Webinars

Speaker (00:00)
Welcome everyone. My name is Gershon Morgulis. I am the founder of Imperial Advisory. We are a fractional CFO firm and we provide fractional CFOs, CFO services. So we have a whole team of CFOs. Most of our CFOs have 30 to 40 years of experience and we go into businesses that need help but don’t need us on a full-time basis. So we’ll either be working for a CFO ⁓

that might be on helping get them ready for an audit or augmenting their FP &A process. have a offering on the FP &A side as well, ⁓ guiding them through certain things as a variety of things that we do for CFOs to help support them. ⁓ Most of our business though is working with smaller companies that do not have a CFO, don’t necessarily need a full-time CFO and kind of having owner who’s trying to be their own CFO and

not doing a great job, doesn’t have the time, et cetera, et And we go into these businesses and we help them. provide them with top-notch expertise and help them with a variety of things. So there’s the day-to-day things that we do, helping with strategy, execution, et cetera. And then there’s all sorts of things that come up on a as-needed basis. One of those things that come up on an as-needed basis is &A.

And so that could be working for a CFO who maybe doesn’t have the internal team to do the pre-deal work or working for a CEO or sometimes even an individual that’s looking to buy a business. So a CEO that’s looking to do an add-on or an individual looking to buy a business or a business looking to prepare itself for sale. So what we find is that

that &A can be used as a tool for growth similar to marketing or other things, or like I said, it could really be a standalone deal. And the topic today is the anatomy of a purchase agreement. But before you get to the purchase agreement, there’s often a lot of work done to understand the company, understand the target company, understand what’s going on, understand how this fits into the existing company, if it’s a company acquiring. ⁓

And if it’s not a company acquiring, there’s still a lot of work really. I like to break it into two phases. There’s understanding what is really going on. So sometimes we find that the story that the seller is trying to spin isn’t really true. We don’t believe it. And sometimes we find that we believe the story is just not a very good story. It’s not a story worth paying for to quote one of our clients.

If they gave us this business for free, should we take it? And that was a business that was doing 8 million revenue, wanted 8 million and wasn’t making any money. So you have both of these things and these are the things that we work on with our clients, helping them figure out if this business is something that they want or if this is a business that they, well, again, one, do we really trust what’s going on here? And the story that we’re being told and we’ve uncovered all sorts of weird things. ⁓

And then if we believe the story, then is that something worth them buying into? Anyway, after all that, we get to the topic of today’s webinar, which is setting up a purchase agreement. Typically, that’s going to be done by an attorney. And I know we have a bunch of attorneys here. Happy to see you all. And we’re especially happy to have Avi, who is our speaker today. Avi is a partner at Rivkin Radler. He’s worked at

bunch of different firms, I think here on Long Island. I think he’s coming to our networking event tonight. And by the way, for any of you in Nassau County, we have a networking and mastermind event tonight that we’re hosting at our office. If any of you are interested, send me a message. But anyway, back to Avi. So Avi’s been doing this for a while and…

⁓ and we’re very, we’re very happy to have him here. I’m looking forward to learning a lot. without further ado, Avi, take it away.

Thank you very much Gershon. Good morning. Thank you, Imperial for having me. Good to see everybody. ⁓ Today, as Gershon said, we’re going to be talking about ⁓ &A purchase agreements. As Gershon said, buying a business can be a long and arduous journey. ⁓ There can be all sorts of ups and downs, starts and stops, and lots of decisions to make, lots of traps.

for the unwary lots of problems to solve. And we’re going to get into a bunch of that today. ⁓ Just wanted to say at the outset with that, this program is going to be almost exclusively framed from the buyer’s perspective. But there’s also a lot to learn in here if you’re a potential seller as well. Cause like, you know, lot of the concepts are just kind of.

zero sum shoe on one foot shoe on the other foot. So it’s important to understand the concepts regardless of what side you’re on. So Gershaw made some very good points. One very bad point that he made was that he said purchase agreements are typically prepared by an attorney. I think we should just get rid of that word typically and make sure that you have an attorney involved in this process. And I would say very importantly, whether it’s me or somebody else that you have a &A specializing

attorney handling your &A and not someone for whom that is not what they’re doing on a day-to-day basis. ⁓ So just a piece of free advice at the top. ⁓ So the things that Gershon said that was right on point is that there’s a lot that goes into an &A that happens well before you get anywhere close to drafting, let alone signing a purchase agreement.

So that begs the question for a program that is ostensibly about kind of an overview and at the outset of an &A and things to think about, why are we having a conversation here today about the purchase agreement? And the answer is not just because I’m a lawyer who specialized in agreements, there’s really good reasons why I think this makes sense. ⁓ And one of those reasons is that

I’m the type of person, and I think it’s a very helpful way of thinking about things, who likes to often start at the end. ⁓ Every deal has a different start. Every deal has different journey along the way. But any transaction that ends successfully and ends with a transaction being consummated and actually happening is going to end with a purchase agreement like this. So I think it’s often very helpful to say, let’s start at the end and work backwards. And how are we going to get to that end point? And I think the purchase agreement is one of those things that

Really provides a lot of the meat and the bones of what makes up a transaction and lets you kind of at the outset say. Here we know where we’re going to end we’re going to end with something that has all of these different components. How are we going to navigate a process and set up a process that allows us to get to that endpoint in a successful way and do so as efficiently as possible. ⁓ It almost I view the purchase agreement almost as a roadmap ⁓ because.

It allows you to determine those friction points and those possible points of tension early on ⁓ and deal with them and see if this is even a viable deal. Because the last thing you want is to spend months and all the time and all the money that goes with that negotiating and working through all these different potential pitfalls only to then have something pop up at the one yard line and sink a deal. So to the extent you can raise these issues early,

and understand what we’re going to have to deal with at the outset, ⁓ it could avoid that problem. The next thing why to me purchase agreement is very important is because there’s a fundamental difference between two different components of what makes a transaction. I often like to tell clients that there’s only two things that are negotiable on every &A transaction, price and terms. Price is what the business people are always focused on. They wanna know what are we paying and the seller obviously wants to know what am I getting?

That’s the fundamental business transaction, right? That’s the main thing that everyone cares about. But there’s a whole bunch of other terms to a transaction that are often just as important ⁓ that really go fundamentally to what it is that you are buying and how are you going to protect what you are buying. And the purchase agreement is where all of those things get set out and memorialized and specified. And thirdly,

the reason why I think purchase agreement is important, particularly for a buyer, because the purchase agreement is essentially what the buyer gets. The purchase agreement is like your deed. It’s like, it’s your piece of paper that says, hey, seller, I wrote you a check for whatever many millions of dollars, and you’ve in exchange given me your business. And the purchase agreement is the document that certifies that, that says, I now own this business. These are the rights that come along with that.

these are the restrictions that are now placed on the seller that prevents them from pursuing this business, interfering with their business or whatever obligations they have on a going forward basis. The purchase agreement is going to be your key to go into court if anyone ever challenges your rightful ownership of this business and say, hey court, check out this agreement, this business is mine now, see, I paid money, now the business is mine. So the purchase agreement is a really important component for

⁓ for the buyer to think about from the beginning of the transaction. And while we are on the subject of why, ⁓ probing the why to me is also one of the most important parts of thinking about the outset of any transaction, specifically sitting with a buyer and understanding why are you doing this deal? Why are you pursuing an &A at all and this specific ⁓ &A? And the answer to that why will provide

Potential answers to all sorts of different questions, including many of the questions that we’re going to encounter today, because the why for, let’s say, a financial acquisition being conducted by a private equity fund is very different from that of a strategic add on that a corporate buyer might be making or that an independent sponsor who is viewing this as their path towards entrepreneurship might be thinking about.

And the why you’re doing the transaction is going to significantly impact your answers to a lot of the what’s that we’re going to deal with over the course of the next hour or so. So let’s jump into it. ⁓ Before we kind of go through the breakdown, ⁓ this is on the on the screen here. We have what I would say is the most typical purchase agreement.

structure you’re going to see. 95 % of the time, a purchase agreement is going to be broken down into these categories. And we’re going to focus today on the ones that are highlighted and bolded. Obviously, we always start with some section of definitions, whether that’s in Article 1 or an exhibit at the end. And we’re always going to end with miscellaneous terms that most of the time, nobody reads except for the lawyers. That’s where you deal with all your severability, entire agreement, headings, all that fun stuff.

But the real meat we’re going to be talking about are articles two through articles seven. Article two, purchase and sale. This is where we kind of really just like outset. This is the basic transaction. What are we giving? What are we getting? Articles three, closing, is going to deal with the timing of the closing, what is required to be done at the closing. And as you’ll see, depending on the timing and how a transaction is structured, ⁓ what might be happening before a closing. Articles four and five is going to deal with the

representations and warranties that each of the parties are going to make. Typically, you would see the representations from the seller in Article 4, representations from the buyer in Article 5. Article 6 is our section on covenants. These are obligations that occur in the future. So people often confuse representations, warranties, and covenants and like use them almost interchangeably in terminology. There are actually three very distinct things.

⁓ Let’s say distinct representations and warranties are distinct representations and warranties versus covenants are very distinct. ⁓ Representing a representation is a statement of facts as of a moment in time. So you’re saying as of today, I am asserting that such and such is true. A warranty is a statement of fact that is future looking. So when a manufacturer warranties that their product is going to work for a year.

They are making a statement of fact as of today with regard to something that will happen in the future. Representation is you’re saying as of today or backwards looking. A covenant is not a statement of fact. A covenant is a future obligation of a party. it’s things that starting from today, the day we’re signing this agreement and going forward, these are obligations of buyer and seller vis-a-vis this transaction. And then finally, our section on indemnification.

Another good word for indemnification is your remedies. ⁓ This is the rights of the various parties should something go wrong. If somebody breaches the agreement in some way, or if somebody does something that they weren’t supposed to do. ⁓ So that’s our basic overview of the skeleton of the agreement. As I said, almost every typical purchase agreement is gonna, if not follow this exact order, they will all have these different sections or different components.

⁓ So let’s start going down this road. And we’re going to start with Article 2, purchase and sale. So as I said, purchase and sale is going to literally cover, it’s going to have a basic description of the transaction itself. What is being bought and what is it being bought for? ⁓

And obviously, we know where it’s not always so simple as, I’m buying your business for $10 million. This is where we are going to set out the specific type of transaction that is being conducted. And so when I say, what are we buying? Typically the fundamental threshold question on any transaction is what are we buying? Are we buying the stock of the target company? Are we buying the assets? Possibly we’re doing a merger, although, you in private.

Company transactions, closely held companies, mergers are pretty rare. So it’s not something that we’re really going to focus on today. But just have in mind that that is a third option and there are actually more options that are kind of hybrids between the various things that we’re to talk about today. But general high level focus is going to be asset sale versus stock sale. And the corollary to that is what are we going to give?

So that comes down to what is our purchase price? And we’re going to get into a little bit more detail on the various ways that a purchase price can be comprised. So as I said, fundamental question is going to be stock sale versus asset sale. And we’re going to assume here that we’re talking about like a full buyout of an entire company here. ⁓ You could in theory have a situation where somebody is making a

in that minority investment or even a majority investment, but they’re buying something less than the entire company. So we’re not really gonna be talking about that today. We’re going to assume in a stock sale that the buyer is buying 100 % of the stock or membership interest if it’s an LLC of the business. We’re going to assume if it’s an asset sale that this is a full enterprise, we’re not just buying a division of a company, we’re buying the whole mothership.

Presumably we are going to be buying substantially or all of the assets of the target business. So when it comes to understanding the difference between a stock sale and an asset sale and why a buyer may favor one versus the other, spoiler alert, you wanna buy assets, but we’ll get into why. ⁓ We’re gonna focus on three overall concerns to think about.

⁓ The first is the legal structure. So we’ll get into a little bit of just mechanically the difference between how one works versus how the other works. ⁓ We want to very much understand the treatment of assets and liabilities, specifically liabilities, because as a buyer, ideally you want to avoid liabilities of the existing business. And then, of course, we also want to understand the difference between how taxes will be affected by

our transaction structure. So in terms of the deal structure itself, here are some what I think are helpful pictures that I found on the internet that kind of lay out what happens on the two different types of transactions. So stock sale is for most people the simplest one to understand because almost all of us have at some point owned stock, whether it’s in our companies that we own today, but more likely

you own some form of stock on a public security market. So if, for example, I am a shareholder of Apple and I own a hundred shares of Apple and I want to sell my stock to Gershon. Now that’s not typically what would happen. I would typically just sell it on the public market, but just to make this simpler, if you look at our stock sale picture, so we have target shares, is another word for that is what you could call shareholders. So if I’m the shareholder today, I own the shares of the target.

Now in a stock sale, what happens is the acquirer, in this case Gershon, would send money to me, exchange for which I would send the shares to him. So the shares of Apple are exactly the same today as they are tomorrow. Everything contained in the shares of Apple are exactly the same as today and tomorrow. The only difference is that today the owner of the shares is Avi and tomorrow the the owner of the shares is Gershon. Very, very simple. An asset sale is a little bit different.

As you see from the picture here in the asset sale, the shareholder again owns the target. However, the asset sale is really not a transaction between me and Gershon. It is a transaction between Gershon as the buyer and the target company that I own. Because when a business is owned by an entity, all of the assets, all of the liabilities, everything that makes up that

business are housed inside the entity. I am merely the owner of the entity. I don’t have anything in my own name. ⁓ There’s good reasons for me to still be party to the transaction for other reasons, which we’ll get into, but fundamentally the transaction is happening between the target and the buyer. The target here is the seller. And what happens is that the target is going to ship off its assets to acquirer. Buyer ideally is either

has an existing entity or forms a new entity in order to consummate this transaction. And the buyer entity is then going to send the money to Target. Now, Target is presumably going to, if not immediately, then shortly thereafter, distribute those funds up to their shareholders because the shareholders are the ones who ultimately want the money. ⁓ But fundamentally, this transaction happens at the entity level.

And the reason why that difference is important is because of the way that assets and liabilities get treated in the two different types of transactions. So as I kind of tried to explain with a stock sale, in a stock sale, there is no change in terms of the ownership of the assets of the underlying business. So.

If I, as I said, if I own Apple and let’s just, you let’s get rid of the Apple analogy. ⁓ I have a business, know, Sienenski incorporated is a consulting firm and we have assets. have, you know, we have goodwill. We have a customer list. have employees. We have furniture in our office. We have rights under contracts, under leases, any stock sale. All of that is staying exactly where it is. It is not moving at all today. The company is Sienenski incorporated.

tomorrow the company will be in Sineski Incorporated. The only difference is that instead of it being owned by Sineski, it’s going to be owned by Morgulis or Morgulis. I don’t know how pronounce your name. Let’s go back to Gershaw. So the only thing that’s happening is the ownership up top is changing. Everything down below stays exactly where it is. It is not changed. And that means that all of the assets, all of the liabilities simply by operation of law,

by just staying where they are now belong to the buyer. ⁓ And the key there is going to be the liabilities. On an asset sale by contrast, it works completely different because we are physically, not physically, physically moving all of the assets from let’s say, Sienensky incorporated now to a new entity called Sienensky 2 incorporated.

we get to pick and choose what we wanna move. We don’t have to take all of the assets. We can take only some of them if we want. And we don’t have to take any of the liabilities. And that is really, really crucial. So in every asset purchase agreement, you are going to have a section on assets and liabilities that spells out essentially what are four categories, purchased assets and excluded assets, assumed liabilities and excluded liabilities. And this allows a buyer

To go through the assets and liabilities of a business and come to an agreement with a seller and make a determination about what we’re taking and what we’re not taking. So, there could be that you want every single 1 of those assets, but there might also be an asset that is not really relevant to this business. ⁓ The most common thing you’ll see is that there are, you know, I’ve heard a rumor that sometimes some small businesses will have assets that.

You know, are technically not necessarily business assets, but they are titled in the business’s name, like, you know, somebody’s car or, you know, certain memorabilia. And like, I know no one would ever, you know, they taxes or do anything like that. But like, I heard this might have happened on 1 or 2 occasions. ⁓ And typically stuff like that are not things that a buyer is going to buy in an and a transaction. Right? They don’t want the owners personal assets. There might be other.

you know, assets in there that really, you know, sometimes we’ve seen that like, you somebody has some sort of like property investment and they just like ran it through the business and it has nothing to do with the business. ⁓ So it’s important for everyone to identify those assets and make sure that those are not being sold as part of this transaction because that’s not what this deal is about. And as I said, the more important part is the liabilities. The fundamental starting point for a buyer is we want to buy none of the liabilities. We want none of those to transfer.

And that will usually be the default is that any liabilities that are not expressly written as assumed stay behind with the seller and remain seller’s problem. Any debts, any lawsuits that may exist for the past? Yes, Gershon. Question. I once heard that if you transfer all the assets under some situations, liabilities can automatically transfer because you can’t like completely gut a business. Is that for real?

So there are certainly certain categories of liabilities for which we say a concept of successor liability applies. ⁓ we’re gonna deal with those in a little bit, but ⁓ to answer your question, the answer is yes. There are certain types of liabilities that cannot be escaped. The most common one is taxes, right? The government is not letting anyone get away with taxes just because you sold your business.

