Understanding contracts when buying or selling a business

Introduction

There are several stages to buying or selling a business. They include valuing the business, getting tax advice, market research and marketing, preliminary offers, negotiating terms, heads of agreement, legal sale and purchase agreement concurrently with due diligence, and finally, completing the sale.

Research thoroughly to ensure each stage of the negotiation is documented in order to include all agreements and conditions in the final contract. Do this even if the business is small and the sale straightforward.

Seek expert advice from an accountant and a solicitor early in your planning through to completion to avoid costly mistakes and unexpected obligations. You can also seek advice from a tax specialist to ensure that the deal you agree is tax efficient for you. Sellers should decide whether to use a business broker or corporate financier to handle the initial part of the process.

This guide sets out the main agreements and contracts involved in the process of buying or selling a business, what they should cover, and where to seek advice.

Preparing to negotiate the sale of a business

Whether buying or selling a business, take time to plan it carefully. You need to research the business sector, the target businesses to buy or target buyers, valuations, and your financial options. Get advice from experts to assess the risks, set clear aims and a strategy for achieving them.

The first contracts you sign will be with a financial adviser for finance and tax advice, a solicitor for information on your legal options, and, for the seller, a business transfer agent or business broker to approach possible buyers. You need to clearly define tasks and fee structures. For more information, see our guides on how to choose and work with a solicitor and choose and work with an accountant.

The seller’s solicitor will draw up a legally-binding confidentiality or non-disclosure agreement to be signed by all prospective buyers before they receive the sales memorandum. A business broker or corporate finance adviser will often also do this. It is the seller’s responsibility to check the credit-worthiness of prospective buyers.

In the sales memorandum, which is not legally binding, the seller gives details of:

• the business sector
• how long the business has been trading
• main financial details, eg profit, cashflow, asset value, total debt
• number, age, length of service, job descriptions and details of salaries and benefits of all staff
• location of premises, size, rent and rates, freehold or leasehold (with terms) special considerations (eg special licenses)
• the structure of the sale, eg is the sale of part or all of the business

Ideally, all purchase offers should be made in writing. Any initial verbal purchase offer should be followed up with a letter setting out the main details and stating prominently that the offer is “subject to contract”, in other words, not legally binding.

The offer should include the terms for vendor handover and premises takeover, eg:

• what you want to buy, eg the business or its assets
• the offer price and payment terms
• the main information you need before making a firm offer, eg whether leases, licences and client contracts are transferable, liabilities for employees, etc

At this stage, the seller compares offers and selects a buyer. The buyer then needs to start checking the business – this is called preliminary due diligence. Due diligence should not be started until lawyers have been instructed and a firm purchase offer has been agreed and signed.

Preparing for the final contract

When buyer and seller are satisfied with their initial checks, and an initial offer has been made and accepted, the next step is to negotiate the firm purchase offer, which is called a Heads of Terms agreement, or Heads of Agreement. This document sets out the main points of the sale and is not usually legally binding – except for issues of exclusivity and confidentiality. The Heads of Agreement should cover:

• what is included in the sale
• the price and payment structure
• the terms of the period of exclusivity to complete the sale, including that period’s termination (usually the buyer offers a small deposit in return for the seller taking the company off the market)
• preconditions for the sale (eg minimum level of profits or orders within a certain time)

Parts of the agreement are legally binding and set out in separate documents:

• exclusivity
• confidentiality
• warranties
• indemnities

Other legally-binding agreements include the seller’s disclosure letter limiting his liabilities under the warranties, and any agreements from the seller and buyer to pay each other’s costs in certain circumstances if the sale falls through.

All these documents need to be carefully prepared and thoroughly checked. If the seller does not meet the preconditions, the sale will probably not go ahead. If warranties are breached, the buyer can sue for damages. It is a criminal offence for the seller to give false or misleading information about shares.

Once the Heads of Agreement is signed, the buyer’s advisers carry out thorough searches into the business records, called detailed due diligence. There are three types of due diligence:

• legal – for example, checking that the business has legal title to the assets which it is selling/transferring
• financial – checking that everything is in order financially
• commercial – assessing the business’ position in the market place

During this period, negotiations continue with the seller on drafting the final sale agreement, or sale purchase contract.

Signing and completing the sale

You should ensure all the agreements made during the negotiations are included in the sale purchase contract and that all the necessary details are set out in the accompanying documentation. Most of these documents are drawn up by the buyer’s solicitor and negotiated, finalised and signed remotely.

The final documentation typically includes:

• the sale agreement
• the tax deed (in share purchases, this is the seller’s indemnity against unforeseen tax liability)
• any other indemnity agreements, where the seller agrees to reimburse the buyer in full for undisclosed liabilities incurred by the company before the sale
• minutes of the board meeting agreeing the transfer of ownership and resignation of directors
• transfer documents for licences, leases, client contracts, shares, etc
• service agreements (for the seller and other directors remaining in an advisory role and for employees remaining with the business)
• finance details for the sale (including guarantees, loan or share agreements)
• agreements for any deferred payments by the buyer
• warranties, for example guaranteeing the accuracy of the seller’s statements on all key information
• the seller protection schedule for the buyer’s claims against warranties
• the seller’s disclosure letter and documentary evidence regarding warranties
• non-compete agreements or covenants (for the seller not to set up a competing business in the same area within a given time period)

After signing, the buyer’s and seller’s solicitors ensure that each side keeps the original documents they need. The buyer’s solicitors prepare a file or CD of all the documentation for both the seller and the buyer.

