The purchase of a residence is the single largest transaction in which most individuals will ever be involved. For an entrepreneur or small business owner a similar statement can be made about the buying or selling of a business. In short, it is often the deal of a lifetime.
Legal considerations affect even the most basic aspects of such a transaction. For example, the risk of assuming unwanted environmental or employee benefits liabilities may rule out a particular structure for a transaction or prevent the transaction from going forward at all. Consultations between client and counsel at an early planning stage are essential to (1) close the deal in a timely manner, (2) ensure a smooth post-closing transition, (3) avoid surprises about the value of the business, and (4) avoid the assumption of unwanted or unknown liabilities.
This Article briefly summarizes some of the major legal considerations involved in the buying or selling of a business. While the article focuses on negotiated corporate transactions occurring in the United States and is oriented to the Buyer’s viewpoint, similar considerations apply to the Seller and other types of acquisitions.
Negotiated acquisitions are most often structured as either asset or stock purchases. In certain circumstances, statutory mergers or consolidations are involved.
In a merger or consolidation, two corporations are combined. In a merger, the stock of one is exchanged for the stock of the other, cash or other consideration. In a consolidation, the stock of both is exchanged for the stock of a third corporation, cash or other consideration. The surviving corporation carries on the business of the combined corporations and either or both of the original corporations ceases to exist.
There are advantages to a merger or consolidation. The acquisition can be structured as a tax-deferred transaction. In addition, there are no minority shareholders after the merger or consolidation. Sales taxes are generally not incurred. A merger or consolidation may also qualify for more favorable “pooling of interest” accounting treatment. In relative terms, the documentation of a merger or consolidation can be simpler than that used to document other types of transactions.
Disadvantages of a merger or consolidation include acquisition by the Buyer of all liabilities of the target, whether fixed, contingent, disclosed or undisclosed. While this problem can be obviated somewhat by obtaining warranties, representations and indemnities from the target company and its major shareholders, warranties and representations made by the acquired company ordinarily do not survive the merger. In addition, in a merger transaction, target stockholders may have dissenters rights enabling them to receive cash for their stock at an appraised value set ultimately by a court.
In an asset purchase, an acquirer may purchase all, substantially all, or selected assets of the target in return for any combination of stock, cash, debt or property. The advantages of an asset acquisition include the ability to purchase selected assets free of liabilities not specifically assumed. As with a merger, after consummation of the transaction, there are no minority stockholders of the target. Ordinarily, shareholders of the target do not have appraisal rights.
There are also disadvantages to an asset purchase. Identification of the assets to be acquired is important and may be a time-consuming task. Consummation may also require obtaining consents to assignment of contracts and prepayment of debt. Deeds and other settlement documentation must be prepared for transfers of real estate. Bills of sale and other assignment documents are required for transfers of other assets, including contracts, licenses, and permits. More complex documentation and more time is ordinarily required to conclude an asset purchase. Real estate transfer and sales taxes may also be incurred.
In a stock purchase, an acquirer may purchase all, substantially all or majority of the target’s stock. Advantages include the preservation of the target’s identity, franchises, licenses and permits. In general there are no transfer or sales taxes incurred. The contract rights of the acquired business are ordinarily not impaired. Less documentation may be required. Disadvantages include the fact that the transaction may leave minority shareholders in the target. All target liabilities are also acquired.
Variations and combinations of the foregoing are also possible, including the use of earn-out arrangements. In an earn-out, additional purchase price payments may become due in accordance with a formula based on the future performance of the acquired business. Problems with earn-outs abound, particularly as to the creation of the formula, measurement methods and verification. Invariably, if the maximum earn-out is not achieved, disputes will result.
Sale of business transactions may be structured so as to defer the recognition of United States federal income tax. Analogous provisions generally apply to defer state income taxes. All such structures require the issuance of stock of the acquirer or its parent and that either the target’s historic business be continued or a significant portion of its assets remain engaged in a new business. In addition, the target stockholders must intend to retain an amount of stock of the acquirer equal to at least 50% of the total consideration.