So if there’s a tax liability ⁓ and you sell your business, buyer can be held liable as a successor. The same is the case for environmental. You see this very frequently in real estate transactions that buyer would step into historical liabilities of the seller. ⁓ You also see it with all sorts of employee and employee benefit liabilities. Again, the policy reason there being that

want to protect employees and we don’t want some, you know, there was some pension that got set up and you can’t sell the business and now, you know, the seller disappears and the liability goes away. And there are ways to protect against that. the better than having a way to protect against the liability is to never have any claim that the liability is yours. So, you know, if you do an asset sale, and the reason why you want to do an asset sale is

If let’s say a customer has a lawsuit because they bought a product from seller a year ago and today it killed somebody and they run into court and they, who are they gonna sue? They’re gonna sue everybody, right? They’re gonna sue the seller, they’re gonna sue the seller’s owner, they’re gonna hear that the business got sold, they’re gonna sue the buyer, they’re gonna sue the buyer’s owner. And the best thing that a buyer is able to do in that circumstance is to go into court and say, hey judge, this has nothing to do with me. You see here, they bought this product from,

XYZ Inc in 2022, we’re actually ABC Corp and we weren’t even formed until 2024 when we bought this business. This has nothing to do with us. And I would say 95 out of a hundred times, you’re gonna get that thrown out immediately because you’re not the party to the lawsuit. You haven’t been properly brought into this lawsuit. It has nothing to do with you. The other important things that you want to think about and that are

more important when it comes to an asset sale is the retitling of certain types of assets ⁓ and any consents that go along with that. Most often this is going to be in the context of a contract. ⁓ Think about your lease, right? Your lease has a provision in there that says you can’t assign it to somebody else because your landlord did a credit check on you. They vetted you ⁓ as a tenant. You can’t just call up your landlord one day and say, by the way,

I sold the business, here’s your new tenants. Landlord is not gonna be okay with that. So when you sell your business, you’re gonna have to go to your landlord and tell them in advance, you’re gonna have to get their consent and make sure that they sign on to the assignment of the lease to the new buyer. Same will often be the case with various customer agreements, vendor agreements, and other contracts that you may have, that a seller may have that your attorney, that’s part of the diligence process are going to review those contracts and see

You know, is there anything in here that will require the involvement and consent of a 3rd party in order to transfer title to certain assets when it comes to pieces of equipment that might be least same thing applies certain vehicles. You have to have them retitled in the name of the new entity. So that’s just some additional components that might make an asset sale a little bit more complicated, but.

the ability to essentially walk away from those liabilities makes those extra hoops you have to jump through well, well worth it. And then finally, we’re going to talk about the tax implications of the two types of transactions. And again, here’s a situation where the general rule of thumb as a buyer is going to be you want to buy assets. From the seller’s perspective, the tax treatment is very simple.

When you sell stock, you get long-term capital gains treatment, assuming you held the stock for more than one year, an amount equal to your gain on the stock over your basis taxed at long-term capital gains. And the same thing is going to apply for a buyer. The buyer is going to acquire a basis in the stock and

Will not have the ability to recover its purchase price until it liquidates the business ⁓ and. The most important principle in terms of. How tax affects economics is. That an asset sale allows the buyer to start recovering their purchase price immediately, ⁓ depending on the types of assets, but because when you buy assets, you get to.

take a step up in the basis of the value of the assets because when you sell assets, the IRS doesn’t view it as a sale of a business per se, they view it as a sale of the individual assets. So I’m not selling you the business, I’m selling you the tables and chairs of the office and the goodwill and the rights under this customer contract and the rights to employ this group of employees. And all those different assets are kind of viewed by the IRS as separate sales.

they are therefore taxed at an amount based on the type of asset that they are. So we generally speaking divide assets into different types. We have our capital assets and we have our depreciable assets. The capital assets such as your intangibles and your goodwill get taxed at the more favorable rate. Your depreciable assets get taxed at the higher rate. So depending on

the type of business that you have and the types of assets that the business that you’re acquiring is comprised of that will impact the exact tax rate. Usually what you end up with is some sort of hybrid between the 20 % capital gains rate and the 37 % ordinary income rate. It’s not gonna be exactly one or the other, but if you have a business that veers more towards those capital gains assets, the seller might pay 22%, whereas

When if it’s more of a business with harder assets, ⁓ it might be on the higher end. But because of the step up in basis, because of the buyer’s ability to start depreciating certain types of those assets immediately and deducting them against their gains, the asset sale form is highly advantageous to a buyer. So because of the ability to…

walk away from those liabilities because of the advantages on the tax side to buying assets. The starting point almost all the time for a buyer is going to be, wanna buy assets. Now that’s not always possible. First of all, as we said, there’s always a lot of very zero sum elements to this. So the reasons why an asset sale are good for a buyer also makes a stock sale good for a seller. So a seller may wanna say,

I want to just be done with this. You’re taking the assets, you’re taking the liabilities, you’re buying the stock, period, the end. I’m not interested in an asset sale where I’m going to have to, you know, wind down and deal with stuff afterwards. Seller might say, I want my long-term capital gains. I don’t want to deal with this whole allocation and figuring out one of my different types of assets and potentially pay more. I always assume that when I sell my business, I’m going to sell the stock. I’m to just pay capital gains on the whole thing. And that’s what I’m doing.

⁓ And depending on your leverage or negotiating power, you may or may not have the ability to dictate the structure of the transaction. There are workarounds to solve for both of those issues. And sometimes there are elections that you can make under the tax code, such as 338 H10 or 336 E. There’s something called an F-RE-ORG. And these all give you the ability to create a

transaction as an asset sale for tax purposes while still treating it as a stock sale for all other purposes, such as corporate purposes and legal purposes. But, you know, generally speaking, if we’re we’re using one or the other, you know, the stock sale is going to be more advantageous for the seller and asset sale for the buyer. In addition to your seller saying, I want to sell stock when we just talked about consents, it could be that a asset sale is just not practical.

Think about a scenario where you’re buying a business that has hundreds of contracts and 75 of them need consents to assign it to a new party. Now, maybe you’ll be able to go out and get all those consents, but that seems like a lot of work and it just might not be practical. There also could be specific types of permits or government approvals that simply are not transferable. And it could take months, if not years, depending on the organization and when you have to deal with certain government.

bodies, it could take a really long time to get the approval. And you may want to just go forward with your transaction. And that means you’re going to have to buy the stock because that’s where the permit is. That’s the entity ⁓ that is approved. That’s the EIN that’s on record. And you just might not have any choice. So yes. I want to just add one thing. And this is your talk. So correct me if I’m wrong. But we once had a client who was looking to

potentially purchase a business and they had workers comp experience that had been building up for a long time. And they felt that that was a reason why they would buy it, even though they knew there were liabilities and skeletons in the closet. didn’t go through the transaction in end anyway, but they, at least that’s what they told me at the time. They’re like, if we want to get the benefit of this experience of the workers comp experience that won’t trade had built up like enough body of work that it

it impacted their rates favorably. Correct. And if they were starting from scratch, even if they did somehow manage to transfer the contracts, they would end up having to charge much more or pay much more and therefore they’d lose money or be not competitive. Yeah. I mean, I don’t know a lot about workers comp. So I’ll just kind of grant your premise that that’s how it works. if that’s how it works, then that makes sense, right?

there could be benefits to stepping into an existing company. I’ve also seen situations where an existing company has an easier time getting financing than a new company because if it’s history now, ⁓ that shouldn’t typically be the case because you should be able to show the bank that you’re taking over a going concern and that the revenue is basically then going to be and cash flows should be imputed to the new company. But depending on your underwriter, they may just look more favorably at, you know,

a company name that has this history versus a buyer that’s starting from scratch. ⁓ OK, so for most, the most important part of the agreement is going to be the purchase price. ⁓ And we’re going to talk quickly about how we get to a purchase price. How do we, know, how much do we pay and how are we going to pay it, right? Two parts. in terms of how we determine how much to pay, ⁓

It’s really not my area of expertise. You’re gonna probably wanna speak to someone like Gershon or to someone who’s an investment banker or broker or someone who’s in the business evaluating companies. But typically what we see is most common is a multiple of EBITDA is used to determine a purchase price. ⁓ will vary largely based on the industry that you’re in, the size of the business.

Most typical is you see something in the range of four to eight times a multiple of EBITDA. Depending on the type of business and your type of buyer, you might use a multiple of revenue. One X revenue is the most common that I see. You also are going to want to factor in some sort of public research in terms of what are similar companies selling for the same way that a real estate valuation consultant would look at, you

What are other properties in the neighborhood selling for? You wanna know what is a consulting business or a medical practice or a pharmaceutical company that does this type of revenue, this type of sales, this type of profit, what is that going for? Because as I said, the multiples, the variations can be different depending on geography, depending on industry. You also, depending on what type of buyer you are, this is more when you’re on a

you know, on an add-on transaction or a corporate inquirer strategic, you have to think about potential synergies because you are not just buying necessarily this business for itself. There may be other things that this business brings to the table that fits into your existing business. ⁓ It’s not just that, you know, okay, they have a great business and we’re going to just acquire that cash flow. We may be able to grow the pie because we have other products, other services that we can sell now to a new customer base, maybe

This company has some piece of IP that we can incorporate into one of our existing offerings. And that makes the company worth even more than how it looks on paper. ⁓ So that might also factor in. In terms of paying the purchase price, what are we going to give our seller? ⁓ Most common is we’re going to give them cash, right? But we also can frequently give them some sort of property. When we talk about property, what we are typically talking about is some sort of equity

either in the buyer itself or somewhere in the buyer enterprise, what is called rollover equity. Very, very typical in the private equity context and becoming more and more typical in all sorts of &A contexts, especially as the price of capital gets more and more expensive over the last few years. ⁓ The ability to pay with something other than cash is very enticing to a buyer.

There are, it’s also beneficial to seller in many ways because A, they get to defer taxes on any things that they take in equity and they don’t have to pay any tax on it until they liquidate that buyer stock. Number two is it gives seller potential upside. If seller believes in their buyer’s theory of the case, they think that this buyer is going to add value, whether it’s through infusion of capital, whether it’s through synergies, whether it’s through,

professionalizing their business. The business that today is worth $25 million may very well be worth $50 million in three to five years. And frankly, that is what, if you’re selling to private equity, that is what they’re betting on. So this gives the seller the ability to take a piece of their ⁓ purchase price proceeds and roll it over, let it ride, and see if it can grow into even more. Similarly, buyers are often looking to

pay whatever amount that they’re paying in cash sometime other than today. ⁓ For two main reasons. Number one, if you’re a financial person, obviously you understand fundamentally a dollar today is worth more than a dollar tomorrow. So to the extent we have an ability to defer the time when we have to pay a portion of our purchase price, that is financially beneficial. Number two is it provides you some sort of protection and whether

We have our deferred payment being paid under a promissory note, whether it’s that we have money that is put in escrow or whether we make a portion of the purchase price subject to an earn out, which means that it’s not guaranteed. It is only paid if certain conditions are met, usually financial metrics about the business. That gives the buyer, as I said, protection because they have the ability to

have money that’s available in the case something goes wrong. So if it turns out that this business is not what seller said it was and you have a claim against the seller, you don’t wanna have to be in a position where you have to go chase them and say, hey seller, pay me back my money. You wanna be able to say, good thing we have this escrow over here with $3 million in it that we can make a claim against or good thing that we have a promissory note or an earn out that is supposed to be paid next year that we can basically say to the seller, hey, that $2 million that we were supposed to pay you.

we’re not paying it to you because we have a $2 million claim or we’re only paying you a million because we have a million dollar claim. ⁓ There is also typically going to be an adjustment component to your purchase price. ⁓ The two main types of adjustments, and you kind of think of this as the, you’re like kind of like your paycheck where you have the number at the top, which is the enterprise value. And then there’s the number at the bottom, which is what we’re actually paying. And

those get adjusted either upwards or downwards ⁓ based on A, the cash and debt in the business, because most transactions are structured as what we call cash-free, debt-free, especially on a stock sale. On a stock sale, you would almost never assume long-term debt and you would almost never buy cash. I mean, it doesn’t really make sense to purchase cash, right? ⁓ It’s just, you know, I give you a dollar and you sell me a dollar. doesn’t really…

Make any sense? So cash is typically going to always stay with the seller. Debt is always going to stay with the seller. And those get adjusted from the purchase price. So to the extent there is any cash left in the business, on a stock sale, seller doesn’t have to pull the cash out. We just increase the purchase price by the amount of the cash. And similarly, we would deduct for the amount of debt that is on the books. The more common and more complicated adjustment that we have to deal with is with respect to working capital.

And the reason there is that buyers typically want to expect that when they buy a business, they don’t have to now write another check to fund operations of the business. They want to buy a business that’s viable and that runs itself based on its cash flows and working capital. So early on in the process, you’re always going to want to determine

what is the working capital that this business needs? Usually you do that by determining some sort of trailing average, six months, 12 months, 18 months, and look at the history of the business and what does this business need on an average monthly basis to fund operations. And the seller is going to be expected to deliver a business that has working capital equal to that target average amount. If at closing the working capital is insufficient,

there will be a credit towards the buyer and a reduction of the purchase price. And likewise, if the seller over delivers, they get a credit and purchase price goes up. And the working capital is usually done as an estimate at closing and then gets trued up, but they’re 90 days, 120 days down the road. ⁓ As always, I’ve front loaded the majority of this presentation. It looks like we’re… ⁓

running low on time, so I’m going to try to make sure we get to some of the rest of this. The next section in your transaction document is going to be deal with the closing. ⁓ It’s a pretty mechanical section. It mostly just has like a list of items that needs to be delivered at closing. This is gonna be, and this is where you’re going to cover the various other transaction documents other than the purchase agreement itself.

⁓ So again, in terms of roadmap, this is where you want to think about what else do we need? Is there going to be a new lease that we’re going to enter into? Do we want to put in place employment agreements or equity arrangements for management? Do we need some sort of transition agreement for, you know, maybe there’s some component of the business that can’t be transferred right away and we need to figure out how that’s going to be managed during the interim. The most important consideration for this section, the closing section is

whether or not the transaction is going to be conducted as what we call a simultaneous sign and close or as a bifurcated sign and close. A simultaneous sign and close is the more simple version and for pretty much any transaction, I would say let’s say under $100 million ⁓ is almost always gonna be the norm. And that just means the day we signed the purchase agreement is the day that we close. It all happens at the same time in one shot.

By contrast, a bifurcated signing close is what is more common on a real estate deal, right? Think about when you bought your house. You signed a contract and then, just based on you seeing the house, and then you have to go get financing, you hire an inspector to do diligence. So in a bifurcated signed and close, we signed an agreement today with an agreement to close in the future. And it’s a real binding agreement. However, it’s subject to conditions, meaning

seller is going to have obligations for how they operate the business in the interim and what we call our interim operating covenants. ⁓ Very important because if you’re agreeing to buy a business, you want to make sure that seller is going to conduct the business and your ordinary course that they’re not going to do anything differently. In the meantime, they’re not going to start selling off key assets or firing key employees. You want to make sure that the business that shows up at closing is the same business that we agreed to buy. The main reason why you would want to

do a bifurcated sign and close is, as I said, if there are financing considerations ⁓ and some lenders want to see an executed purchase agreement before they will sign a commitment letter, you may also require various consents and you just want to have the ability to sometimes, sometimes you want to announce the transaction and start telling people that it occurred. So you want to have a signed binding agreement so that you can do that. ⁓

I mentioned the hundred million dollar threshold. It’s actually a little bit higher, but I remember the exact number. If you need to get antitrust approval under the Hartscott-Rodino Act, which applies to any transaction over a certain size, that requires as well that you have a signed purchase agreement and then you have, I think, 30 or 60 days to go get that approval to make sure the transaction can proceed.

The representations and warranties are almost always the largest section of the transaction. If you have, let’s say, a 50 page purchase agreement, you will often see that 25 to 30 of those pages are comprised of the reps and warranties. And the reps and warranties are in many ways the most important section because this is where the seller goes on the record about what the business is and what it isn’t.

The reps and warranties, a good way to think about them is that they’re kind of your backstop to your due diligence. So you sign a letter of intent and that’s when the seller is going to start opening its books and showing you its records and telling you about everything about business, the good, the bad and the ugly and give you an ability to do quality of earnings on the financials, ⁓ review all their contracts, look to see if there’s been any litigation, any problems, any customer complaints, all of these things will be.

uncover during due diligence. ⁓ The problem with due diligence, or I guess what would say, where due diligence is lacking is that your due diligence is only as good as what your seller gives you. When we’re dealing with private companies, there’s no public record of anything. You can’t go out and say, OK, we’re going to go. There’s no website where you can go and say, give me all of the contracts that this company is party to and tell me.

all the problems that they have. You’re relying on the seller, the shareholders to own up to that stuff and produce it to you. Now, in a perfect world, would, know, I’m sure we’re all comfortable with the honor system and we don’t need any of this, but unfortunately that’s not the way the real world works. So what the representations do is they require the seller to back up the due diligence process by putting in writing what they’ve produced.

