of payments from clients that have been successfully absorbed by the successor professional.
Employee Stock Ownership Plans A business owner may opt to sell his or her stock in the corporation to his or her employees through an employee stock ownership plan or “ESOP”. Although it is expensive to create an ESOP, it can be a viable exit plan for a business owner since it allows employees to indirectly acquire the corporation with pre-tax dollars because, with certain restrictions, the purchase payments for the stock are tax deductible.
Selling The Client’s Business Interests To an Outside Third Party
Whenever a business owner sells his or her business interests to an outside third party, the transaction is intricate and detail oriented. The buyer of the business interests typically will perform an exhaustive due diligence review of the business and have several documents prepared to instigate the purchase such as asset purchase agreements, stock purchase agreements, merger or conversion agreements, covenants not to compete, promissory notes, security agreements, consulting and employment agreements, and other due diligence and closing documents. This section will go over the key stages of an outside third party’s purchase of a business interest. Along the way, it will consider the tax implications of the sale.
Letter of Intent Negotiations are always a part of a business’s purchase. The start of the negotiation process is almost always initiated by a party’s letter of intent, a letter from a party that sets forth all the aspects of the business deal. From a business owner’s perspective, the letter of intent should outline all of the major points of the transaction that could be deal breakers. From the standpoint of an outside third party purchaser, the letter of intent should outline all the major points that could be deal breakers. Once each party has sent a letter of intent, the negotiating period has begun. The negotiating period will typically begin with a due diligence period and end with the signing of various documents, closing the deal.
Due Diligence Period Almost always, there is a due diligence period prior to an outside third party purchaser’s acquisition of a business interest. The due diligence period serves as an educational period, whereby the purchaser spends time gathering information in regards to the business and determines whether it is a viable business deal. The seller bears the burden during the due diligence period. The outside third party purchaser has the ultimate choice as to whether to purchase the business. Therefore, in order to get the best price for the business with the most favorable terms and the quickest closing, the seller has to expeditiously provide the outside third party purchaser with all relevant information involved in the business deal. One of the selling business owner’s biggest headaches during the due diligence period is working with third parties to ensure a smooth transition of all the business’s obligations. The selling business owner should, as soon as possible, take steps to get actions and consents from third parties to transfer liens and liabilities from the name of the selling business owner to the name of the outside third party purchaser.
Federal Income Tax Issues Whenever a business interest is sold to an outside third party, the federal income tax consequences of the transaction should always be considered. For tax purposes, a transaction is usually considered from both parties’ perspectives. If the tax implications are not favorable for one party, it could potentially be a deal breaker. From the selling business owner’s perspective, there is the desire to achieve two main tax objectives— Incurring tax at just a single level, and Taxation at capital gains rates
A great way to achieve both of these goals is for the selling business owner to sell his or her business interests rather than the underlying business assets. However, this transaction hardly ever occurs since an outside third party purchaser generally will not accept the risk of unknown liabilities associated with the purchased business interest. Additionally, an outside third party purchaser will have tax goals different from those of the selling business owner, making such a purchase undesirable. Thus, a selling business owner is usually unable to negotiate a direct sale of his or her business interests.
Nevertheless, the selling business owner’s two goals can be achieved through an asset sale so long as the entity being sold is a “pass-through” entity with only one level of business income tax, such as a partnership, limited liability company, or S corporation. Other than depreciation recapture, all gain from the sale should be taxed at capital gains rates. Therefore, whenever a pass-through entity is being sold, the selling business owner’s tax goals can be met through an asset sale and purchase.
These goals, however, are harder to meet when the business is a C corporation. A C corporation has an inherent double income tax structure, making a sale of the corporation’s assets subject to double taxation. Additionally, if the gain from the sale can be characterized as a dividend, then some of the gain would be susceptible to tax at ordinary rates.
From the outside third party purchaser’s perspective, it is almost always better to purchase a business’s assets rather than its interests. The reason for this preference is that the outside third party purchaser will be able to allocate the assets’ purchase price to depreciable and amortizable assets for deductions and other tax benefits. Such a sale is beneficial for both parties, so long as the business being sold is a pass through entity. The selling business owner can sell the business’s assets without the worry of double taxation or higher tax rates, and the outside third party purchaser can purchase the assets and spread its cost to assets that will give future tax benefits.
Whenever a business is sold between parties, it is important to keep in mind I.R.C. § 1060. I.R.C. § 1060 was enacted by Congress due to the impression that sellers and buyers of a business would not construe the sale in the same manner for tax purposes. In order to boost the amount of money received as capital gain, sellers were persuaded to allocate the purchase price toward goodwill. Buyers, on the other hand, would want to allocate the purchase price toward tangible depreciable personal property in order to obtain depreciation deductions and other tax benefits. I.R.C. § 1060 mandates that the seller and buyer of a business agree to a purchase price allocation. From there, the seller and buyer must report the federal income tax consequences of the sale in accordance with that agreement. To inform the I.R.S. of the agreement, the seller and buyer must file Form 8594 with their respective returns in the year of sale. The form will demonstrate that the seller and buyer had agreed on a purchase price.
