Selling your business: How to navigate the legal minefield

By: Scott McKenzie (Director) and Andrew Henshaw (Director)

Selling a business can be a bittersweet moment.

On one hand, you are ‘cashing in’ and will have the opportunity to free up time for other priorities. However, ending your journey can be a tough moment, particularly where you have a strong personal connection with your business.

Being emotionally invested can make it difficult to maintain focus and objectivity. In our experience, this often heightens risk. Although adopting a cavalier approach and rushing to settlement to ‘get the deal done’ might seem like the easiest option in the short term, it can potentially cause sleepless nights and financial losses in the years after the transaction is finalised.

When selling your business, the dream is to reach settlement and walk off into the sunset without having to worry about the business ever again. In order to do so, a vendor needs to carefully navigate the transaction process, and ensure that they have robust protections in place.

The Process

Selling a business is not just a matter of signing a contract and waiting for payment. Even the most simple business sale transactions will have six key milestones, which are as follows:

 

Navigating the Minefield – The Key Traps!

Business owners looking to sell often fall into avoidable legal traps. Careful planning and meticulous execution of the transaction can reduce these risks significantly. The table below provides some guidance about navigating the minefield.

 

Issue Description
Why can the purchaser pull out of the deal at the last minute? Vendors are often too generous with ‘conditions precedent’, which create a platform for the purchaser to pull out of the transaction.

Some common conditions precedent are:

  • subject to finance;
  • subject to due diligence; and
  • subject to the transfer of a lease.

Although the conditions precedent above might seem benign, it is important to place appropriate parameters around these conditions to minimise the risk of the purchaser being able to pull out of the deal at the last minute.

Where did my money go? Many business owners negotiate a great purchase price, but then end up having it whittled away by various adjustments within the Business Sale Agreement. Some examples of common adjustments which can erode the purchase price include:

  • unearned revenue adjustments (e.g. if you collected revenue in advance for services not yet rendered, and the purchaser seeks to recover those amounts from you);
  • employee entitlement adjustments (e.g. if your employees are transferring across to the purchaser, adjustments will often be sought for personal leave, long service leave and annual leave balances);
  • payout of existing contractual obligations (e.g. if any of your assets are subject to finance arrangements, the purchaser may require you to either pay those arrangements out or adjust the purchase price by the finance amount).
Why haven’t I got my money yet, and why does the future performance of the business matter? Another key potential issue regarding the purchase price is whether there is any ‘Deferred Consideration’ or ‘Earnout’ component. These aspects can be briefly summarised as follows:

  • deferred consideration means that part of the price is paid after settlement (e.g. 50% of the purchase price is paid six months after settlement); and
  • earn out arrangements usually mean that payment will be subject to the future performance of the business (e.g. 25% of the purchase price will only be paid if net profit for the business increases in the year following settlement).

Getting clarity on the operation of any proposed deferred consideration or earn out arrangement is critical, because you can potentially end up with far less in your bank account at the end of the process than what you expected.

Get me out of here! Vendors are at risk of mentally and emotionally ‘checking out’ from the business once the Business Sale Agreement is signed. Cunning purchasers might identify issues during due diligence and then use those issues as leverage to re-negotiate the purchase price.
Why am I still on the hook? A ‘clean exit’ will be impossible to achieve if appropriate vendor protections are not included in the Business Sale Agreement. There are two main traps for vendors in this area, which are:

  • not obtaining proper releases: it is remarkably easy to end up still ‘on the hook’ for various liabilities (e.g. personal guarantees or liability to pay rent under the lease) after settlement. Strong legal protections should be put in place so that you are released from liability from settlement onwards; and
  • aggressive warranty package: you can potentially be liable for minor issues with the business after settlement if the purchaser has locked you into an aggressive ‘warranty package’ (i.e. a broad and onerous set of legal promises about the business). To mitigate this risk, you should seek a generous suite of limitations of liability.
That’s not what we agreed! The devil is in the detail with the Business Sale Agreement, and generic or ‘off the shelf’ contracts should be avoided at all costs.

Vendors can find themselves in a very precarious position if the terms of the deal are not accurately reflected in the Business Sale Agreement. A disconnect between the verbal agreement between the parties and the wording of the contract has the potential to cost a vendor tens of thousands of dollars.

Why can’t I do anything? Restraint of trade obligations can greatly restrict your freedom after you sell your business. Some common restrictions include:

  • non-compete obligations (e.g. you are not allowed to set up a competing business within 25km of the business premises for a period of three years); and
  • non-solicit obligations (e.g. you are not allowed to entice employees or customers away from the business that you sold for a period of three years).

Although restraints are sometimes a necessary evil, it is important to understand exactly what you are restricted from doing to ensure that there are no nasty surprises after settlement.

 

 

Dictionary of Terms

There are a lot of technical legal terms used during business sale transactions. Here is a short dictionary of common legal jargon used in these processes, along with a short simple English explanation.

 

Term Simple Explanation
Heads of Agreement / Memorandum of Understanding A short form contract which sets out the key terms of the deal. This document must be very carefully worded to avoid any unexpected Capital Gains Tax consequences.
Warranties Contractual promises about the business. For example, the vendor might provide a warranty that ‘the business is not currently involved in any court disputes’.
Indemnity A promise to protect another party against something. For example, the vendor might provide an indemnity to the purchaser relating to financial losses which flow from any historical underpayment of employees. In this situation, the vendor will essentially be required to reimburse the purchaser for any financial loss suffered due to underpayment of employees.
Completion / Settlement / Closing This is the point at which the ownership legally transfers from the vendor to the purchaser.
PPSR This is an abbreviation for ‘Personal Properties Securities Register’. The PPSR is a public noticeboard which provides a list of security interests which have been registered against a particular ACN, ABN or company name.
Conditions Precedent A condition which must be satisfied before the parties are required to complete the transaction. For example, ‘subject to finance’ is a condition precedent.

 

Summary

The end of the business ownership journey can be a very exciting time, and a time that many business owners dream about. It is important to carefully navigate the minefield of potential legal traps to ensure that this dream does not turn into a nightmare.

 

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Sydney NSW 2000

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