So for example, you wanna know that seller has not been sued in the last three years, right? Cause I don’t wanna buy a company that gets sued all the time. So you’ll run your litigation searches. You’ll ask your seller to tell you, give me copies of any complaints of any letters that you’ve gotten from lawyers, any lawsuits that have been filed. ⁓ And you’re hopeful that they’ve complied.

But what you wanna do in the purchase agreement is actually have seller put in writing, we’ve not been sued during the last five years, three years, 10 years, we’ve not been party to any lawsuits. During the last three years, none of our employees have made a claim of sexual harassment or discrimination. We’ve filed all of our tax returns and paid all of our taxes, things like that. So we kind of, I like to think of this process as three stages.

You have your due diligence where you review everything, then you have your representations and warranties where the seller makes these statements. And then you have your disclosure schedules, which get attached to the representations and warranties. And that is where the seller does one of two things. Either they provide lists of things. So you may have a representation that says, set forth on schedule A is a list of all of our customer contracts.

Set forth on exhibit B is a list of all of our employees and their salaries and their job title. You also would put on the disclosure schedules if you’re a seller, the exceptions to any of your representations and warranties, because I’ve yet to see a business that is able to make all of the representations cleanly without any exception, right? In a perfect world, a seller would be able to say, we’ve had no litigation, we’ve had no complaints, we’ve had no problems.

But in reality, a seller needs to be able to say, have had no complaints, we’ve had no litigations, we’ve had no problems, except for the litigations, complaints, and problems that we’ve listed on exhibit C of the schedules. And that’s where it all ties together. So you have your diligence, you have your reps, and then you have your schedules. And the job of the buyer and his advisors is to make sure those all line up and that what we saw in due diligence is consistent with what?

seller is now vouching for on the schedules because if there is something that a seller represented that was not true, buyers going to want to have the ability to get compensated for that. Our representations are typically grouped into different categories. We have our fundamental representations, we have our legal representations, and we have our business representations. Our fundamental representations, we call them that because they are

fundamental to the business, fundamental to the transaction. Things like seller actually owns the business that it’s selling. It didn’t sell it to somebody else last week. The shareholders of the company are the three people that were claiming there’s no fourth person out there who’s going to show up next year and say, hey, I was an owner in this business and I’m entitled to a piece of the action. ⁓ The seller entity actually has title to all of the assets that it’s selling. There’s no.

significant asset that is actually in some other entity that is in the personal name of one of the shareholders. The assets are not subject to any liens. There’s nobody else out there that has any sort of claim on anything that has to do with this business. Again, these are what we call fundamental. And the implication of them being fundamental is that typically they will survive indefinitely, which means no matter when buyer discovers that there’s a breach of one of these representations,

And no matter the amount, buyer should be able to be made whole. Whether even if it’s in 10 years, if it turns out you didn’t really own the business, essentially a breach of a fundamental representation is another word for that is fraud. ⁓ So those will typically have the longest legs and the greatest ability to recover under. ⁓ Then we have our legal representations, which have to go towards.

compliance with laws and these are the ones that as Gershaw mentioned earlier, at least some of these is where you may see successor liability. So you wanna be extra sensitive to these and this is why often on transactions, you will see a whole bunch of specialists get involved because these are, we’re gonna be very sensitive to a potential environmental issue or an employee benefit issue because of the successor angle.

And then finally we have what we call our business representations. These are things that, yes. We’re running short on time. Does it make sense to continue this another time or should we just hold Q and A till 12 o’clock and wind down by then? I’m happy to do either. I’m happy to make myself available for another time if you think that makes sense. But yes, we are running low on time and there is more stuff to talk about. So it’s all super interesting and very valuable.

We could also just continue like I am available. So it’s really up to you. Okay, so I got a 1230 no problem Well, I’ll stay and listen everyone we We generally wind these things down by noon. So we don’t want to hold you forever if any of you are interested in the In the recording so that you can get the rest of it reach out to Brittany. We are recording this and We can get you the recording

I’m going to put up the poll now so that people, if you can answer that, that’s great. then whoever is able to stay, I will be staying. So ⁓ we’ll continue and we’ll all be in one place. Same price. Same price. Look at that. Buy one, get one 50 % off. ⁓ So I just put the poll up and I guess we’ll continue in a minute.

Do we want to answer any questions in the internal before? yeah, that’s a good idea. Any questions up until now? We have one question, at least one question in the poll in the.

in the chat. Have you seen situations where non-union companies purchased a union company through an asset purchase in order to not take on the liabilities? Yes. My understanding is that it’s impossible to get around. is. So I’m not sure what you mean by impossible to get around. ⁓ You can do. There’s really.

Well, I wanted to make sure I understand your question right. So in a pension situation, there, if you sell the business, it will be treated as a withdrawal from the pension funds and withdrawal liability can become due. There are ways to structure a transaction as an asset sale when there are union liabilities. There’s a section of ERISA called section 4204.

that allows you to, allows the buyer to assume the pension liability, ⁓ requires certain obligations. I think you need to post some sort of bond. You need the buyer needs to agree to continue contributing to the fund at the same rates for I think five years. ⁓ Seller remains secondarily liable to the fund. There’s a whole, there’s a bunch of hoops you have to jump through, but.

an asset sale can be done in a union context. Is there a way to basically just shut out the union and the pension and make everyone walk away from the liabilities? No. ⁓ And more so on the seller side, meaning a seller can really never get away from potential liabilities of the union because they are party to the CBA and agreed to

Apply with the CBA and make contributions to the union and they’re going to be liable for the withdrawal from the pension fund. If your question is, a purchaser avoid assuming. The liabilities, ⁓ the answer is yes. However, if they’re going to be hiring the union employees, then the union is going to require that you assume the CBA and take over that contribution.

obligation under the pension fund. So I’m not sure if that answers your question, because I’m not sure if I completely understood it. So it doesn’t have to be a stock purchase. ⁓ It can be done as an asset purchase, but the asset purchase would almost certainly be done in a way so that the buyer is taking over the obligation. So I’m hoping I answered that. But if not, feel free to ask again or ask it differently.

Is there any other questions? didn’t see any. Okay. So we’re talking about reps and warranties and our last category is our business representations. And these, know, unpredictably, they go to things that are more relate to the operations of the business, ⁓ the profits and losses reflected in the financial statements. ⁓ It’s very important.

from the outset to, and this is why you wanna hire someone like Gershon as soon as possible ⁓ because financial statements are only as good as the paper they’re written on, right? You need to understand the financials. You need to dig into the financials. And very crucially, you need to understand the methodology that is used to reach the numbers in the financials. ⁓

both from an accounting’s perspective, are they on cash basis or accrual basis? Are they done in accordance with GAAP? ⁓ Depending on the size of your business, of the business that you’re buying, the buyer will want the seller to essentially represent that the financial statements were prepared in accordance with GAAP. So that way we can make sure that we understand what these numbers mean. To the extent they’re not done in accordance with GAAP, what you would typically see is,

something to the effect of this is again where the schedules come in, you would say the financials are prepared in accordance with GAAP except that set forth on schedule blank where we explain our accounting methodology. And that’s where the seller might say something like, we’re not in accordance with GAAP except we recognize deferred revenue in some weird way that is not in accordance with GAAP or we depreciate this type of asset in a certain way that again is not in accordance with GAAP.

⁓ And particularly when you are paying a multiple of something in the financial statements to determine your purchase price, it’s really, really important that you understand the financials and that the seller makes representations about its financials. ⁓ All the other stuff here on the list, ⁓ not as important necessarily as the financials, or at least not as fundamental to what a buyer cares about, but also really, really important to understand.

Here’s a list of all of our contracts. We don’t have any other contracts other than these, because as a buyer, you don’t want to find out that later down the road, there was some contract that was never disclosed and was imported to this business that now you’ve not acquired the rights to. You also want the seller to represent that the contracts are all in effect, that there’s no defaults. There’s no reason to think there’s a default, right? You don’t want to

step into a contract and then find out six months down the road that that customer hasn’t been paying in a year. And now you’ve factored into your financial analysis, the revenues from this customer that are real revenues on paper because we use a cruel method and when we make the sale, we treat it as revenue. ⁓ But if the customer doesn’t pay, that’s not worth as much.

⁓ So I thought according to some financial experts. Yes, Giles, did you agree with that? Yeah, if they don’t pay, it’s not revenue. That’s my position. But there’s something related to this that I, something you said a moment ago, that I once heard, was at a conference, we’ll give Anshin a shout out prior to COVID. And they had these people talking about buying and selling businesses. It was an &A conference. And they said, it’s very easy to agree on the multiple.

The question is, what are you applying that multiple to? And that’s where all the real debate happens. Like we could all agree on four times, but if we don’t look at accounts receivable the same way, you think they’re gonna pay and I think they’re not, then what is that 4X applying to? Whether we multiply by four and that’s where all the fighting. Yeah, yeah. happens there, right. It’s it’s what is actually EBITDA, right?

⁓ In this business, and that’s where you want to have that rigorous quality of earnings done on your target because that’s where you’re going to discover things like. Add backs and deductions that should be made to even ⁓ based on, as I said, things that are sometimes included in the business in the financials that aren’t really part of the business and therefore should be removed. ⁓

That’s where you may also find that there is a heavy customer concentration. You’re buying this business that has $25 million of revenue. But if half of that revenue is coming from two customers, then you’re putting, as a buyer, a lot of your eggs in those two baskets. And you’re relying on the fact that you’re going to be able to keep those customers. ⁓ And depending on whether or not your seller is sticking around and the relationships going forward, that’s not necessarily a sure thing. ⁓

⁓ Especially if one of those customers is seller’s brother-in-law or seller’s college buddy who’s giving him the business because why not? And now that there’s a new owner, maybe he’ll continue, maybe he won’t. And customer concentration adds risk for a buyer. So it’s really, really important to do that analysis properly, make sure you understand the financials of the company that you’re buying. ⁓ And then as we say in the reps and warranties,

make sure that seller is willing to stand behind those financials. A seller that’s not willing to stand behind their financials ⁓ is a major, major red flag.

⁓ Okay, so that takes us through our representations. And these are the representations on the seller side. Buyer will typically make representations as well. Those are usually gonna be fairly plain vanilla. It’s gonna be kind of like the stuff that we talked about, the fundamental representations. know, buyer has the authority to enter into the agreement, et cetera, et cetera. To the extent that there is a rollover happening, seller may want

some additional representations, because if you’re essentially telling them part of your consideration is the right, the opportunity to invest into the buyer business, then the seller has the decent right to say, well, then you need to tell me things about your business that I’m now acquiring 5 % of, or whatever it may be. So the buyer reps might get a little bit more.

out depending on the situation, but usually they’re going to be pretty insubstantial.

Okay, so next we are going to move to our covenant section. As we said before, these are the future obligations of the parties. ⁓ Generally speaking, we’re going to separate these into two main categories, the ones in the top and the ones at the bottom, the ones at the top, these first three, ⁓ we colloquially refer to these as restrictive covenants. These are essentially negative covenants. These are things that the sellers are not allowed to do.

And this is good time to bring this up. So I mentioned earlier that even in an asset sale, you’re likely going to want the individual owners to still be party to the transaction, even though they are not really fundamentally part of the transaction, right? The fundamental transaction is occurring between the seller entity and the buyer. However, both because of confidence and also because of representations, which I should have mentioned that they are, and when we get to indemnification,

you want the individuals on the hook personally as well. So you want them individually making the representations and warranties and being on the hook for indemnification, just because as a practical purpose, if you have a claim, you wanna be able to assert that claim against somebody other than the seller LLC or corporation, which pretty quickly after closing is not gonna have any real assets. Certainly by the time a claim arises,

You could bring the biggest claim in the world against seller corporation. If there’s nothing there, you’re out of luck. So therefore you want to have the right to go after the individual seller and you want them to be on the hook. Same concept goes with covenants. You think about your non-compete. It’s not that I care whether or not your corporation is out of the marketplace competing with the business now. I care if you, the seller who has the reputation, has the goodwill who people know.

has all the relationships, it’s you who I don’t want competing with me. So it’s an absolute must that the individual sellers are party to the agreement for purposes of these covenants. So non-competed and non-solicit. So most of, this is a very, probably the second most important part of what you’re buying, right? You’re buying a business. So you’re buying the assets that come with the business. But on top of that,

What you’re really also buying is putting the seller out of business. You want exclusivity on this business. You don’t want your seller opening up a new business the next day that competes with you. That is a fundamental part of what you are paying him for. ⁓ So you are always going to have some form of non-compete. When we talk about a non-compete, we talk about three main different components.

⁓ in terms of what the non-compete applies to, what it restricts. We talk about the scope, we talk about geography, and we talk about duration. Duration, simple. How long does this last? How long is this restriction? ⁓ Most common starting point is five years. Five years, I would say, is probably also the most common endpoint, although depending on the situation, it can be negotiated shorter.

very infrequently do I see it go longer than five years. But I would say three to five is really where you’re gonna end up with, I think five being the most common. Next is geography. Again, pretty straightforward. Where does it apply? If you’re a buyer, you want it to be anywhere, right? That’s, know, in an ideal world, you cannot be in this business anywhere in the world. ⁓ Now there are issues with

There could be issues with enforceability ⁓ and there will likely also be issues with getting a buyer, a seller to agree to that ⁓ and whether or not it makes sense. And those kind of always go hand in hand. So typically what you want to think about is where has seller been in business and where is buyer going to be in business? And those are most crucial. So if this is a business that has been operating in the entire Northeast, then obviously you want the Northeast to be covered.

If buyer has specific plans to expand into the Midwest or buyer, know, this is a strategic add on and buyers already in the Midwest. Same, same idea. You don’t want them competing with you, whether or not you can, you can extend it to places that, you know, are not really contemplated is a kind of a deal by deal basis. I mean, I, you know, when I’m on a buyer side, I typically want to see us start out as having a geographic scope that covers the entire United States.

In 2025 with e-commerce and all that sort of stuff, again, depending on the type of business, it’s not what it once was to expand to a new market. It can be done fairly easily depending on the business that you’re in and you really don’t want to see your seller out there competing with you anywhere where you might potentially be doing business. ⁓ In terms of scope, that is going to often be the most

heavily negotiated in terms of what are they not allowed to do? ⁓ And this is where it’s really important for us to define what is the business? ⁓ What is the business that is being sold? It is particularly important from a seller’s perspective, at least, if they are selling you only a division or a component, ⁓ or if they are in adjacent businesses that are doing something similar, the seller is going to want to be really careful to make sure that they are not

prohibiting themselves from continuing their other businesses, right? If I have a business in related, in a same vertical, but it’s not part of this business per se, like, I sell car parts, but then I also operate a body shop and I’m just selling you the car parts business, you’re not buying the body shop. So you don’t get to tell me that I can’t fix cars, I just can’t sell parts anymore. So very important that those get negotiated and…

very specifically drafted to, you really to protect both sides, just to make sure that everyone is on the same page in terms of what the settler is allowed to do and what they are not allowed to do. Crucial question in terms of enforceability. I know a lot of people have probably seen that there’s been, you know, developments in the law that, you know, non-competes are fading away. There was, you know, there’s attempts in jurisdictions, including the last administration tried to.

ban them on a nationwide level. regardless of whether or not these individually hold up, there’s definitely a cultural trend against non-competes. ⁓ Importantly, almost nobody is seeking to eliminate non-competes in the context of a sale transaction. So when we talk about non-competes being banned, we’re almost always talking about them in the context of an employer-employee relationship. ⁓

It would essentially, kind of for the reason we just talked about, it would almost destroy M &A activity if you ban non-competes in this context because who in their right mind would buy a business from someone if the person’s allowed to continue in that business? For a certain product, maybe you would, but anything that’s like a service business, you would never buy a consulting business or a law firm or a medical practice or anything like that if the doctor can just go.

start a new practice the next day and say, hey, everybody, come see me at my new office. Stop going to my old office. It just wouldn’t make any sense at all. Non-solicit is a… How does this work with someone leaving? Leaving…

There’s someone who I know, let’s not get too specific. There’s someone I know who was kind of like a partner in the business, not my business, but sort of a partner in the business and then left. Is he able to just tell all his clients, come with me? I’m- what contractual obligations are in place. ⁓ If he has a restriction against that, then certainly he’s-

gonna be challenged for doing that. ⁓ Barring that, I mean, it would really, I’d say, depend on the facts and circumstances. You could conjure a case for something like torches interference with our business ⁓ and that sort of stuff, but it’s gonna depend on the facts. It’s gonna depend on how these customers got there in the first place. What did the person actually do? Because while we’re talking about soliciting,

Soliciting has a very specific meaning. It means that I solicit you. It doesn’t mean that I do business with you. ⁓ And buyers want to prevent all of it. So when, if we’re on the buyer side, we want to see a provision that says, I’m not allowed to solicit your customers, but I’m also not allowed to even do business with your customers. And the reason for that is that solicitation is very hard to prove. ⁓

you could claim, I didn’t solicit them, they called me. ⁓ And how are we going to establish that bar? Obviously, you could do depositions and discovery and all that stuff, and maybe you’ll uncover something, but it’s a lot easier to just say, I don’t care who solicited who, I don’t care how you ended up in business, the point is you’re in business now with each other, and I want to prevent that. ⁓ So we would say, no conducting business, I’m on the employee side, you wanna say no solicitations and no hire.