In a tax-deferred transaction, the recognition of gain for the target and its stockholders is deferred and the transaction may qualify for pooling accounting treatment. In such a transaction, the acquirer obtains a carryover basis in the stock or assets of the target and the tax attributes of the target are carried over to the acquirer. A tax-deferred transaction avoids tax problems that can arise in a taxable transaction such as recapture of depreciation and loss of investment tax credits.
Structures that require the recognition of taxable income and gain upon consummation of the transaction include a purchase of stock or assets for cash, debt securities, or a combination. In addition, a merger or consolidation where cash or debt securities are paid generally would be a taxable transaction, as would an installment sale of a business. Regardless of structure, the acquisition of a corporation with net operating losses, investment credit carry forwards or other carry forwards presents special problems that must be dealt with on a case-by-case basis.
A question frequently asked by a potential Buyer of a business is, “Where will I get the money?” Sources of capital for payment of the purchase price range from self-generation from internal operations, to family and friends, to venture capitalists to banks, vendors, suppliers, employees and even the Seller. If bank borrowing is involved, assets, such as real property, plant, equipment, inventory and accounts receivable usually serve as collateral. The interrelationships and priorities among financing sources can be intricate and require time-consuming negotiations and careful drafting to avoid later problems. In addition, fraudulent conveyance issues must be addressed when using the target’s assets as collateral in a so-called leveraged buyout.
In addition, in many financing transactions, federal and state securities laws must be dealt with. In this area, ignorance of the law can be very painful to a business enterprise and its owners. All sales of securities are regulated under both federal and state securities laws. The term “security” for purposes of these laws is interpreted very broadly, and includes stock options, warrants and some forms of debt, along with common and preferred stock and convertible debt.
The securities laws prohibit misrepresentation (whether by misstatement or omission) in connection with the purchase or sale of any security. The securities laws also require certain written disclosures about the financial and business status, prospects and management of the business, the securities being sold, how the money raised in the offering will be used, the risks associated with the investment, and any other material facts that an investor should know before making an investment decision.
Misrepresentations or omissions of material facts in connection with the purchase or sale of a security may subject corporate officers and management personnel to personal liability for investor losses. Personal liability may extend to the outside directors, and to others who are involved in promoting the purchase or sale of the security. Misrepresentations may be intentional or only negligent, and may include incomplete statements as well as failure to disclosure important information.
Due Diligence Investigation
Once a decision to move forward has been made, the Buyer typically conducts a due diligence investigation of the Seller. Often the investigation is done in stages with more extensive examinations reserved for after the signing of a letter of intent or the definitive purchase agreement. The objective of the due diligence examination is to evaluate the target’s business. The examination should expose potential problems so that specific agreements can be reached to deal with them. Areas of particular concern include environmental, product liability, employee benefits, and other potential sources of contingent liabilities. A thorough due diligence investigation will also evaluate technology, proprietary rights, accounting systems and other aspects of the target’s business and identify legal and contractual impediments to completion of the proposed acquisition.
Other considerations which often are critical in structuring or documenting the purchase or sale of a business include those regarding (1) environmental matters, (2) pension and other employee benefit plans, (3) intellectual property, (4) product liability matters, (5) state corporate law considerations, (6) federal and state antitrust laws, (7) regulation of foreign investment or ownership, and (8) industry regulation.
Perhaps no area holds as many traps for the unwary as potential environmental liability. Federal and state laws impose liability for clean-up of hazardous substances on present owners and operators of real property from which there has been a release of any hazardous substances. The continuation, knowingly or unknowingly, of a prior practice may give rise to liability, as may a release arising from past activities that occurs or continues at a site. Past violations of clean air and water acts and other regulations governing emissions, discharges and permits may also become the responsibility of the new owner. Fines may be imposed, operations forced to shut down and expensive pollution control equipment required. The purchase transaction may also trigger reporting obligations that must be complied with in order to avoid later problems.