To complete the sale:

• the buyer’s solicitors register the change of ownership and directors at Companies House
• in asset and goodwill deals, the seller deregisters and the buyer registers for VAT
• the financial agreements are put into effect
• the seller – and the buyer if necessary – must have informed and consulted affected employees and be compliant under the Transfer of Undertakings (Protection of Employment) (TUPE) regulations
• buyer and seller work through the task list for the handover

Negotiating the deal- the buyer’s perspective

Throughout your research and negotiations, keep sight of your aims and the risk assessment you made for buying this business at the price you have offered. You might lose money on advisers’ fees, but it is better to cancel the sale than take on liabilities you cannot afford. Have at least one other target business lined up in case this deal falls through.

Do your own valuation of the company, its market position, future profits, how it will fit with your existing business, if you have one, and weigh the total cost against total benefit before you make an initial offer. Find out why the seller wants to sell and if the business has any major problems. Decide whether you want to buy the assets only, and therefore have no legal obligations for previous contracts, or the entire business. If attempting to buy assets only, be aware that a seller may expect a higher price to compensate for any loss of tax benefits available from the sale of shares.

You need to find the balance between protecting yourself against future liability and maintaining trust with the seller, especially if you want the seller to continue in an advisory role during a certain period. Your inquiries need to be thorough but also discreet enough not to disrupt the business.

Before you decide to buy, be sure that

• the seller has given you all the information you need
• the seller’s claims are confirmed by the business’ records and by your discussions with clients, suppliers, etc
• you know the exact ownership of the business and its assets
• the warranties and disclosure letter cover all unexpected contractual obligations
• you know the cost of your liabilities to the business’ employees, especially concerning pensions and redundancy pay
• all problems have been resolved and agreed in writing with the seller

Negotiating the deal- the seller’s perspective

Throughout the negotiations, keep in mind what you want to achieve in selling your business. If necessary, reconsider what you are prepared to sell, the kind of buyer and financing. For example, you could try for an employee buyout rather than a trade sale. Even if you lose money on advisers’ fees, it might be better than selling and not achieving your aims.

If selling to another business, use a business transfer agent, business broker or corporate financier to issue your sales memorandum. This way you do not reveal your business’ identity until you have made your choice of potential buyers.

Before you start discussions, get your buyers to sign confidentiality or non-disclosure agreements. You need to check their credit-worthiness at this early stage to eliminate prospective buyers who cannot pay. Compare the prices and payment terms in their initial offers. Some may include too many future payments conditional on profits or other targets. Make your first choice, but keep other buyers lined up in case this deal falls through.

You may have decided to sell to the highest bidder or the one who best secures the business’ future. Either way, you should be prepared to continue working for the business during a certain period if your knowledge and contacts are vital to the business.

Take great care over the wording and what is covered by the warranties and indemnities. Have your solicitor draft a disclosure letter to limit your liabilities and a vendor protection schedule to limit the time period within which they apply.

You need to take equal care over the financial details and make a more detailed check of your buyer’s financial track record and the payment structure they are offering.

Before you agree to sell, make sure that all problems have been resolved and agreed in writing with the buyer.

Checklist before you sign a contract

Before you sign, you need to double-check the details written into the final contract and its accompanying documents. Once you have signed, there is a further list of tasks you need to do before you can complete the sale.

Before you sign, you should:

• review your aims and how well this contract meets them
• make sure all the agreements made during the negotiation are included in the contract
• make sure there are no vaguely worded provisions, exclusions or limitations in the contract which could give rise to problems later
• if you are buying, ensure you have non-compete agreements in place
• check the financial and tax details again with your financial adviser
• check your obligations and the wording of the contract and other agreements again with your solicitor
• ensure all the necessary documentation and signatories are present at the signing session
• establish a schedule of tasks for completing the sale, making the handover, continuing the business and meeting future obligations
• make sure you have copies of all negotiated agreements kept in a safe place
• have informed and consulted affected employees in compliance with the Transfer of Undertakings (Protection of Employment) (TUPE) regulations

Once you have signed, make sure that:

• all others who need to sign have signed the relevant documents
• your solicitor has all the original documents you need to keep
• the buyer’s solicitor has copies of all the documents and will present a CD version to both the buyer and seller
• the financial agreements are put into effect
• the buyer’s solicitor makes the change of ownership return to Companies House
• in asset and goodwill deals, the seller deregisters and the buyer registers for VAT
• the seller – and the buyer if applicable – continues to inform and consult affected employees in compliance with TUPE as necessary
• both sides are ready for the handover and for informing clients, suppliers, etc
• the business operates smoothly up to and after the sale is completed

Business Link 24.11.2010