Same reason. I don’t want to have to start digging into, know, did they just respond to an add on indeed and ended up with you or did you poach them? That’s gonna be really expensive and possibly impossible to prove. So I just want a restriction. You can’t hire my employees. Confidentiality is, you know, pretty straightforward concepts. You have a seller who’s been involved in this business for 25 years. They know everything about the business.

You obviously don’t want them going out in the marketplace and telling anybody anything that’s proprietary or confidential about the business you just bought. So those are negative restrictive covenants. Then we have our affirmative covenants, our ⁓ obligations going forward that parties have to comply with. You may see some concept of a transition period. ⁓

depending on your seller, depending on the business. you’re in a strategic add-on situation, you may not need this, right? If you were just essentially buying a customer list and just expanding a territory, you may be perfectly fine with your seller going away at closing as long as you have his head of sales or whoever. Or maybe not even, maybe you’re just, we got this. ⁓ But in many situations, you want some sort of time period that the seller

is at a minimum available to you. ⁓ Now, you may have that under some sort of employment agreement or consulting agreement, depending on your business deal, but you may also wanna just have that as an obligation under the purchase agreement itself, that for a period of three months, six months, nine months, after closing, seller is going to assist with the transition of customers and the business. There might also be…

As I said earlier, there might be specific assets or specific components of the business that are not transferable or for practical reasons doesn’t make sense to transfer. Last year I was on a transaction that was supposed to close on like November 28th and to transfer all over the employees onto new buyers payroll and benefits and all that sort of stuff on November 30th was going to be just like a massive administrative shit show.

And it was, everyone agreed, just like it didn’t make sense to do that. The best time to really have the transition of the employees was going to be January 1st of the following year. So what we did is we built in a transition period where the employees stayed with the seller for that last 35 days. They were on seller payroll, seller benefit plan, seller everything, and buyer just cut a check to seller to basically cover the cost ⁓ of all of that ⁓ employee costs.

⁓ So, you know, that’s, you know, a perfect example of a transition arrangement where seller is still running a piece of the operations. In this case, payroll and employee everything, you know, HR, but buyer still owns the business. ⁓ When it comes to employees, that’s also a very important difference between stock sale and asset sale. In a stock sale, like everything else, employees stay where they are. They remain employed by

the same employer. In an asset sale, the employees all are terminated at closing by the seller. And then depending on your business deal, usually are hired by the buyer. Now, buyer may or may not want to hire everybody. This is often going to be a point of contention. You have sellers that care and you have some sellers that don’t care.

Every seller cares about liabilities and there’s all sorts of things that have to be done, whether it’s under worn or with regards to benefit plans or accrued vacation and PTO and various other things that are beyond the scope here that need to be done correctly in order to make sure that no one is assuming liabilities that they don’t want to. But there’s also just many sellers have the concern of they want to do right by their employees and they want to make sure that buyer commits to hire all of the employees, give them the same.

salary and benefits at least, commit to keep them employed for some period of time. None of these are statutory obligations under the law. These are all would-be contractual obligations that a buyer would either agree to or not agree to. And it will depend on what the business deal is. Sometimes you’ll see that a buyer will agree to hire at least 90 % of the employees.

or they’ll literally make a list sometimes. I’ve seen transactions where there’s a list of, we’re hiring everyone except for the eight people on the schedule. agreeing either we don’t need them, we don’t want them, or what happens a lot is these are people that are on payroll that just happen to be related to the sellers that are not necessarily providing value to the business that the buyer wants to pay. ⁓ So those are typically employees that you would see a buyer say, we don’t need those people.

understanding what’s going on with those people also ties into the value of the business and what what it’s going to look like from a profitability standpoint going forward. If you have any amount of people who are not contributing to the business, the business might be worth more. You might be willing to pay more, ⁓ might be willing to pay more for it. on the other, depending on the type of business, the employees are the asset, right? You know,

like we were talking about service businesses, that’s the main asset is the people that are the revenue comes from you having this group. ⁓ If you’re, you you’re some businesses, the sales team is, you know, this, have a rock star sales team and that’s what makes this business run. ⁓ And if we don’t have those people locked up, there is no business or at least the business is not what we think we’re buying. So, and that’s why you will frequently see the inclusion of employment agreements for key employee, the creation of an equity plan to incentivize, you know,

key core members of management, whether that includes the seller or not, there might be a CFO, a head of sales, a head of operations who are crucial to the future operations of this business. And you wanna make sure that they are locked up, that they’re incentivized to keep producing and that they’re kind of on board with buyer’s vision to grow and improve this business and make it even more profitable. ⁓

In terms of taxes that it really, that really just goes more to who is responsible for certain types of transfer taxes who’s responsible for filing tax returns for certain periods. ⁓ Not not something we need to dig into in great detail. And finally, we come to our indemnification section, ⁓ which is where we lay out the buyer. I mean, it’s really both sides, but.

Typically we’re talking about the buyer because the buyer is usually gonna be the one, if there’s a claim, they’re gonna be the ones who have the claim. Indemnification provides the rights and the mechanisms under which buyer can be compensated and made whole in the event that seller reaches the agreement in some way. And the two main ways that a seller can breach an agreement, number one is they breach a representation. ⁓

they made a representation about their business and it turns out that that was not true. So they said, you know, our financial statements are prepared in accordance with GAP. And it turns out that they prepared them in some other way and completely misrepresented what their EBITDA is. And you paid 6X at 3 million EBITDA, you gave them $18 million. And now that you run the numbers correctly, you realize that EBITDA should have only been 2.1 million and you now think they owe you $6 million.

So that’s a breach of rep. Similarly, if they tell you, you know, all of our customer contracts are in effect, none of them are in default, turns out you call up the new customer and say, hey, good news, new buyer in town. And they’re saying, new buyer, we’re not doing business with you. You you guys sold us faulty product last year and we told the seller and they never fixed it and we’re terminating our contract. So same thing. Now you were counting on.

$800,000 of revenue from this customer because you had a good valid contract with them, except it turns out you didn’t have a good valid contract with them because seller breached it last year. So seller is in breach of a representation. A buyer is going to have a right to be made whole. Other thing that a seller can breach is the covenant. Seller has an obligation to not compete with the business, not solicit customers, not solicit employees, but they do.

You want to have a right to be made whole. You also will want to have some sort of equitable right to be able to go into court and get an injunction to prevent the action. So that’s a separate category. But in terms of your right to be made whole, you’ve now interfered with my business, caused me loss of revenue, and devalued it. So I have a right to bring a claim against you and get paid. And again here, who is responsible?

very, very crucially, you want to have the individuals on the hook. mean, now, if you have a corporate seller and they have, you know, other divisions that are remaining and they have significant assets, there can be situations where you don’t need the individuals. When we’re talking about buying a closely held company, almost always you’re talking about a situation where they’re going to liquidate the corporation shortly after closing. So you need to have those sellers there to go after.

Now, you’re also going to often have, as we talked about earlier, you’re to have your escrow, you’re going to have your deferred purchase price, you’re going to want to have the ability to go after that money that’s sitting there, but depending on the size of your claim, the escrow may or may not cover it. you know, typically you’re going to see an escrow of 10 to 20 % of the purchase price. You may have a claim up to 50 % of the purchase price. Although we’ll talk about baskets and caps in a second.

The, when we think about indemnification, we, this is kind of like an exercise of the five W’s. So it’s the who, what, where, when, why, except not really the why or the where. So it’s the who, what, when. So the who is the company and the shareholders. The what, what are they indemnifying you for? For breaches, right? The when is, we talked about earlier, the difference between the fundamental representations and other representations. Your fundamental representations,

the fraud-like representations. We really own this business. The company has title to the assets. You’re typically gonna see those lasting indefinitely. For a minimum, they’re gonna last as long as the statute of limitations runs. When it comes to all the other representations, those are usually gonna have a finite survival period. Most common range is between six months and 24 months with a year kind of being a good sweet spot, 12 to 18 months.

which gives buyer that period of time to kind of suss out whether or not there are any problems with the business after closing. Frankly, to the extent that there’s a significant claim and a significant problem, it usually will be discovered fairly quickly. It’s pretty rare that this time period runs and it’s like three years later that you discover that there’s like some customer issue or employee issue that was not disclosed. So it’s usually fine.

⁓ But it’s, you know, obviously the longer that buyer can extend that period, the safer it is, the more time it has to make sure that it got what it bargained for. ⁓ There are typically going to be limitations. I just mentioned earlier caps and baskets. ⁓ A basket is a word that is often used in &A. It’s kind of similar to the concept of a deductible ⁓ in an insurance context.

A buyer, a seller is often gonna say, sure, I’ll indemnify you, but like, don’t come nickel and dime me for ticky tack stuff. Like, don’t want, you can’t bring a claim against me for $500. There’s going to be a threshold at which once we pass that threshold, you could start asserting claims. Usually you see it around 1 % of the purchase price. So anything that’s immaterial, you’ll start accruing those damages, but until they cross that level, you’re not allowed to assert a claim.

cap is on the other side of that. It’s the maximum amount that you could go after. And that is always going to be heavily negotiated. A seller wants to have some certainty that there’s an amount of their money that is completely safe. And whether or not they’re going to agree to a cap of the purchase price, which is if I’m a buyer, that’s what I want it to be. But you often will see it compromised at something like 50 % of the purchase price or 25 % of the purchase price.

It really depends on the size of the deal as well. The larger the deal, the lower of a cap on a percentage basis that you can agree to because ⁓ if you have a $10 million deal, there’s more likely to be a 50 % claim on a $10 million deal than on a $1 billion deal. So caps are very important. And crucially, fundamental representations will typically not be bound by the caps. So when we said before, you know,

They’re not bound by time. They’re typically also not going to be bound by these caps and baskets. there’s no, hey, I sold you the company, but I didn’t really own it. But you’re capped at 50 % of the purchase price. No, get the hell out of here. If you committed fraud and you sold me a business you didn’t own, I’m coming after you for the whole thing and more. Also my lawyer’s fees and whatever other costs I had, because you committed fraud, ⁓ you’re not going to be able to ⁓ avail yourself of any sort of cap. ⁓

The last thing to mention here is the concept of representation and warranty insurance, ⁓ which has become incredibly popular in the last five, 10 years. ⁓ It is something that has become basically a staple of deals over a certain size. I would say, I can’t remember the last 50 million plus deal that I did that did not have representation or warranty insurance. And it’s becoming even more common.

on smaller transactions as volume increases and insurers are becoming more comfortable insuring those deals. And what it does, it’s a really phenomenal product because it essentially ensures the breach of representations and warranties in a transaction. So rather than going after the seller for a breach, buyer goes after an insurance policy that covers up to a certain amount. Now policy obviously costs money,

the insurance policy is going to engage its own law firm, that’s going to do its own due diligence and that’s going to cost money. So it can increase the upfront costs of a deal, but it makes everybody sleep a lot better and make sure that there’s money available in the case of a breach. ⁓ It’s also great for a buyer because it eliminates a lot of tension because frequently buyers will not even

go after sellers or don’t want to go after sellers because it’s just like not a good look and it’s not good for business. Especially if you’re like, you if you’re a private equity buyer who’s like a serial acquirer of companies, you really don’t want to get a reputation for being a buyer that sues their sellers because then, you know, the next group of sellers are going to sell to a different fund. ⁓ This kind of allows you to have your cake and eat it too. You don’t need to bother your sellers. You don’t need to insult them. You don’t need to…

affect their bottom line, but you can still get made whole because there’s an insurance policy in place. ⁓ So thank you. Thank you for bearing with me. I’m sorry if it went a little bit longer than people expected, but I think we covered a lot. This was valuable. ⁓ Certainly I would expect that there are questions. I’m happy to take those now if there are, but you can also feel free to

reach out if there’s something you wanna talk about in greater detail. I’m happy to be a resource for anyone who is thinking about a transaction or just wants to learn a little bit more about anything we talked about today or any other related &A topic. ⁓ I’m happy to send my slides to Gershon and he can share them with the recording. that’s all I got. Please do, please send the slides to Brittany and I thank you all for joining. We had a few people request that story.

Send that out. usually send out the recording to everyone, but whoever wants slides, we’ll get them that as well. ⁓ thank you, Avi, for a top notch presentation. And, ⁓ I learned a lot. I probably should listen to this again, cause I’m sure there’s, there’s some things I’ll get on the second round. ⁓ and yeah, if anyone listening to this needs help on the financial side of due diligence or needs a CFO reach out to us, we can help. we’ve got an amazing team.

Then we’ll see you all next time. Thank you, Avi. It’s very good. Thank you. Avi, we’re going to see you tonight. I plan to. I plan to be there. All right. Looking forward to meeting everyone. Bye bye. Thank you all.

Speaker (00:00)
Welcome everyone. My name is Gershon Morgulis. I am the founder of Imperial Advisory. We are a fractional CFO firm and we provide fractional CFOs, CFO services. So we have a whole team of CFOs. Most of our CFOs have 30 to 40 years of experience and we go into businesses that need help but don’t need us on a full-time basis. So we’ll either be working for a CFO ⁓

that might be on helping get them ready for an audit or augmenting their FP &A process. have a offering on the FP &A side as well, ⁓ guiding them through certain things as a variety of things that we do for CFOs to help support them. ⁓ Most of our business though is working with smaller companies that do not have a CFO, don’t necessarily need a full-time CFO and kind of having owner who’s trying to be their own CFO and

not doing a great job, doesn’t have the time, et cetera, et And we go into these businesses and we help them. provide them with top-notch expertise and help them with a variety of things. So there’s the day-to-day things that we do, helping with strategy, execution, et cetera. And then there’s all sorts of things that come up on a as-needed basis. One of those things that come up on an as-needed basis is &A.

And so that could be working for a CFO who maybe doesn’t have the internal team to do the pre-deal work or working for a CEO or sometimes even an individual that’s looking to buy a business. So a CEO that’s looking to do an add-on or an individual looking to buy a business or a business looking to prepare itself for sale. So what we find is that

that &A can be used as a tool for growth similar to marketing or other things, or like I said, it could really be a standalone deal. And the topic today is the anatomy of a purchase agreement. But before you get to the purchase agreement, there’s often a lot of work done to understand the company, understand the target company, understand what’s going on, understand how this fits into the existing company, if it’s a company acquiring. ⁓

And if it’s not a company acquiring, there’s still a lot of work really. I like to break it into two phases. There’s understanding what is really going on. So sometimes we find that the story that the seller is trying to spin isn’t really true. We don’t believe it. And sometimes we find that we believe the story is just not a very good story. It’s not a story worth paying for to quote one of our clients.

If they gave us this business for free, should we take it? And that was a business that was doing 8 million revenue, wanted 8 million and wasn’t making any money. So you have both of these things and these are the things that we work on with our clients, helping them figure out if this business is something that they want or if this is a business that they, well, again, one, do we really trust what’s going on here? And the story that we’re being told and we’ve uncovered all sorts of weird things. ⁓

And then if we believe the story, then is that something worth them buying into? Anyway, after all that, we get to the topic of today’s webinar, which is setting up a purchase agreement. Typically, that’s going to be done by an attorney. And I know we have a bunch of attorneys here. Happy to see you all. And we’re especially happy to have Avi, who is our speaker today. Avi is a partner at Rivkin Radler. He’s worked at

bunch of different firms, I think here on Long Island. I think he’s coming to our networking event tonight. And by the way, for any of you in Nassau County, we have a networking and mastermind event tonight that we’re hosting at our office. If any of you are interested, send me a message. But anyway, back to Avi. So Avi’s been doing this for a while and…

⁓ and we’re very, we’re very happy to have him here. I’m looking forward to learning a lot. without further ado, Avi, take it away.

Thank you very much Gershon. Good morning. Thank you, Imperial for having me. Good to see everybody. ⁓ Today, as Gershon said, we’re going to be talking about ⁓ &A purchase agreements. As Gershon said, buying a business can be a long and arduous journey. ⁓ There can be all sorts of ups and downs, starts and stops, and lots of decisions to make, lots of traps.

for the unwary lots of problems to solve. And we’re going to get into a bunch of that today. ⁓ Just wanted to say at the outset with that, this program is going to be almost exclusively framed from the buyer’s perspective. But there’s also a lot to learn in here if you’re a potential seller as well. Cause like, you know, lot of the concepts are just kind of.

zero sum shoe on one foot shoe on the other foot. So it’s important to understand the concepts regardless of what side you’re on. So Gershaw made some very good points. One very bad point that he made was that he said purchase agreements are typically prepared by an attorney. I think we should just get rid of that word typically and make sure that you have an attorney involved in this process. And I would say very importantly, whether it’s me or somebody else that you have a &A specializing

attorney handling your &A and not someone for whom that is not what they’re doing on a day-to-day basis. ⁓ So just a piece of free advice at the top. ⁓ So the things that Gershon said that was right on point is that there’s a lot that goes into an &A that happens well before you get anywhere close to drafting, let alone signing a purchase agreement.

