Due DiligenceSelling A Business

5 Risks to Avoid When Selling a Business

By May 16, 2021 No Comments

Selling a business is complicated.  While everyone involved has some level of distaste for the due diligence process, there is a reason it exists.  Buyers must be confident that they are getting what they paid for, while the Sellers wants the Buyer to be content with their purchase, as to avoid any post-closing misunderstandings or litigation.   Along with working with a business sales broker and M&A attorney, it’s a good idea for sellers to be aware of the potential risks, in case something goes wrong. By being aware, it’s much easier to avoid these risks and have a happy transition from Seller to Buyer.

Why Worry About the Risks?

Risks in a deal can come with various consequences.  Depending on the type of problem and what happens, the consequences could be major or minor. In some cases, consequences could mean the sale does not go through, and the Seller must start the sales process over and look for a new Buyer. In other cases, if there is a major issue, post-close, it could open the Seller up to litigation and cost them a significant amount of time and money to fix. It’s also possible for minor issues to seem like major issues, until more research is done.  Instead, it’s better to be aware of these possible risks and to know what to do to mitigate them, so the Seller and Buyer can focus on a smooth transition.

Due Diligence Issues

Buyers will have a due diligence period.  It’s that simple.  Here, they will want to learn as much as possible about your business as possible.  Buyers want a sound investment and will investigate the business to ensure the business is as it appears to be. There are quite a few different issues that can occur here. While certainly not an exhaustive list, they include:

  • The Buyer finding “off-balance sheet” liabilities or expenses paid from a personal account. This can include debt contracts that exist, either “on paper” or verbal that do not appear on a Seller’s balance sheet.  On the expense side, this includes the Seller paying certain bills from his personal account, rather than through the business accounts.  It’s important here for a Seller to have clean and complete financial records.  No shoeboxes full of receipts, please.
  • The Buyer finds tax issues. In certain states, owners of business entities pay “personal property” taxes on equipment and inventory in a business. Some Sellers don’t realize they need to pay these taxes.  This can become an issue before the close.  Most deals at the “Main Street” level are asset purchases, rather than stock purchases, due to the need to protect the Buyer from any existing or “contingent” liabilities.  This can include lawsuits that have not yet been filed during the prior Owner’s history of owning the business.  While an asset purchase can protect a Buyer from consumer and commercial litigation in the Business’s history, pre-close, unpaid taxes can be a different story. The government wants their tax money.  It is debatable whether an asset purchase is enough to protect from past tax liabilities.  A Seller should make sure they have paid all applicable taxes, including sales, personal property, excise, tariff, etc., before any issues arise during due diligence.
  • It is a good idea for sellers to practice full disclosure during due diligence. Chances are, the Buyer will find out about any major problems with the business during due diligence.  However, if the Seller does not disclose these major issues, such as the recent loss of an important customer, this could be considered fraudulent.  No amount of legalese in the legal documents can protect against fraud.  It’s better to be up front about any important issues, even if the Seller can “get away with it”.  This will lead to post-close litigation.

Terms for Price Adjustments

If there are major issues that arise during due diligence, the Buyer may want to adjust how much they’re willing to pay for the business. While there are no hard and fast rules for how and when this can be done, the buyer is free to request a reduction in price at any time.  The Seller may need to accept it, depending on the circumstances and how far along in the sale they are, if major issues are discovered. Unfortunately, when there is little due diligence done in the beginning of a deal, price adjustments can be a unwanted consequence. In order to mitigate the hated “price adjustment”, a business sales broker and a Seller should prepare materials and due diligence items ahead of bringing a deal to the market.

Consulting or Employment After the Sale

After the sale has concluded, the Seller will need to stay on for some sort of transition period or training.  This period is normally free and may last from a few weeks to approximately three months.  However, the Buyer and Seller may agree that the Seller stay on for a limited time beyond this as an employee or a consultant, beyond the free training period.  It is important to have a clear understanding of the expectations and the details of this written up, before the sale is finalized. Details should include the scope of the Seller’s duties after the sale, how long they will perform those duties, pay rates for consultancy or employment, and any other agreed upon terms. For sellers, it’s imperative that all of this is set out in a consultancy or employment agreement to make sure there are no misunderstandings, later.  For smaller deals that are governed by SBA loan terms, sellers can only stay on for a year, while, in larger deals, the employment or consultancy terms can extend to multiple years.  It’s important to have a clear understanding between both parties, so there are no misunderstandings.

Liability After the Sale

In most deals, once the sale is completed, the Seller should not worry all that much about post-close litigation, as long as the Seller has not committed fraud. However, there are certain situations where sellers must take care of any pre-close liabilities, post-close.  These should be taken care before closing, when possible.  When not possible, sellers must do everything in their power to pay for these liabilities in a timely fashion.  For instance, if sellers owe vendors post-closing, it could complicate the relationship between the new Buyer and that vendor, if these bills are not paid. The best practice for sellers is to make sure the Buyer is properly trained and take care of any outstanding liabilities, as soon as possible, after the close, especially if it is an asset sale.  Buyers want to feel like they are taken care of, rather than having the business “dropped” on them, post-close.

Warranties for the Buyer

Most sellers will include warranties for the Buyer to help complete the sale. Before offering any warranties or insurance, the Seller needs to make sure they’re aware of what is being offered and what it means for them, if anything happens. Sellers should read through these clauses carefully and speak with their M&A attorney, accountant, advisors, or business sales broker to determine if there are any issues to be aware of, before they sign. Understanding the scope of the warranties can help the seller prevent them from being contested when the sale is finished.

How to Minimize Potential Risks

Sellers have options to help them reduce the risks they have when selling the business. Some of the best ways to minimize the potential risks will include the following.

  • Know What the Risks Are – Sellers should take the time to learn more about the risks mentioned here, as well as other risks more specific to their business. Knowing the risks can help them avoid any issues.
  • Look Into All Options – Depending on the risks, there are various options to handle it before or after something has occurred. Sellers should know what their options are as well as the repercussions for choosing each option.
  • Read Everything Carefully – Read through the sales contract and everything else carefully before signing any paperwork. It is imperative the Seller understands what they are agreeing to with the Buyer during the sale.
  • Work With a Professional – The best way to minimize risks is to work with an M&A attorney and a business sales broker who have significant experience with selling businesses. Your M&A attorney and business sales broker know what the risks are and how to avoid them.

There are risks whenever someone wants to sell a business, but there are ways to avoid those risks and minimize the potential for anything to happen. Those who are looking to sell a business can talk to a business sales broker to learn more about all of their options and what they should expect during the sales process. With professional help, it’s a lot easier to minimize what can go wrong and make sure the sale proceeds and closes as smoothly as possible.