Agreements Made When Business Is Sold To An Outside Third Party Whenever a small business is sold to an outside third party, the primary document used to instigate the purchase will be some sort of buy-sell purchase or merger agreement such as an asset purchase agreement, a stock purchase agreement, or a merger or conversion agreement. Oftentimes other agreements, such as covenants not to compete, promissory notes, security agreements, consulting or employment agreements, due diligence certificates, and closing certificates, will be made. For any agreement that is signed by a business owner and an outside third party, the following considerations should always be made— Warranties and Representations Right of Offset Seller Concerns When Considering Warranties and Representations Other Closing Documents
Warranties and Representations Whenever someone sells his or her business, he or she unsurprisingly wants to receive the business’s purchase price with the buyer having as few rights as possible regarding the refund of all or a portion of the purchase price or an institution of deferred payments. Aside from stipulations that may be placed on deferred payments, the buyer will naturally want the seller to make representations and warranties that, when breached, will allow the buyer to enforce certain rights contained within the deal. Attorneys try to reduce a seller and buyer’s warranties and representations to the amount required to smoothly initiate the deal. A seller’s attorney will, more likely than not, restrict his or her warranties and representations to the basic ones pertaining to organization and existence of the seller, the seller’s ownership of stock or assets exchanged in the deal, authority to initiate the deal, not violating the buy-sell agreement, and not defaulting on liabilities. A buyer’s attorney will typically counter, asking for a plethora of additional warranties and representations. The additional warranties and representations oftentimes involve the accuracy of information pertinent to the deal.
If the sale involves a large business, the seller’s attorney will typically be required under the terms of the buy-sell agreement to give a legal opinion regarding the validity and extent of certain warranties and representations. If the sale is an asset sale rather than a stock sale, where the business owners directly receive the proceeds of the sale, the buyer’s attorney must ensure that the sellers themselves and not just the sellers as officers of the corporation agree to be bound by the deal’s warranties and representations and become joint and severally liable in the event of such breach.
Right of Offset Parties to a business deal do not just care about the warranties and representations made between the parties. They also care about the remedies available to them under the deal in the event of a breach. Whenever a business deal is made by an asset acquisition, a buyer will find a right of offset to be very helpful. A “right of offset” is a remedy that allows a buyer to offset damages caused by the seller’s breach of a warranty or representation against future payments due to the seller under the original deal. The right of offset is incredibly important for a buyer since a business’s defects may not be discovered during the due diligence period. If the right is properly drafted, a seller will have to initiate a court action to disprove his or her breach of warranty or representation. Under South Carolina law, there is no statutory right of offset that will be triggered if the right is not expressly provided for in the contract.
Seller Concerns When Considering Warranties and Representations A harsh reality for any seller of a business is that in every deal involving sophisticated parties, he or she will have to make extensive warranties and representations. Regardless, it is easy to implement important limitations on such warranties and representations. Keep in mind that the reason for all of the warranties and representations is the buyer’s fear that some latent defect in the business will be discovered years down the road, regardless of his or her efforts during the due diligence period. Realizing this is the case, a seller can oftentimes successfully contract the waiver or lapse of most if not all of the warranties and representations made in the deal after the buyer has operated the business for a reasonable amount of time. In addition to the waiver or lapse of warranties and representations, damages against the seller can be contractually limited to a specified amount.
Other Closing Documents Other than the basic, authoritative buy-sell agreement, there are other important documents that a business owner must consider in a business acquisition. Whenever there is an acquisition, there will be various documents relating to the assets that are purchased and a release and assumption of various liens and liabilities. If the deal is a seller financed or leveraged buyout, the seller will want to preserve his or her right to payment in the transaction by drafting promissory notes, security agreements, deeds of trust, UCC-1 financing statements, and possibly guarantee agreements. If the deal is done as a lease of assets rather than a financed sale of assets or if there are leased assets associated with the business, lease agreements, landlord approved estoppel documents, and lease assignments would have to be drafted. Other documents to consider are restrictive covenant agreements such as covenants not to compete and non-solicitation prohibitions to reasonably limit the buyer’s activity immediately after sale. Additionally, if the buyer wants to maintain the employment of the business’s workers or keep the seller around as a consultant to train the buyer after sale, the buyer will want respectively employment agreements or consulting agreements outlining those relationships.
The Continual Buyer-Seller Relationship Whenever a third party purchases a business, it is important to realize that after the deal is closed, the buyer and seller may have a continuing business relationship in the short term. Due to the need for financing, which is oftentimes provided by the seller, the seller will, more likely than not, be in a continual financial relationship with the buyer after closing. If a consulting agreement is drafted so that the seller sticks around to train the buyer, the seller should realize that the mentorship that will be involved in passing the torch from one business owner to the next. Recognizing that the buyer/seller relationship is not short lived, it is important to remember reasonableness and civility when going into the business deal so that a rocky road at the initiation stages does not lead to a long term falling out between business colleagues.
A Final Note On Avoiding Reactive Succession Planning
Procrastination is in human nature. Whenever something does not seem like a necessity, our first instinct is to put it off or save it for a later date when it absolutely has to be done. Business succession planning is no different. However it is important to know that even if you are planning spontaneously and unexpectedly, most if not all of the avenues that we have discussed can be used to properly hand your business over to the next generation. The important thing to remember is not to plan haphazardly as a result of not planning in advance. With proper legal guidance, a well thought business succession plan can be developed within a relatively short period of time no matter the circumstances.