So that begs the question for a program that is ostensibly about kind of an overview and at the outset of an &A and things to think about, why are we having a conversation here today about the purchase agreement? And the answer is not just because I’m a lawyer who specialized in agreements, there’s really good reasons why I think this makes sense. ⁓ And one of those reasons is that

I’m the type of person, and I think it’s a very helpful way of thinking about things, who likes to often start at the end. ⁓ Every deal has a different start. Every deal has different journey along the way. But any transaction that ends successfully and ends with a transaction being consummated and actually happening is going to end with a purchase agreement like this. So I think it’s often very helpful to say, let’s start at the end and work backwards. And how are we going to get to that end point? And I think the purchase agreement is one of those things that

Really provides a lot of the meat and the bones of what makes up a transaction and lets you kind of at the outset say. Here we know where we’re going to end we’re going to end with something that has all of these different components. How are we going to navigate a process and set up a process that allows us to get to that endpoint in a successful way and do so as efficiently as possible. ⁓ It almost I view the purchase agreement almost as a roadmap ⁓ because.

It allows you to determine those friction points and those possible points of tension early on ⁓ and deal with them and see if this is even a viable deal. Because the last thing you want is to spend months and all the time and all the money that goes with that negotiating and working through all these different potential pitfalls only to then have something pop up at the one yard line and sink a deal. So to the extent you can raise these issues early,

and understand what we’re going to have to deal with at the outset, ⁓ it could avoid that problem. The next thing why to me purchase agreement is very important is because there’s a fundamental difference between two different components of what makes a transaction. I often like to tell clients that there’s only two things that are negotiable on every &A transaction, price and terms. Price is what the business people are always focused on. They wanna know what are we paying and the seller obviously wants to know what am I getting?

That’s the fundamental business transaction, right? That’s the main thing that everyone cares about. But there’s a whole bunch of other terms to a transaction that are often just as important ⁓ that really go fundamentally to what it is that you are buying and how are you going to protect what you are buying. And the purchase agreement is where all of those things get set out and memorialized and specified. And thirdly,

the reason why I think purchase agreement is important, particularly for a buyer, because the purchase agreement is essentially what the buyer gets. The purchase agreement is like your deed. It’s like, it’s your piece of paper that says, hey, seller, I wrote you a check for whatever many millions of dollars, and you’ve in exchange given me your business. And the purchase agreement is the document that certifies that, that says, I now own this business. These are the rights that come along with that.

these are the restrictions that are now placed on the seller that prevents them from pursuing this business, interfering with their business or whatever obligations they have on a going forward basis. The purchase agreement is going to be your key to go into court if anyone ever challenges your rightful ownership of this business and say, hey court, check out this agreement, this business is mine now, see, I paid money, now the business is mine. So the purchase agreement is a really important component for

⁓ for the buyer to think about from the beginning of the transaction. And while we are on the subject of why, ⁓ probing the why to me is also one of the most important parts of thinking about the outset of any transaction, specifically sitting with a buyer and understanding why are you doing this deal? Why are you pursuing an &A at all and this specific ⁓ &A? And the answer to that why will provide

Potential answers to all sorts of different questions, including many of the questions that we’re going to encounter today, because the why for, let’s say, a financial acquisition being conducted by a private equity fund is very different from that of a strategic add on that a corporate buyer might be making or that an independent sponsor who is viewing this as their path towards entrepreneurship might be thinking about.

And the why you’re doing the transaction is going to significantly impact your answers to a lot of the what’s that we’re going to deal with over the course of the next hour or so. So let’s jump into it. ⁓ Before we kind of go through the breakdown, ⁓ this is on the on the screen here. We have what I would say is the most typical purchase agreement.

structure you’re going to see. 95 % of the time, a purchase agreement is going to be broken down into these categories. And we’re going to focus today on the ones that are highlighted and bolded. Obviously, we always start with some section of definitions, whether that’s in Article 1 or an exhibit at the end. And we’re always going to end with miscellaneous terms that most of the time, nobody reads except for the lawyers. That’s where you deal with all your severability, entire agreement, headings, all that fun stuff.

But the real meat we’re going to be talking about are articles two through articles seven. Article two, purchase and sale. This is where we kind of really just like outset. This is the basic transaction. What are we giving? What are we getting? Articles three, closing, is going to deal with the timing of the closing, what is required to be done at the closing. And as you’ll see, depending on the timing and how a transaction is structured, ⁓ what might be happening before a closing. Articles four and five is going to deal with the

representations and warranties that each of the parties are going to make. Typically, you would see the representations from the seller in Article 4, representations from the buyer in Article 5. Article 6 is our section on covenants. These are obligations that occur in the future. So people often confuse representations, warranties, and covenants and like use them almost interchangeably in terminology. There are actually three very distinct things.

⁓ Let’s say distinct representations and warranties are distinct representations and warranties versus covenants are very distinct. ⁓ Representing a representation is a statement of facts as of a moment in time. So you’re saying as of today, I am asserting that such and such is true. A warranty is a statement of fact that is future looking. So when a manufacturer warranties that their product is going to work for a year.

They are making a statement of fact as of today with regard to something that will happen in the future. Representation is you’re saying as of today or backwards looking. A covenant is not a statement of fact. A covenant is a future obligation of a party. it’s things that starting from today, the day we’re signing this agreement and going forward, these are obligations of buyer and seller vis-a-vis this transaction. And then finally, our section on indemnification.

Another good word for indemnification is your remedies. ⁓ This is the rights of the various parties should something go wrong. If somebody breaches the agreement in some way, or if somebody does something that they weren’t supposed to do. ⁓ So that’s our basic overview of the skeleton of the agreement. As I said, almost every typical purchase agreement is gonna, if not follow this exact order, they will all have these different sections or different components.

⁓ So let’s start going down this road. And we’re going to start with Article 2, purchase and sale. So as I said, purchase and sale is going to literally cover, it’s going to have a basic description of the transaction itself. What is being bought and what is it being bought for? ⁓

And obviously, we know where it’s not always so simple as, I’m buying your business for $10 million. This is where we are going to set out the specific type of transaction that is being conducted. And so when I say, what are we buying? Typically the fundamental threshold question on any transaction is what are we buying? Are we buying the stock of the target company? Are we buying the assets? Possibly we’re doing a merger, although, you in private.

Company transactions, closely held companies, mergers are pretty rare. So it’s not something that we’re really going to focus on today. But just have in mind that that is a third option and there are actually more options that are kind of hybrids between the various things that we’re to talk about today. But general high level focus is going to be asset sale versus stock sale. And the corollary to that is what are we going to give?

So that comes down to what is our purchase price? And we’re going to get into a little bit more detail on the various ways that a purchase price can be comprised. So as I said, fundamental question is going to be stock sale versus asset sale. And we’re going to assume here that we’re talking about like a full buyout of an entire company here. ⁓ You could in theory have a situation where somebody is making a

in that minority investment or even a majority investment, but they’re buying something less than the entire company. So we’re not really gonna be talking about that today. We’re going to assume in a stock sale that the buyer is buying 100 % of the stock or membership interest if it’s an LLC of the business. We’re going to assume if it’s an asset sale that this is a full enterprise, we’re not just buying a division of a company, we’re buying the whole mothership.

Presumably we are going to be buying substantially or all of the assets of the target business. So when it comes to understanding the difference between a stock sale and an asset sale and why a buyer may favor one versus the other, spoiler alert, you wanna buy assets, but we’ll get into why. ⁓ We’re gonna focus on three overall concerns to think about.

⁓ The first is the legal structure. So we’ll get into a little bit of just mechanically the difference between how one works versus how the other works. ⁓ We want to very much understand the treatment of assets and liabilities, specifically liabilities, because as a buyer, ideally you want to avoid liabilities of the existing business. And then, of course, we also want to understand the difference between how taxes will be affected by

our transaction structure. So in terms of the deal structure itself, here are some what I think are helpful pictures that I found on the internet that kind of lay out what happens on the two different types of transactions. So stock sale is for most people the simplest one to understand because almost all of us have at some point owned stock, whether it’s in our companies that we own today, but more likely

you own some form of stock on a public security market. So if, for example, I am a shareholder of Apple and I own a hundred shares of Apple and I want to sell my stock to Gershon. Now that’s not typically what would happen. I would typically just sell it on the public market, but just to make this simpler, if you look at our stock sale picture, so we have target shares, is another word for that is what you could call shareholders. So if I’m the shareholder today, I own the shares of the target.

Now in a stock sale, what happens is the acquirer, in this case Gershon, would send money to me, exchange for which I would send the shares to him. So the shares of Apple are exactly the same today as they are tomorrow. Everything contained in the shares of Apple are exactly the same as today and tomorrow. The only difference is that today the owner of the shares is Avi and tomorrow the the owner of the shares is Gershon. Very, very simple. An asset sale is a little bit different.

As you see from the picture here in the asset sale, the shareholder again owns the target. However, the asset sale is really not a transaction between me and Gershon. It is a transaction between Gershon as the buyer and the target company that I own. Because when a business is owned by an entity, all of the assets, all of the liabilities, everything that makes up that

business are housed inside the entity. I am merely the owner of the entity. I don’t have anything in my own name. ⁓ There’s good reasons for me to still be party to the transaction for other reasons, which we’ll get into, but fundamentally the transaction is happening between the target and the buyer. The target here is the seller. And what happens is that the target is going to ship off its assets to acquirer. Buyer ideally is either

has an existing entity or forms a new entity in order to consummate this transaction. And the buyer entity is then going to send the money to Target. Now, Target is presumably going to, if not immediately, then shortly thereafter, distribute those funds up to their shareholders because the shareholders are the ones who ultimately want the money. ⁓ But fundamentally, this transaction happens at the entity level.

And the reason why that difference is important is because of the way that assets and liabilities get treated in the two different types of transactions. So as I kind of tried to explain with a stock sale, in a stock sale, there is no change in terms of the ownership of the assets of the underlying business. So.

If I, as I said, if I own Apple and let’s just, you let’s get rid of the Apple analogy. ⁓ I have a business, know, Sienenski incorporated is a consulting firm and we have assets. have, you know, we have goodwill. We have a customer list. have employees. We have furniture in our office. We have rights under contracts, under leases, any stock sale. All of that is staying exactly where it is. It is not moving at all today. The company is Sienenski incorporated.

tomorrow the company will be in Sineski Incorporated. The only difference is that instead of it being owned by Sineski, it’s going to be owned by Morgulis or Morgulis. I don’t know how pronounce your name. Let’s go back to Gershaw. So the only thing that’s happening is the ownership up top is changing. Everything down below stays exactly where it is. It is not changed. And that means that all of the assets, all of the liabilities simply by operation of law,

by just staying where they are now belong to the buyer. ⁓ And the key there is going to be the liabilities. On an asset sale by contrast, it works completely different because we are physically, not physically, physically moving all of the assets from let’s say, Sienensky incorporated now to a new entity called Sienensky 2 incorporated.

we get to pick and choose what we wanna move. We don’t have to take all of the assets. We can take only some of them if we want. And we don’t have to take any of the liabilities. And that is really, really crucial. So in every asset purchase agreement, you are going to have a section on assets and liabilities that spells out essentially what are four categories, purchased assets and excluded assets, assumed liabilities and excluded liabilities. And this allows a buyer

To go through the assets and liabilities of a business and come to an agreement with a seller and make a determination about what we’re taking and what we’re not taking. So, there could be that you want every single 1 of those assets, but there might also be an asset that is not really relevant to this business. ⁓ The most common thing you’ll see is that there are, you know, I’ve heard a rumor that sometimes some small businesses will have assets that.

You know, are technically not necessarily business assets, but they are titled in the business’s name, like, you know, somebody’s car or, you know, certain memorabilia. And like, I know no one would ever, you know, they taxes or do anything like that. But like, I heard this might have happened on 1 or 2 occasions. ⁓ And typically stuff like that are not things that a buyer is going to buy in an and a transaction. Right? They don’t want the owners personal assets. There might be other.

you know, assets in there that really, you know, sometimes we’ve seen that like, you somebody has some sort of like property investment and they just like ran it through the business and it has nothing to do with the business. ⁓ So it’s important for everyone to identify those assets and make sure that those are not being sold as part of this transaction because that’s not what this deal is about. And as I said, the more important part is the liabilities. The fundamental starting point for a buyer is we want to buy none of the liabilities. We want none of those to transfer.

And that will usually be the default is that any liabilities that are not expressly written as assumed stay behind with the seller and remain seller’s problem. Any debts, any lawsuits that may exist for the past? Yes, Gershon. Question. I once heard that if you transfer all the assets under some situations, liabilities can automatically transfer because you can’t like completely gut a business. Is that for real?

So there are certainly certain categories of liabilities for which we say a concept of successor liability applies. ⁓ we’re gonna deal with those in a little bit, but ⁓ to answer your question, the answer is yes. There are certain types of liabilities that cannot be escaped. The most common one is taxes, right? The government is not letting anyone get away with taxes just because you sold your business.

So if there’s a tax liability ⁓ and you sell your business, buyer can be held liable as a successor. The same is the case for environmental. You see this very frequently in real estate transactions that buyer would step into historical liabilities of the seller. ⁓ You also see it with all sorts of employee and employee benefit liabilities. Again, the policy reason there being that

want to protect employees and we don’t want some, you know, there was some pension that got set up and you can’t sell the business and now, you know, the seller disappears and the liability goes away. And there are ways to protect against that. the better than having a way to protect against the liability is to never have any claim that the liability is yours. So, you know, if you do an asset sale, and the reason why you want to do an asset sale is

If let’s say a customer has a lawsuit because they bought a product from seller a year ago and today it killed somebody and they run into court and they, who are they gonna sue? They’re gonna sue everybody, right? They’re gonna sue the seller, they’re gonna sue the seller’s owner, they’re gonna hear that the business got sold, they’re gonna sue the buyer, they’re gonna sue the buyer’s owner. And the best thing that a buyer is able to do in that circumstance is to go into court and say, hey judge, this has nothing to do with me. You see here, they bought this product from,

XYZ Inc in 2022, we’re actually ABC Corp and we weren’t even formed until 2024 when we bought this business. This has nothing to do with us. And I would say 95 out of a hundred times, you’re gonna get that thrown out immediately because you’re not the party to the lawsuit. You haven’t been properly brought into this lawsuit. It has nothing to do with you. The other important things that you want to think about and that are

more important when it comes to an asset sale is the retitling of certain types of assets ⁓ and any consents that go along with that. Most often this is going to be in the context of a contract. ⁓ Think about your lease, right? Your lease has a provision in there that says you can’t assign it to somebody else because your landlord did a credit check on you. They vetted you ⁓ as a tenant. You can’t just call up your landlord one day and say, by the way,

I sold the business, here’s your new tenants. Landlord is not gonna be okay with that. So when you sell your business, you’re gonna have to go to your landlord and tell them in advance, you’re gonna have to get their consent and make sure that they sign on to the assignment of the lease to the new buyer. Same will often be the case with various customer agreements, vendor agreements, and other contracts that you may have, that a seller may have that your attorney, that’s part of the diligence process are going to review those contracts and see

You know, is there anything in here that will require the involvement and consent of a 3rd party in order to transfer title to certain assets when it comes to pieces of equipment that might be least same thing applies certain vehicles. You have to have them retitled in the name of the new entity. So that’s just some additional components that might make an asset sale a little bit more complicated, but.

the ability to essentially walk away from those liabilities makes those extra hoops you have to jump through well, well worth it. And then finally, we’re going to talk about the tax implications of the two types of transactions. And again, here’s a situation where the general rule of thumb as a buyer is going to be you want to buy assets. From the seller’s perspective, the tax treatment is very simple.

When you sell stock, you get long-term capital gains treatment, assuming you held the stock for more than one year, an amount equal to your gain on the stock over your basis taxed at long-term capital gains. And the same thing is going to apply for a buyer. The buyer is going to acquire a basis in the stock and

Will not have the ability to recover its purchase price until it liquidates the business ⁓ and. The most important principle in terms of. How tax affects economics is. That an asset sale allows the buyer to start recovering their purchase price immediately, ⁓ depending on the types of assets, but because when you buy assets, you get to.

take a step up in the basis of the value of the assets because when you sell assets, the IRS doesn’t view it as a sale of a business per se, they view it as a sale of the individual assets. So I’m not selling you the business, I’m selling you the tables and chairs of the office and the goodwill and the rights under this customer contract and the rights to employ this group of employees. And all those different assets are kind of viewed by the IRS as separate sales.

they are therefore taxed at an amount based on the type of asset that they are. So we generally speaking divide assets into different types. We have our capital assets and we have our depreciable assets. The capital assets such as your intangibles and your goodwill get taxed at the more favorable rate. Your depreciable assets get taxed at the higher rate. So depending on

the type of business that you have and the types of assets that the business that you’re acquiring is comprised of that will impact the exact tax rate. Usually what you end up with is some sort of hybrid between the 20 % capital gains rate and the 37 % ordinary income rate. It’s not gonna be exactly one or the other, but if you have a business that veers more towards those capital gains assets, the seller might pay 22%, whereas

When if it’s more of a business with harder assets, ⁓ it might be on the higher end. But because of the step up in basis, because of the buyer’s ability to start depreciating certain types of those assets immediately and deducting them against their gains, the asset sale form is highly advantageous to a buyer. So because of the ability to…

walk away from those liabilities because of the advantages on the tax side to buying assets. The starting point almost all the time for a buyer is going to be, wanna buy assets. Now that’s not always possible. First of all, as we said, there’s always a lot of very zero sum elements to this. So the reasons why an asset sale are good for a buyer also makes a stock sale good for a seller. So a seller may wanna say,

I want to just be done with this. You’re taking the assets, you’re taking the liabilities, you’re buying the stock, period, the end. I’m not interested in an asset sale where I’m going to have to, you know, wind down and deal with stuff afterwards. Seller might say, I want my long-term capital gains. I don’t want to deal with this whole allocation and figuring out one of my different types of assets and potentially pay more. I always assume that when I sell my business, I’m going to sell the stock. I’m to just pay capital gains on the whole thing. And that’s what I’m doing.

