Selling a business in California is a fairly complex--but ultimately rewarding--process. It is one exit strategy that business owners use to realize gains from building and operating a successful business. Because there are so many moving parts to selling a business, clear documentation of the terms of the sale is critical. In general, there are four stages to selling a business: preparation, negotiation, due diligence, and documentation. This article presents an overview of some of the factors to consider in each of the four stages of selling a business in California.
Preparing to Sell a Business
Selling a business is not that different from selling a car or a house. You need to know what you are selling and how much money you are willing to accept. In addition, you need to clean up and advertise your business. The following items summarize some actions you should take to prepare your business for a sale:
- Asset versus entity sale. As a preliminary issue, a business owner needs to decide whether to sell the business entity (stock in a corporation or membership interest in a limited liability company) along with all of the assets and liabilities, or just the business assets by themselves. Buyers will typically favor an asset sale because they can pick and choose which assets they want without assuming unknown liabilities. Sellers will favor an entity sale because it is a simpler process and it allows the owner to unload the entire company along with all of the associated liabilities. If you are considering an entity sale, you should check with the California Secretary of State to make sure your entity is in good standing. The type of sale you choose could affect your future liability to the buyer, so it is also wise to get advice from an attorney who specializes in mergers and acquisitions for small businesses.
- Valuation. Before you can sell a business you need to have a good understanding of what it is worth. You can get a rough estimate of your business’ value by researching the sales price of other businesses within your industry. However, this is only an estimate. At some point you will need to get an expert opinion from a business valuation expert such as an accountant, business broker, or business appraiser. Having this piece of information is going to be critical in every other stage of selling your business.
- Company resolutions, documents and agreements. As you prepare to sell your business it is important to clean up and organize all aspects of your business. This includes making sure that your relationship with vendors, customers, distributors, and others is well documented. You will also need to review internal company documents, resolutions, and agreements to make sure they tell a clear story of how the business has been run. This is especially important if you decide to do an entity sale rather than an asset sale. Annual information statements filed with the California Secretary of State can be obtained for a small fee by filing a Business Entities Records Order Form at the Secretary of State Information Requests.
- Selling memorandum. A standard form of advertisement used in selling a business is the selling memorandum. This document is used to market a business by presenting accurate information about the operations of the company including financial health, management, employees, products and services, and, of course, the purchase price. You will want to prepare a selling memorandum for potential buyers to review. Since this document will contain very sensitive information you do not want to distribute it to just anyone. Only serious buyers who have signed a confidentiality agreement should receive a copy of the selling memorandum.
Negotiating Terms of Purchase
Once you have prepared your business for sale you can list it with a broker or use some other form of advertisement to communicate to potential buyers that it is for sale. Interested buyers and brokers will want to discuss a variety of terms that will eventually be a part of any sales transaction. Here are some items you should be prepared to negotiate with potential buyers:
- Purchase price. You can anticipate that potential buyers will want to negotiate a lower price from the price at which you advertise your business. The asking price should be flexible enough to accommodate a healthy negotiation process. Having an appraisal will give credibility and context to your asking price.
- Terms of financing and interest. The purchase price can be paid in a lump sum cash payment or it can be stretched out over time. Often small business owners have to finance a portion of the purchase price. Financing the purchase price typically requires a promissory note along with some form of security agreement with collateral pledged against the future payment of the note. California regulates how much interest you can charge a buyer. You can review the California usury laws provided by the California Attorney General.
- Representations and warranties. Both the buyer and the seller will need to make certain representations and warranties to the other party. A representation is a presentation of facts and a warranty is promise that the facts as presented are true. For example, the seller will represent and warrant that he or she is the legal owner of the business and is authorized to sell it. The buyer will represent and warrant that he or she is authorized to enter into the transaction and no that the agreement is enforceable.
- Lease. If you have a lease on office space, your buyer will probably want to take over the lease. This can be done through a sublease arrangement or by negotiating a new lease with the landlord.
After you have gone through the process of negotiating the basic terms of selling your business, you and the buyer will sign a document that briefly outlines those terms. This is called a “letter of intent.” It is not a binding contract but helps to keep track of what has already been negotiated. This document makes it easier to produce the final purchase agreement.
Due Diligence and Inspection Period
Once you have a serious buyer who has signed a confidentiality agreement and a letter of intent, they will want some time to inspect your business to make sure everything you have represented checks out. The inspection period gives the buyer the opportunity to inspect the physical state of your business including the building, equipment, inventory and employees, as well as the financial records, legal contracts and company books. In order to ensure a smooth transition for the new buyer, you want to make sure that you disclose everything up front. The following is a list of items you should prepare and make available to any serious buyer:
- Company books which include corporate records of organization, meeting minutes, company resolutions, ownership certificates, certificates of good standing, and records of company structure
- Financial records and tax returns including profit and loss statements, and balances sheets
- Material contracts with vendors, suppliers, clients, customers, distributors or any other ongoing business relationship that is a critical part of your business
- Accounts receivable reports that detail the future payments the company expects to receive from transactions that have closed prior to the sale of the business
- Valuation report prepared by a CPA or business appraiser that justifies your asking price for the business and gives context to the buyer for understanding how the price was determined.
In addition to inspecting records and physical facilities of your business, a prudent buyer will want to contact business partners who have experience doing business with you. This might include speaking with vendors, customers, distributors, or other business partners to assess the strength of the various business relationships. If there are skeletons in the closet of your business, it is a good idea to deal with them in a straightforward and honest manner. The more information the buyer has about potential problems the better equipped they will be to handle those problems after you close the transaction.
Documenting the Transaction
A purchase agreement is the primary legal document used for the acquisition of a business. The purchase agreement outlines all of the details of the sale and mirrors the letter of intent. Depending on how you structure this transaction you may also need a bill of sale, promissory note, security agreement, stock transfer certificate, and company resolutions. The purchase agreement should include all of the following:
- clear statement of who is buying the business and who is selling it
- whether this is a sale of business assets or an entity sale
- the purchase price and method of payment
- actions that the buyer and seller must take prior to closing
- the closing date
- representations and warranties of the buyer
- representations and warranties of the seller
- future covenants against competition and confidentiality
- default provisions for sales involving seller financing
- boilerplate legal provisions
- exhibits of other relevant documents, such as bill of sale and promissory note.
Even honest people are sometimes forgetful. By documenting the details of the business sale, a business seller can avoid an expensive and time-consuming legal battle.
It is important to follow through with the following items once you have closed the sale of your business:
- Close business bank accounts. Closing a business bank account should be done as soon as all accounts receivables have been processed and no more money will be processed through the business account. The bank will close the account and issue a final check or cash payment of the remaining funds from the account once you provide them notice that you are closing the account.
- Cancel general liability insurance. You may want to discuss with your insurance broker the terms of your policy to make sure you do not need to carry a form of tail insurance to cover any liabilities that could arise following the transfer of your business.
- Winding up the business entity. California requires that you file certain forms with the Secretary of State and Employment Development Department in order to terminate a business entity. These forms are available at California Secretary of State and the Employment Development Department.