Both to take advantage of what is termed the “innocent purchaser” defense to an environmental claim, and to learn more about potential liability exposure, environmental audits are strongly advised in all transactions involving the transfer of real estate or the lease of industrial property. Typically, these are done in phases. In a “Phase I” study, employees are interviewed, records reviewed and the site inspected. Based on the results of the Phase I study, a “Phase II” study involving testing and ground water and soil sampling may be required. Appropriate representations, warranties and indemnification of the Buyer by the Seller in the acquisition agreement (and occasionally, having the ability to walk away from the deal) are essential to protect against unwanted liabilities.
As to pensions and other employee benefit plans, the acquirer may become liable for excess taxes or become subject to a lien on both its and the target’s assets if the target’s plans have not met minimum funding or other requirements of the Employee Retirement Income Security Act (ERISA). If the acquirer wishes to assume, freeze or terminate the target’s plans, specific steps must be taken to ensure compliance with ERISA. Multi-employer pension plans, employee stock ownership plans (ESOPs), profit sharing and other plans holding employer securities, and other stock plans for employees, present special problems that must be addressed on a case by case basis.
Intellectual property concerns revolve around the treatment in the acquisition of such items as patents, trademarks, service marks, copyrights and trade secrets. In general such items are transferable. Alternatively, ownership of intellectual property can be retained by the Seller and use rights licensed to the Buyer in exchange for the payment of royalties. Clear identification of the target’s intellectual property must be made and the adequacy of the steps the target has taken to protect its rights must be determined. To the extent the target has not taken proper protective actions, curative measures must be undertaken to ensure that good title is transferred to the Buyer.
With respect to product liability issues, the Buyer will assume liability for injuries and damages caused by products distributed by the target company upon the merger or acquisition of stock of the target company. A carefully drafted purchase contract may limit the liabilities assumed in this area. Note, however, that particularly where the target’s business is continued in much the same manner by the acquirer after the purchase or where there is an overlap or commonality of ownership before and after the transaction, successor liability is possible regardless of the structure of the transaction.
Regarding state corporate law considerations, directors of both the target and the Bueyer must be cognizant of their fiduciary duties to shareholders and, in cases involving companies that are insolvent, to the creditors of the insolvent company. While directors may take advantage of the business judgment rule and statutory protections which insulate them from liability for actions taken in good faith, after due deliberation and believed to be in the best interest of the company, special situations may require that specific steps be taken. For instance, where transfer of control of the target is contemplated, elimination of a minority ownership interests is an important consideration. In other contentious situations, it may be advisable to obtain fairness opinions from an investment banking firm prior to approval of a transaction.
Depending on the size of the acquisition, the involved industries and the concentration of competition within the involved markets, federal and state antitrust laws may be implicated in the sale of a business. For instance, both the Clayton Act and the Sherman Antitrust Act prohibit certain business combinations that lessen competition. In addition, prior to concluding transactions of certain size, the parties must file a Hart-Scott-Rodino premerger notification and observe a statutory waiting period. During the waiting period, the government may object to the transaction. Obviously, any governmental interference should be anticipated and appropriately dealt with in documenting and implementing the proposed transaction.
Another area of potential is regulation of foreign investment or ownership of United States companies and real estate. For instance a filing with the Committee on Foreign Investment in the United States (CFIUS) and a waiting period may be required if a transaction involves a non-U.S. acquirer. Filings and approvals under other federal laws may also be required, particularly where the business of the target is defense related or involves other key industry sectors, such as government contracting.
Similar considerations may apply regardless of foreign involvement, if the proposed acquisition involves regulated industries. These include electric, gas and other utilities, insurance companies, banks or bank holding companies, savings and loan associations, airlines and other transportation carriers or television, radio and other communications properties.
Legal considerations permeate all aspects of the purchase or sale of a business. Because of the complexities involved, early consultation with counsel is advisable to ensure that the deal of a lifetime does not become a real life nightmare.