⁓ And depending on your leverage or negotiating power, you may or may not have the ability to dictate the structure of the transaction. There are workarounds to solve for both of those issues. And sometimes there are elections that you can make under the tax code, such as 338 H10 or 336 E. There’s something called an F-RE-ORG. And these all give you the ability to create a

transaction as an asset sale for tax purposes while still treating it as a stock sale for all other purposes, such as corporate purposes and legal purposes. But, you know, generally speaking, if we’re we’re using one or the other, you know, the stock sale is going to be more advantageous for the seller and asset sale for the buyer. In addition to your seller saying, I want to sell stock when we just talked about consents, it could be that a asset sale is just not practical.

Think about a scenario where you’re buying a business that has hundreds of contracts and 75 of them need consents to assign it to a new party. Now, maybe you’ll be able to go out and get all those consents, but that seems like a lot of work and it just might not be practical. There also could be specific types of permits or government approvals that simply are not transferable. And it could take months, if not years, depending on the organization and when you have to deal with certain government.

bodies, it could take a really long time to get the approval. And you may want to just go forward with your transaction. And that means you’re going to have to buy the stock because that’s where the permit is. That’s the entity ⁓ that is approved. That’s the EIN that’s on record. And you just might not have any choice. So yes. I want to just add one thing. And this is your talk. So correct me if I’m wrong. But we once had a client who was looking to

potentially purchase a business and they had workers comp experience that had been building up for a long time. And they felt that that was a reason why they would buy it, even though they knew there were liabilities and skeletons in the closet. didn’t go through the transaction in end anyway, but they, at least that’s what they told me at the time. They’re like, if we want to get the benefit of this experience of the workers comp experience that won’t trade had built up like enough body of work that it

it impacted their rates favorably. Correct. And if they were starting from scratch, even if they did somehow manage to transfer the contracts, they would end up having to charge much more or pay much more and therefore they’d lose money or be not competitive. Yeah. I mean, I don’t know a lot about workers comp. So I’ll just kind of grant your premise that that’s how it works. if that’s how it works, then that makes sense, right?

there could be benefits to stepping into an existing company. I’ve also seen situations where an existing company has an easier time getting financing than a new company because if it’s history now, ⁓ that shouldn’t typically be the case because you should be able to show the bank that you’re taking over a going concern and that the revenue is basically then going to be and cash flows should be imputed to the new company. But depending on your underwriter, they may just look more favorably at, you know,

a company name that has this history versus a buyer that’s starting from scratch. ⁓ OK, so for most, the most important part of the agreement is going to be the purchase price. ⁓ And we’re going to talk quickly about how we get to a purchase price. How do we, know, how much do we pay and how are we going to pay it, right? Two parts. in terms of how we determine how much to pay, ⁓

It’s really not my area of expertise. You’re gonna probably wanna speak to someone like Gershon or to someone who’s an investment banker or broker or someone who’s in the business evaluating companies. But typically what we see is most common is a multiple of EBITDA is used to determine a purchase price. ⁓ will vary largely based on the industry that you’re in, the size of the business.

Most typical is you see something in the range of four to eight times a multiple of EBITDA. Depending on the type of business and your type of buyer, you might use a multiple of revenue. One X revenue is the most common that I see. You also are going to want to factor in some sort of public research in terms of what are similar companies selling for the same way that a real estate valuation consultant would look at, you

What are other properties in the neighborhood selling for? You wanna know what is a consulting business or a medical practice or a pharmaceutical company that does this type of revenue, this type of sales, this type of profit, what is that going for? Because as I said, the multiples, the variations can be different depending on geography, depending on industry. You also, depending on what type of buyer you are, this is more when you’re on a

you know, on an add-on transaction or a corporate inquirer strategic, you have to think about potential synergies because you are not just buying necessarily this business for itself. There may be other things that this business brings to the table that fits into your existing business. ⁓ It’s not just that, you know, okay, they have a great business and we’re going to just acquire that cash flow. We may be able to grow the pie because we have other products, other services that we can sell now to a new customer base, maybe

This company has some piece of IP that we can incorporate into one of our existing offerings. And that makes the company worth even more than how it looks on paper. ⁓ So that might also factor in. In terms of paying the purchase price, what are we going to give our seller? ⁓ Most common is we’re going to give them cash, right? But we also can frequently give them some sort of property. When we talk about property, what we are typically talking about is some sort of equity

either in the buyer itself or somewhere in the buyer enterprise, what is called rollover equity. Very, very typical in the private equity context and becoming more and more typical in all sorts of &A contexts, especially as the price of capital gets more and more expensive over the last few years. ⁓ The ability to pay with something other than cash is very enticing to a buyer.

There are, it’s also beneficial to seller in many ways because A, they get to defer taxes on any things that they take in equity and they don’t have to pay any tax on it until they liquidate that buyer stock. Number two is it gives seller potential upside. If seller believes in their buyer’s theory of the case, they think that this buyer is going to add value, whether it’s through infusion of capital, whether it’s through synergies, whether it’s through,

professionalizing their business. The business that today is worth $25 million may very well be worth $50 million in three to five years. And frankly, that is what, if you’re selling to private equity, that is what they’re betting on. So this gives the seller the ability to take a piece of their ⁓ purchase price proceeds and roll it over, let it ride, and see if it can grow into even more. Similarly, buyers are often looking to

pay whatever amount that they’re paying in cash sometime other than today. ⁓ For two main reasons. Number one, if you’re a financial person, obviously you understand fundamentally a dollar today is worth more than a dollar tomorrow. So to the extent we have an ability to defer the time when we have to pay a portion of our purchase price, that is financially beneficial. Number two is it provides you some sort of protection and whether

We have our deferred payment being paid under a promissory note, whether it’s that we have money that is put in escrow or whether we make a portion of the purchase price subject to an earn out, which means that it’s not guaranteed. It is only paid if certain conditions are met, usually financial metrics about the business. That gives the buyer, as I said, protection because they have the ability to

have money that’s available in the case something goes wrong. So if it turns out that this business is not what seller said it was and you have a claim against the seller, you don’t wanna have to be in a position where you have to go chase them and say, hey seller, pay me back my money. You wanna be able to say, good thing we have this escrow over here with $3 million in it that we can make a claim against or good thing that we have a promissory note or an earn out that is supposed to be paid next year that we can basically say to the seller, hey, that $2 million that we were supposed to pay you.

we’re not paying it to you because we have a $2 million claim or we’re only paying you a million because we have a million dollar claim. ⁓ There is also typically going to be an adjustment component to your purchase price. ⁓ The two main types of adjustments, and you kind of think of this as the, you’re like kind of like your paycheck where you have the number at the top, which is the enterprise value. And then there’s the number at the bottom, which is what we’re actually paying. And

those get adjusted either upwards or downwards ⁓ based on A, the cash and debt in the business, because most transactions are structured as what we call cash-free, debt-free, especially on a stock sale. On a stock sale, you would almost never assume long-term debt and you would almost never buy cash. I mean, it doesn’t really make sense to purchase cash, right? ⁓ It’s just, you know, I give you a dollar and you sell me a dollar. doesn’t really…

Make any sense? So cash is typically going to always stay with the seller. Debt is always going to stay with the seller. And those get adjusted from the purchase price. So to the extent there is any cash left in the business, on a stock sale, seller doesn’t have to pull the cash out. We just increase the purchase price by the amount of the cash. And similarly, we would deduct for the amount of debt that is on the books. The more common and more complicated adjustment that we have to deal with is with respect to working capital.

And the reason there is that buyers typically want to expect that when they buy a business, they don’t have to now write another check to fund operations of the business. They want to buy a business that’s viable and that runs itself based on its cash flows and working capital. So early on in the process, you’re always going to want to determine

what is the working capital that this business needs? Usually you do that by determining some sort of trailing average, six months, 12 months, 18 months, and look at the history of the business and what does this business need on an average monthly basis to fund operations. And the seller is going to be expected to deliver a business that has working capital equal to that target average amount. If at closing the working capital is insufficient,

there will be a credit towards the buyer and a reduction of the purchase price. And likewise, if the seller over delivers, they get a credit and purchase price goes up. And the working capital is usually done as an estimate at closing and then gets trued up, but they’re 90 days, 120 days down the road. ⁓ As always, I’ve front loaded the majority of this presentation. It looks like we’re… ⁓

running low on time, so I’m going to try to make sure we get to some of the rest of this. The next section in your transaction document is going to be deal with the closing. ⁓ It’s a pretty mechanical section. It mostly just has like a list of items that needs to be delivered at closing. This is gonna be, and this is where you’re going to cover the various other transaction documents other than the purchase agreement itself.

⁓ So again, in terms of roadmap, this is where you want to think about what else do we need? Is there going to be a new lease that we’re going to enter into? Do we want to put in place employment agreements or equity arrangements for management? Do we need some sort of transition agreement for, you know, maybe there’s some component of the business that can’t be transferred right away and we need to figure out how that’s going to be managed during the interim. The most important consideration for this section, the closing section is

whether or not the transaction is going to be conducted as what we call a simultaneous sign and close or as a bifurcated sign and close. A simultaneous sign and close is the more simple version and for pretty much any transaction, I would say let’s say under $100 million ⁓ is almost always gonna be the norm. And that just means the day we signed the purchase agreement is the day that we close. It all happens at the same time in one shot.

By contrast, a bifurcated signing close is what is more common on a real estate deal, right? Think about when you bought your house. You signed a contract and then, just based on you seeing the house, and then you have to go get financing, you hire an inspector to do diligence. So in a bifurcated signed and close, we signed an agreement today with an agreement to close in the future. And it’s a real binding agreement. However, it’s subject to conditions, meaning

seller is going to have obligations for how they operate the business in the interim and what we call our interim operating covenants. ⁓ Very important because if you’re agreeing to buy a business, you want to make sure that seller is going to conduct the business and your ordinary course that they’re not going to do anything differently. In the meantime, they’re not going to start selling off key assets or firing key employees. You want to make sure that the business that shows up at closing is the same business that we agreed to buy. The main reason why you would want to

do a bifurcated sign and close is, as I said, if there are financing considerations ⁓ and some lenders want to see an executed purchase agreement before they will sign a commitment letter, you may also require various consents and you just want to have the ability to sometimes, sometimes you want to announce the transaction and start telling people that it occurred. So you want to have a signed binding agreement so that you can do that. ⁓

I mentioned the hundred million dollar threshold. It’s actually a little bit higher, but I remember the exact number. If you need to get antitrust approval under the Hartscott-Rodino Act, which applies to any transaction over a certain size, that requires as well that you have a signed purchase agreement and then you have, I think, 30 or 60 days to go get that approval to make sure the transaction can proceed.

The representations and warranties are almost always the largest section of the transaction. If you have, let’s say, a 50 page purchase agreement, you will often see that 25 to 30 of those pages are comprised of the reps and warranties. And the reps and warranties are in many ways the most important section because this is where the seller goes on the record about what the business is and what it isn’t.

The reps and warranties, a good way to think about them is that they’re kind of your backstop to your due diligence. So you sign a letter of intent and that’s when the seller is going to start opening its books and showing you its records and telling you about everything about business, the good, the bad and the ugly and give you an ability to do quality of earnings on the financials, ⁓ review all their contracts, look to see if there’s been any litigation, any problems, any customer complaints, all of these things will be.

uncover during due diligence. ⁓ The problem with due diligence, or I guess what would say, where due diligence is lacking is that your due diligence is only as good as what your seller gives you. When we’re dealing with private companies, there’s no public record of anything. You can’t go out and say, OK, we’re going to go. There’s no website where you can go and say, give me all of the contracts that this company is party to and tell me.

all the problems that they have. You’re relying on the seller, the shareholders to own up to that stuff and produce it to you. Now, in a perfect world, would, know, I’m sure we’re all comfortable with the honor system and we don’t need any of this, but unfortunately that’s not the way the real world works. So what the representations do is they require the seller to back up the due diligence process by putting in writing what they’ve produced.

So for example, you wanna know that seller has not been sued in the last three years, right? Cause I don’t wanna buy a company that gets sued all the time. So you’ll run your litigation searches. You’ll ask your seller to tell you, give me copies of any complaints of any letters that you’ve gotten from lawyers, any lawsuits that have been filed. ⁓ And you’re hopeful that they’ve complied.

But what you wanna do in the purchase agreement is actually have seller put in writing, we’ve not been sued during the last five years, three years, 10 years, we’ve not been party to any lawsuits. During the last three years, none of our employees have made a claim of sexual harassment or discrimination. We’ve filed all of our tax returns and paid all of our taxes, things like that. So we kind of, I like to think of this process as three stages.

You have your due diligence where you review everything, then you have your representations and warranties where the seller makes these statements. And then you have your disclosure schedules, which get attached to the representations and warranties. And that is where the seller does one of two things. Either they provide lists of things. So you may have a representation that says, set forth on schedule A is a list of all of our customer contracts.

Set forth on exhibit B is a list of all of our employees and their salaries and their job title. You also would put on the disclosure schedules if you’re a seller, the exceptions to any of your representations and warranties, because I’ve yet to see a business that is able to make all of the representations cleanly without any exception, right? In a perfect world, a seller would be able to say, we’ve had no litigation, we’ve had no complaints, we’ve had no problems.

But in reality, a seller needs to be able to say, have had no complaints, we’ve had no litigations, we’ve had no problems, except for the litigations, complaints, and problems that we’ve listed on exhibit C of the schedules. And that’s where it all ties together. So you have your diligence, you have your reps, and then you have your schedules. And the job of the buyer and his advisors is to make sure those all line up and that what we saw in due diligence is consistent with what?

seller is now vouching for on the schedules because if there is something that a seller represented that was not true, buyers going to want to have the ability to get compensated for that. Our representations are typically grouped into different categories. We have our fundamental representations, we have our legal representations, and we have our business representations. Our fundamental representations, we call them that because they are

fundamental to the business, fundamental to the transaction. Things like seller actually owns the business that it’s selling. It didn’t sell it to somebody else last week. The shareholders of the company are the three people that were claiming there’s no fourth person out there who’s going to show up next year and say, hey, I was an owner in this business and I’m entitled to a piece of the action. ⁓ The seller entity actually has title to all of the assets that it’s selling. There’s no.

significant asset that is actually in some other entity that is in the personal name of one of the shareholders. The assets are not subject to any liens. There’s nobody else out there that has any sort of claim on anything that has to do with this business. Again, these are what we call fundamental. And the implication of them being fundamental is that typically they will survive indefinitely, which means no matter when buyer discovers that there’s a breach of one of these representations,

And no matter the amount, buyer should be able to be made whole. Whether even if it’s in 10 years, if it turns out you didn’t really own the business, essentially a breach of a fundamental representation is another word for that is fraud. ⁓ So those will typically have the longest legs and the greatest ability to recover under. ⁓ Then we have our legal representations, which have to go towards.

compliance with laws and these are the ones that as Gershaw mentioned earlier, at least some of these is where you may see successor liability. So you wanna be extra sensitive to these and this is why often on transactions, you will see a whole bunch of specialists get involved because these are, we’re gonna be very sensitive to a potential environmental issue or an employee benefit issue because of the successor angle.

And then finally we have what we call our business representations. These are things that, yes. We’re running short on time. Does it make sense to continue this another time or should we just hold Q and A till 12 o’clock and wind down by then? I’m happy to do either. I’m happy to make myself available for another time if you think that makes sense. But yes, we are running low on time and there is more stuff to talk about. So it’s all super interesting and very valuable.

We could also just continue like I am available. So it’s really up to you. Okay, so I got a 1230 no problem Well, I’ll stay and listen everyone we We generally wind these things down by noon. So we don’t want to hold you forever if any of you are interested in the In the recording so that you can get the rest of it reach out to Brittany. We are recording this and We can get you the recording

I’m going to put up the poll now so that people, if you can answer that, that’s great. then whoever is able to stay, I will be staying. So ⁓ we’ll continue and we’ll all be in one place. Same price. Same price. Look at that. Buy one, get one 50 % off. ⁓ So I just put the poll up and I guess we’ll continue in a minute.

Do we want to answer any questions in the internal before? yeah, that’s a good idea. Any questions up until now? We have one question, at least one question in the poll in the.

in the chat. Have you seen situations where non-union companies purchased a union company through an asset purchase in order to not take on the liabilities? Yes. My understanding is that it’s impossible to get around. is. So I’m not sure what you mean by impossible to get around. ⁓ You can do. There’s really.

Well, I wanted to make sure I understand your question right. So in a pension situation, there, if you sell the business, it will be treated as a withdrawal from the pension funds and withdrawal liability can become due. There are ways to structure a transaction as an asset sale when there are union liabilities. There’s a section of ERISA called section 4204.

that allows you to, allows the buyer to assume the pension liability, ⁓ requires certain obligations. I think you need to post some sort of bond. You need the buyer needs to agree to continue contributing to the fund at the same rates for I think five years. ⁓ Seller remains secondarily liable to the fund. There’s a whole, there’s a bunch of hoops you have to jump through, but.

an asset sale can be done in a union context. Is there a way to basically just shut out the union and the pension and make everyone walk away from the liabilities? No. ⁓ And more so on the seller side, meaning a seller can really never get away from potential liabilities of the union because they are party to the CBA and agreed to

Apply with the CBA and make contributions to the union and they’re going to be liable for the withdrawal from the pension fund. If your question is, a purchaser avoid assuming. The liabilities, ⁓ the answer is yes. However, if they’re going to be hiring the union employees, then the union is going to require that you assume the CBA and take over that contribution.

obligation under the pension fund. So I’m not sure if that answers your question, because I’m not sure if I completely understood it. So it doesn’t have to be a stock purchase. ⁓ It can be done as an asset purchase, but the asset purchase would almost certainly be done in a way so that the buyer is taking over the obligation. So I’m hoping I answered that. But if not, feel free to ask again or ask it differently.

Is there any other questions? didn’t see any. Okay. So we’re talking about reps and warranties and our last category is our business representations. And these, know, unpredictably, they go to things that are more relate to the operations of the business, ⁓ the profits and losses reflected in the financial statements. ⁓ It’s very important.

from the outset to, and this is why you wanna hire someone like Gershon as soon as possible ⁓ because financial statements are only as good as the paper they’re written on, right? You need to understand the financials. You need to dig into the financials. And very crucially, you need to understand the methodology that is used to reach the numbers in the financials. ⁓

both from an accounting’s perspective, are they on cash basis or accrual basis? Are they done in accordance with GAAP? ⁓ Depending on the size of your business, of the business that you’re buying, the buyer will want the seller to essentially represent that the financial statements were prepared in accordance with GAAP. So that way we can make sure that we understand what these numbers mean. To the extent they’re not done in accordance with GAAP, what you would typically see is,

something to the effect of this is again where the schedules come in, you would say the financials are prepared in accordance with GAAP except that set forth on schedule blank where we explain our accounting methodology. And that’s where the seller might say something like, we’re not in accordance with GAAP except we recognize deferred revenue in some weird way that is not in accordance with GAAP or we depreciate this type of asset in a certain way that again is not in accordance with GAAP.

⁓ And particularly when you are paying a multiple of something in the financial statements to determine your purchase price, it’s really, really important that you understand the financials and that the seller makes representations about its financials. ⁓ All the other stuff here on the list, ⁓ not as important necessarily as the financials, or at least not as fundamental to what a buyer cares about, but also really, really important to understand.

Here’s a list of all of our contracts. We don’t have any other contracts other than these, because as a buyer, you don’t want to find out that later down the road, there was some contract that was never disclosed and was imported to this business that now you’ve not acquired the rights to. You also want the seller to represent that the contracts are all in effect, that there’s no defaults. There’s no reason to think there’s a default, right? You don’t want to

step into a contract and then find out six months down the road that that customer hasn’t been paying in a year. And now you’ve factored into your financial analysis, the revenues from this customer that are real revenues on paper because we use a cruel method and when we make the sale, we treat it as revenue. ⁓ But if the customer doesn’t pay, that’s not worth as much.

⁓ So I thought according to some financial experts. Yes, Giles, did you agree with that? Yeah, if they don’t pay, it’s not revenue. That’s my position. But there’s something related to this that I, something you said a moment ago, that I once heard, was at a conference, we’ll give Anshin a shout out prior to COVID. And they had these people talking about buying and selling businesses. It was an &A conference. And they said, it’s very easy to agree on the multiple.

The question is, what are you applying that multiple to? And that’s where all the real debate happens. Like we could all agree on four times, but if we don’t look at accounts receivable the same way, you think they’re gonna pay and I think they’re not, then what is that 4X applying to? Whether we multiply by four and that’s where all the fighting. Yeah, yeah. happens there, right. It’s it’s what is actually EBITDA, right?

⁓ In this business, and that’s where you want to have that rigorous quality of earnings done on your target because that’s where you’re going to discover things like. Add backs and deductions that should be made to even ⁓ based on, as I said, things that are sometimes included in the business in the financials that aren’t really part of the business and therefore should be removed. ⁓

That’s where you may also find that there is a heavy customer concentration. You’re buying this business that has $25 million of revenue. But if half of that revenue is coming from two customers, then you’re putting, as a buyer, a lot of your eggs in those two baskets. And you’re relying on the fact that you’re going to be able to keep those customers. ⁓ And depending on whether or not your seller is sticking around and the relationships going forward, that’s not necessarily a sure thing. ⁓

⁓ Especially if one of those customers is seller’s brother-in-law or seller’s college buddy who’s giving him the business because why not? And now that there’s a new owner, maybe he’ll continue, maybe he won’t. And customer concentration adds risk for a buyer. So it’s really, really important to do that analysis properly, make sure you understand the financials of the company that you’re buying. ⁓ And then as we say in the reps and warranties,

make sure that seller is willing to stand behind those financials. A seller that’s not willing to stand behind their financials ⁓ is a major, major red flag.

⁓ Okay, so that takes us through our representations. And these are the representations on the seller side. Buyer will typically make representations as well. Those are usually gonna be fairly plain vanilla. It’s gonna be kind of like the stuff that we talked about, the fundamental representations. know, buyer has the authority to enter into the agreement, et cetera, et cetera. To the extent that there is a rollover happening, seller may want

some additional representations, because if you’re essentially telling them part of your consideration is the right, the opportunity to invest into the buyer business, then the seller has the decent right to say, well, then you need to tell me things about your business that I’m now acquiring 5 % of, or whatever it may be. So the buyer reps might get a little bit more.

out depending on the situation, but usually they’re going to be pretty insubstantial.

Okay, so next we are going to move to our covenant section. As we said before, these are the future obligations of the parties. ⁓ Generally speaking, we’re going to separate these into two main categories, the ones in the top and the ones at the bottom, the ones at the top, these first three, ⁓ we colloquially refer to these as restrictive covenants. These are essentially negative covenants. These are things that the sellers are not allowed to do.

And this is good time to bring this up. So I mentioned earlier that even in an asset sale, you’re likely going to want the individual owners to still be party to the transaction, even though they are not really fundamentally part of the transaction, right? The fundamental transaction is occurring between the seller entity and the buyer. However, both because of confidence and also because of representations, which I should have mentioned that they are, and when we get to indemnification,

you want the individuals on the hook personally as well. So you want them individually making the representations and warranties and being on the hook for indemnification, just because as a practical purpose, if you have a claim, you wanna be able to assert that claim against somebody other than the seller LLC or corporation, which pretty quickly after closing is not gonna have any real assets. Certainly by the time a claim arises,

You could bring the biggest claim in the world against seller corporation. If there’s nothing there, you’re out of luck. So therefore you want to have the right to go after the individual seller and you want them to be on the hook. Same concept goes with covenants. You think about your non-compete. It’s not that I care whether or not your corporation is out of the marketplace competing with the business now. I care if you, the seller who has the reputation, has the goodwill who people know.

has all the relationships, it’s you who I don’t want competing with me. So it’s an absolute must that the individual sellers are party to the agreement for purposes of these covenants. So non-competed and non-solicit. So most of, this is a very, probably the second most important part of what you’re buying, right? You’re buying a business. So you’re buying the assets that come with the business. But on top of that,

What you’re really also buying is putting the seller out of business. You want exclusivity on this business. You don’t want your seller opening up a new business the next day that competes with you. That is a fundamental part of what you are paying him for. ⁓ So you are always going to have some form of non-compete. When we talk about a non-compete, we talk about three main different components.

⁓ in terms of what the non-compete applies to, what it restricts. We talk about the scope, we talk about geography, and we talk about duration. Duration, simple. How long does this last? How long is this restriction? ⁓ Most common starting point is five years. Five years, I would say, is probably also the most common endpoint, although depending on the situation, it can be negotiated shorter.

very infrequently do I see it go longer than five years. But I would say three to five is really where you’re gonna end up with, I think five being the most common. Next is geography. Again, pretty straightforward. Where does it apply? If you’re a buyer, you want it to be anywhere, right? That’s, know, in an ideal world, you cannot be in this business anywhere in the world. ⁓ Now there are issues with

There could be issues with enforceability ⁓ and there will likely also be issues with getting a buyer, a seller to agree to that ⁓ and whether or not it makes sense. And those kind of always go hand in hand. So typically what you want to think about is where has seller been in business and where is buyer going to be in business? And those are most crucial. So if this is a business that has been operating in the entire Northeast, then obviously you want the Northeast to be covered.

If buyer has specific plans to expand into the Midwest or buyer, know, this is a strategic add on and buyers already in the Midwest. Same, same idea. You don’t want them competing with you, whether or not you can, you can extend it to places that, you know, are not really contemplated is a kind of a deal by deal basis. I mean, I, you know, when I’m on a buyer side, I typically want to see us start out as having a geographic scope that covers the entire United States.

In 2025 with e-commerce and all that sort of stuff, again, depending on the type of business, it’s not what it once was to expand to a new market. It can be done fairly easily depending on the business that you’re in and you really don’t want to see your seller out there competing with you anywhere where you might potentially be doing business. ⁓ In terms of scope, that is going to often be the most

heavily negotiated in terms of what are they not allowed to do? ⁓ And this is where it’s really important for us to define what is the business? ⁓ What is the business that is being sold? It is particularly important from a seller’s perspective, at least, if they are selling you only a division or a component, ⁓ or if they are in adjacent businesses that are doing something similar, the seller is going to want to be really careful to make sure that they are not

prohibiting themselves from continuing their other businesses, right? If I have a business in related, in a same vertical, but it’s not part of this business per se, like, I sell car parts, but then I also operate a body shop and I’m just selling you the car parts business, you’re not buying the body shop. So you don’t get to tell me that I can’t fix cars, I just can’t sell parts anymore. So very important that those get negotiated and…

very specifically drafted to, you really to protect both sides, just to make sure that everyone is on the same page in terms of what the settler is allowed to do and what they are not allowed to do. Crucial question in terms of enforceability. I know a lot of people have probably seen that there’s been, you know, developments in the law that, you know, non-competes are fading away. There was, you know, there’s attempts in jurisdictions, including the last administration tried to.

ban them on a nationwide level. regardless of whether or not these individually hold up, there’s definitely a cultural trend against non-competes. ⁓ Importantly, almost nobody is seeking to eliminate non-competes in the context of a sale transaction. So when we talk about non-competes being banned, we’re almost always talking about them in the context of an employer-employee relationship. ⁓

It would essentially, kind of for the reason we just talked about, it would almost destroy M &A activity if you ban non-competes in this context because who in their right mind would buy a business from someone if the person’s allowed to continue in that business? For a certain product, maybe you would, but anything that’s like a service business, you would never buy a consulting business or a law firm or a medical practice or anything like that if the doctor can just go.

start a new practice the next day and say, hey, everybody, come see me at my new office. Stop going to my old office. It just wouldn’t make any sense at all. Non-solicit is a… How does this work with someone leaving? Leaving…

There’s someone who I know, let’s not get too specific. There’s someone I know who was kind of like a partner in the business, not my business, but sort of a partner in the business and then left. Is he able to just tell all his clients, come with me? I’m- what contractual obligations are in place. ⁓ If he has a restriction against that, then certainly he’s-

gonna be challenged for doing that. ⁓ Barring that, I mean, it would really, I’d say, depend on the facts and circumstances. You could conjure a case for something like torches interference with our business ⁓ and that sort of stuff, but it’s gonna depend on the facts. It’s gonna depend on how these customers got there in the first place. What did the person actually do? Because while we’re talking about soliciting,

Soliciting has a very specific meaning. It means that I solicit you. It doesn’t mean that I do business with you. ⁓ And buyers want to prevent all of it. So when, if we’re on the buyer side, we want to see a provision that says, I’m not allowed to solicit your customers, but I’m also not allowed to even do business with your customers. And the reason for that is that solicitation is very hard to prove. ⁓

you could claim, I didn’t solicit them, they called me. ⁓ And how are we going to establish that bar? Obviously, you could do depositions and discovery and all that stuff, and maybe you’ll uncover something, but it’s a lot easier to just say, I don’t care who solicited who, I don’t care how you ended up in business, the point is you’re in business now with each other, and I want to prevent that. ⁓ So we would say, no conducting business, I’m on the employee side, you wanna say no solicitations and no hire.

Same reason. I don’t want to have to start digging into, know, did they just respond to an add on indeed and ended up with you or did you poach them? That’s gonna be really expensive and possibly impossible to prove. So I just want a restriction. You can’t hire my employees. Confidentiality is, you know, pretty straightforward concepts. You have a seller who’s been involved in this business for 25 years. They know everything about the business.

You obviously don’t want them going out in the marketplace and telling anybody anything that’s proprietary or confidential about the business you just bought. So those are negative restrictive covenants. Then we have our affirmative covenants, our ⁓ obligations going forward that parties have to comply with. You may see some concept of a transition period. ⁓

depending on your seller, depending on the business. you’re in a strategic add-on situation, you may not need this, right? If you were just essentially buying a customer list and just expanding a territory, you may be perfectly fine with your seller going away at closing as long as you have his head of sales or whoever. Or maybe not even, maybe you’re just, we got this. ⁓ But in many situations, you want some sort of time period that the seller

is at a minimum available to you. ⁓ Now, you may have that under some sort of employment agreement or consulting agreement, depending on your business deal, but you may also wanna just have that as an obligation under the purchase agreement itself, that for a period of three months, six months, nine months, after closing, seller is going to assist with the transition of customers and the business. There might also be…

As I said earlier, there might be specific assets or specific components of the business that are not transferable or for practical reasons doesn’t make sense to transfer. Last year I was on a transaction that was supposed to close on like November 28th and to transfer all over the employees onto new buyers payroll and benefits and all that sort of stuff on November 30th was going to be just like a massive administrative shit show.

And it was, everyone agreed, just like it didn’t make sense to do that. The best time to really have the transition of the employees was going to be January 1st of the following year. So what we did is we built in a transition period where the employees stayed with the seller for that last 35 days. They were on seller payroll, seller benefit plan, seller everything, and buyer just cut a check to seller to basically cover the cost ⁓ of all of that ⁓ employee costs.

⁓ So, you know, that’s, you know, a perfect example of a transition arrangement where seller is still running a piece of the operations. In this case, payroll and employee everything, you know, HR, but buyer still owns the business. ⁓ When it comes to employees, that’s also a very important difference between stock sale and asset sale. In a stock sale, like everything else, employees stay where they are. They remain employed by

the same employer. In an asset sale, the employees all are terminated at closing by the seller. And then depending on your business deal, usually are hired by the buyer. Now, buyer may or may not want to hire everybody. This is often going to be a point of contention. You have sellers that care and you have some sellers that don’t care.

Every seller cares about liabilities and there’s all sorts of things that have to be done, whether it’s under worn or with regards to benefit plans or accrued vacation and PTO and various other things that are beyond the scope here that need to be done correctly in order to make sure that no one is assuming liabilities that they don’t want to. But there’s also just many sellers have the concern of they want to do right by their employees and they want to make sure that buyer commits to hire all of the employees, give them the same.

salary and benefits at least, commit to keep them employed for some period of time. None of these are statutory obligations under the law. These are all would-be contractual obligations that a buyer would either agree to or not agree to. And it will depend on what the business deal is. Sometimes you’ll see that a buyer will agree to hire at least 90 % of the employees.

or they’ll literally make a list sometimes. I’ve seen transactions where there’s a list of, we’re hiring everyone except for the eight people on the schedule. agreeing either we don’t need them, we don’t want them, or what happens a lot is these are people that are on payroll that just happen to be related to the sellers that are not necessarily providing value to the business that the buyer wants to pay. ⁓ So those are typically employees that you would see a buyer say, we don’t need those people.

understanding what’s going on with those people also ties into the value of the business and what what it’s going to look like from a profitability standpoint going forward. If you have any amount of people who are not contributing to the business, the business might be worth more. You might be willing to pay more, ⁓ might be willing to pay more for it. on the other, depending on the type of business, the employees are the asset, right? You know,

like we were talking about service businesses, that’s the main asset is the people that are the revenue comes from you having this group. ⁓ If you’re, you you’re some businesses, the sales team is, you know, this, have a rock star sales team and that’s what makes this business run. ⁓ And if we don’t have those people locked up, there is no business or at least the business is not what we think we’re buying. So, and that’s why you will frequently see the inclusion of employment agreements for key employee, the creation of an equity plan to incentivize, you know,

key core members of management, whether that includes the seller or not, there might be a CFO, a head of sales, a head of operations who are crucial to the future operations of this business. And you wanna make sure that they are locked up, that they’re incentivized to keep producing and that they’re kind of on board with buyer’s vision to grow and improve this business and make it even more profitable. ⁓

In terms of taxes that it really, that really just goes more to who is responsible for certain types of transfer taxes who’s responsible for filing tax returns for certain periods. ⁓ Not not something we need to dig into in great detail. And finally, we come to our indemnification section, ⁓ which is where we lay out the buyer. I mean, it’s really both sides, but.

Typically we’re talking about the buyer because the buyer is usually gonna be the one, if there’s a claim, they’re gonna be the ones who have the claim. Indemnification provides the rights and the mechanisms under which buyer can be compensated and made whole in the event that seller reaches the agreement in some way. And the two main ways that a seller can breach an agreement, number one is they breach a representation. ⁓

they made a representation about their business and it turns out that that was not true. So they said, you know, our financial statements are prepared in accordance with GAP. And it turns out that they prepared them in some other way and completely misrepresented what their EBITDA is. And you paid 6X at 3 million EBITDA, you gave them $18 million. And now that you run the numbers correctly, you realize that EBITDA should have only been 2.1 million and you now think they owe you $6 million.

So that’s a breach of rep. Similarly, if they tell you, you know, all of our customer contracts are in effect, none of them are in default, turns out you call up the new customer and say, hey, good news, new buyer in town. And they’re saying, new buyer, we’re not doing business with you. You you guys sold us faulty product last year and we told the seller and they never fixed it and we’re terminating our contract. So same thing. Now you were counting on.

$800,000 of revenue from this customer because you had a good valid contract with them, except it turns out you didn’t have a good valid contract with them because seller breached it last year. So seller is in breach of a representation. A buyer is going to have a right to be made whole. Other thing that a seller can breach is the covenant. Seller has an obligation to not compete with the business, not solicit customers, not solicit employees, but they do.

You want to have a right to be made whole. You also will want to have some sort of equitable right to be able to go into court and get an injunction to prevent the action. So that’s a separate category. But in terms of your right to be made whole, you’ve now interfered with my business, caused me loss of revenue, and devalued it. So I have a right to bring a claim against you and get paid. And again here, who is responsible?

very, very crucially, you want to have the individuals on the hook. mean, now, if you have a corporate seller and they have, you know, other divisions that are remaining and they have significant assets, there can be situations where you don’t need the individuals. When we’re talking about buying a closely held company, almost always you’re talking about a situation where they’re going to liquidate the corporation shortly after closing. So you need to have those sellers there to go after.

Now, you’re also going to often have, as we talked about earlier, you’re to have your escrow, you’re going to have your deferred purchase price, you’re going to want to have the ability to go after that money that’s sitting there, but depending on the size of your claim, the escrow may or may not cover it. you know, typically you’re going to see an escrow of 10 to 20 % of the purchase price. You may have a claim up to 50 % of the purchase price. Although we’ll talk about baskets and caps in a second.

The, when we think about indemnification, we, this is kind of like an exercise of the five W’s. So it’s the who, what, where, when, why, except not really the why or the where. So it’s the who, what, when. So the who is the company and the shareholders. The what, what are they indemnifying you for? For breaches, right? The when is, we talked about earlier, the difference between the fundamental representations and other representations. Your fundamental representations,

the fraud-like representations. We really own this business. The company has title to the assets. You’re typically gonna see those lasting indefinitely. For a minimum, they’re gonna last as long as the statute of limitations runs. When it comes to all the other representations, those are usually gonna have a finite survival period. Most common range is between six months and 24 months with a year kind of being a good sweet spot, 12 to 18 months.

which gives buyer that period of time to kind of suss out whether or not there are any problems with the business after closing. Frankly, to the extent that there’s a significant claim and a significant problem, it usually will be discovered fairly quickly. It’s pretty rare that this time period runs and it’s like three years later that you discover that there’s like some customer issue or employee issue that was not disclosed. So it’s usually fine.

⁓ But it’s, you know, obviously the longer that buyer can extend that period, the safer it is, the more time it has to make sure that it got what it bargained for. ⁓ There are typically going to be limitations. I just mentioned earlier caps and baskets. ⁓ A basket is a word that is often used in &A. It’s kind of similar to the concept of a deductible ⁓ in an insurance context.

A buyer, a seller is often gonna say, sure, I’ll indemnify you, but like, don’t come nickel and dime me for ticky tack stuff. Like, don’t want, you can’t bring a claim against me for $500. There’s going to be a threshold at which once we pass that threshold, you could start asserting claims. Usually you see it around 1 % of the purchase price. So anything that’s immaterial, you’ll start accruing those damages, but until they cross that level, you’re not allowed to assert a claim.

cap is on the other side of that. It’s the maximum amount that you could go after. And that is always going to be heavily negotiated. A seller wants to have some certainty that there’s an amount of their money that is completely safe. And whether or not they’re going to agree to a cap of the purchase price, which is if I’m a buyer, that’s what I want it to be. But you often will see it compromised at something like 50 % of the purchase price or 25 % of the purchase price.

It really depends on the size of the deal as well. The larger the deal, the lower of a cap on a percentage basis that you can agree to because ⁓ if you have a $10 million deal, there’s more likely to be a 50 % claim on a $10 million deal than on a $1 billion deal. So caps are very important. And crucially, fundamental representations will typically not be bound by the caps. So when we said before, you know,

They’re not bound by time. They’re typically also not going to be bound by these caps and baskets. there’s no, hey, I sold you the company, but I didn’t really own it. But you’re capped at 50 % of the purchase price. No, get the hell out of here. If you committed fraud and you sold me a business you didn’t own, I’m coming after you for the whole thing and more. Also my lawyer’s fees and whatever other costs I had, because you committed fraud, ⁓ you’re not going to be able to ⁓ avail yourself of any sort of cap. ⁓

The last thing to mention here is the concept of representation and warranty insurance, ⁓ which has become incredibly popular in the last five, 10 years. ⁓ It is something that has become basically a staple of deals over a certain size. I would say, I can’t remember the last 50 million plus deal that I did that did not have representation or warranty insurance. And it’s becoming even more common.

on smaller transactions as volume increases and insurers are becoming more comfortable insuring those deals. And what it does, it’s a really phenomenal product because it essentially ensures the breach of representations and warranties in a transaction. So rather than going after the seller for a breach, buyer goes after an insurance policy that covers up to a certain amount. Now policy obviously costs money,

the insurance policy is going to engage its own law firm, that’s going to do its own due diligence and that’s going to cost money. So it can increase the upfront costs of a deal, but it makes everybody sleep a lot better and make sure that there’s money available in the case of a breach. ⁓ It’s also great for a buyer because it eliminates a lot of tension because frequently buyers will not even

go after sellers or don’t want to go after sellers because it’s just like not a good look and it’s not good for business. Especially if you’re like, you if you’re a private equity buyer who’s like a serial acquirer of companies, you really don’t want to get a reputation for being a buyer that sues their sellers because then, you know, the next group of sellers are going to sell to a different fund. ⁓ This kind of allows you to have your cake and eat it too. You don’t need to bother your sellers. You don’t need to insult them. You don’t need to…

affect their bottom line, but you can still get made whole because there’s an insurance policy in place. ⁓ So thank you. Thank you for bearing with me. I’m sorry if it went a little bit longer than people expected, but I think we covered a lot. This was valuable. ⁓ Certainly I would expect that there are questions. I’m happy to take those now if there are, but you can also feel free to

reach out if there’s something you wanna talk about in greater detail. I’m happy to be a resource for anyone who is thinking about a transaction or just wants to learn a little bit more about anything we talked about today or any other related &A topic. ⁓ I’m happy to send my slides to Gershon and he can share them with the recording. that’s all I got. Please do, please send the slides to Brittany and I thank you all for joining. We had a few people request that story.

Send that out. usually send out the recording to everyone, but whoever wants slides, we’ll get them that as well. ⁓ thank you, Avi, for a top notch presentation. And, ⁓ I learned a lot. I probably should listen to this again, cause I’m sure there’s, there’s some things I’ll get on the second round. ⁓ and yeah, if anyone listening to this needs help on the financial side of due diligence or needs a CFO reach out to us, we can help. we’ve got an amazing team.

Then we’ll see you all next time. Thank you, Avi. It’s very good. Thank you. Avi, we’re going to see you tonight. I plan to. I plan to be there. All right. Looking forward to meeting everyone. Bye bye. Thank you all.

Speaker (00:00)
Welcome everyone. My name is Gershon Morgulis. I am the founder of Imperial Advisory. We are a fractional CFO firm and we provide fractional CFOs, CFO services. So we have a whole team of CFOs. Most of our CFOs have 30 to 40 years of experience and we go into businesses that need help but don’t need us on a full-time basis. So we’ll either be working for a CFO ⁓

that might be on helping get them ready for an audit or augmenting their FP &A process. have a offering on the FP &A side as well, ⁓ guiding them through certain things as a variety of things that we do for CFOs to help support them. ⁓ Most of our business though is working with smaller companies that do not have a CFO, don’t necessarily need a full-time CFO and kind of having owner who’s trying to be their own CFO and

not doing a great job, doesn’t have the time, et cetera, et And we go into these businesses and we help them. provide them with top-notch expertise and help them with a variety of things. So there’s the day-to-day things that we do, helping with strategy, execution, et cetera. And then there’s all sorts of things that come up on a as-needed basis. One of those things that come up on an as-needed basis is &A.

And so that could be working for a CFO who maybe doesn’t have the internal team to do the pre-deal work or working for a CEO or sometimes even an individual that’s looking to buy a business. So a CEO that’s looking to do an add-on or an individual looking to buy a business or a business looking to prepare itself for sale. So what we find is that

that &A can be used as a tool for growth similar to marketing or other things, or like I said, it could really be a standalone deal. And the topic today is the anatomy of a purchase agreement. But before you get to the purchase agreement, there’s often a lot of work done to understand the company, understand the target company, understand what’s going on, understand how this fits into the existing company, if it’s a company acquiring. ⁓

And if it’s not a company acquiring, there’s still a lot of work really. I like to break it into two phases. There’s understanding what is really going on. So sometimes we find that the story that the seller is trying to spin isn’t really true. We don’t believe it. And sometimes we find that we believe the story is just not a very good story. It’s not a story worth paying for to quote one of our clients.

If they gave us this business for free, should we take it? And that was a business that was doing 8 million revenue, wanted 8 million and wasn’t making any money. So you have both of these things and these are the things that we work on with our clients, helping them figure out if this business is something that they want or if this is a business that they, well, again, one, do we really trust what’s going on here? And the story that we’re being told and we’ve uncovered all sorts of weird things. ⁓

And then if we believe the story, then is that something worth them buying into? Anyway, after all that, we get to the topic of today’s webinar, which is setting up a purchase agreement. Typically, that’s going to be done by an attorney. And I know we have a bunch of attorneys here. Happy to see you all. And we’re especially happy to have Avi, who is our speaker today. Avi is a partner at Rivkin Radler. He’s worked at

bunch of different firms, I think here on Long Island. I think he’s coming to our networking event tonight. And by the way, for any of you in Nassau County, we have a networking and mastermind event tonight that we’re hosting at our office. If any of you are interested, send me a message. But anyway, back to Avi. So Avi’s been doing this for a while and…

⁓ and we’re very, we’re very happy to have him here. I’m looking forward to learning a lot. without further ado, Avi, take it away.

Thank you very much Gershon. Good morning. Thank you, Imperial for having me. Good to see everybody. ⁓ Today, as Gershon said, we’re going to be talking about ⁓ &A purchase agreements. As Gershon said, buying a business can be a long and arduous journey. ⁓ There can be all sorts of ups and downs, starts and stops, and lots of decisions to make, lots of traps.

for the unwary lots of problems to solve. And we’re going to get into a bunch of that today. ⁓ Just wanted to say at the outset with that, this program is going to be almost exclusively framed from the buyer’s perspective. But there’s also a lot to learn in here if you’re a potential seller as well. Cause like, you know, lot of the concepts are just kind of.

zero sum shoe on one foot shoe on the other foot. So it’s important to understand the concepts regardless of what side you’re on. So Gershaw made some very good points. One very bad point that he made was that he said purchase agreements are typically prepared by an attorney. I think we should just get rid of that word typically and make sure that you have an attorney involved in this process. And I would say very importantly, whether it’s me or somebody else that you have a &A specializing

attorney handling your &A and not someone for whom that is not what they’re doing on a day-to-day basis. ⁓ So just a piece of free advice at the top. ⁓ So the things that Gershon said that was right on point is that there’s a lot that goes into an &A that happens well before you get anywhere close to drafting, let alone signing a purchase agreement.

So that begs the question for a program that is ostensibly about kind of an overview and at the outset of an &A and things to think about, why are we having a conversation here today about the purchase agreement? And the answer is not just because I’m a lawyer who specialized in agreements, there’s really good reasons why I think this makes sense. ⁓ And one of those reasons is that

I’m the type of person, and I think it’s a very helpful way of thinking about things, who likes to often start at the end. ⁓ Every deal has a different start. Every deal has different journey along the way. But any transaction that ends successfully and ends with a transaction being consummated and actually happening is going to end with a purchase agreement like this. So I think it’s often very helpful to say, let’s start at the end and work backwards. And how are we going to get to that end point? And I think the purchase agreement is one of those things that

Really provides a lot of the meat and the bones of what makes up a transaction and lets you kind of at the outset say. Here we know where we’re going to end we’re going to end with something that has all of these different components. How are we going to navigate a process and set up a process that allows us to get to that endpoint in a successful way and do so as efficiently as possible. ⁓ It almost I view the purchase agreement almost as a roadmap ⁓ because.

It allows you to determine those friction points and those possible points of tension early on ⁓ and deal with them and see if this is even a viable deal. Because the last thing you want is to spend months and all the time and all the money that goes with that negotiating and working through all these different potential pitfalls only to then have something pop up at the one yard line and sink a deal. So to the extent you can raise these issues early,

and understand what we’re going to have to deal with at the outset, ⁓ it could avoid that problem. The next thing why to me purchase agreement is very important is because there’s a fundamental difference between two different components of what makes a transaction. I often like to tell clients that there’s only two things that are negotiable on every &A transaction, price and terms. Price is what the business people are always focused on. They wanna know what are we paying and the seller obviously wants to know what am I getting?

That’s the fundamental business transaction, right? That’s the main thing that everyone cares about. But there’s a whole bunch of other terms to a transaction that are often just as important ⁓ that really go fundamentally to what it is that you are buying and how are you going to protect what you are buying. And the purchase agreement is where all of those things get set out and memorialized and specified. And thirdly,

the reason why I think purchase agreement is important, particularly for a buyer, because the purchase agreement is essentially what the buyer gets. The purchase agreement is like your deed. It’s like, it’s your piece of paper that says, hey, seller, I wrote you a check for whatever many millions of dollars, and you’ve in exchange given me your business. And the purchase agreement is the document that certifies that, that says, I now own this business. These are the rights that come along with that.

these are the restrictions that are now placed on the seller that prevents them from pursuing this business, interfering with their business or whatever obligations they have on a going forward basis. The purchase agreement is going to be your key to go into court if anyone ever challenges your rightful ownership of this business and say, hey court, check out this agreement, this business is mine now, see, I paid money, now the business is mine. So the purchase agreement is a really important component for

⁓ for the buyer to think about from the beginning of the transaction. And while we are on the subject of why, ⁓ probing the why to me is also one of the most important parts of thinking about the outset of any transaction, specifically sitting with a buyer and understanding why are you doing this deal? Why are you pursuing an &A at all and this specific ⁓ &A? And the answer to that why will provide

Potential answers to all sorts of different questions, including many of the questions that we’re going to encounter today, because the why for, let’s say, a financial acquisition being conducted by a private equity fund is very different from that of a strategic add on that a corporate buyer might be making or that an independent sponsor who is viewing this as their path towards entrepreneurship might be thinking about.

And the why you’re doing the transaction is going to significantly impact your answers to a lot of the what’s that we’re going to deal with over the course of the next hour or so. So let’s jump into it. ⁓ Before we kind of go through the breakdown, ⁓ this is on the on the screen here. We have what I would say is the most typical purchase agreement.

structure you’re going to see. 95 % of the time, a purchase agreement is going to be broken down into these categories. And we’re going to focus today on the ones that are highlighted and bolded. Obviously, we always start with some section of definitions, whether that’s in Article 1 or an exhibit at the end. And we’re always going to end with miscellaneous terms that most of the time, nobody reads except for the lawyers. That’s where you deal with all your severability, entire agreement, headings, all that fun stuff.

But the real meat we’re going to be talking about are articles two through articles seven. Article two, purchase and sale. This is where we kind of really just like outset. This is the basic transaction. What are we giving? What are we getting? Articles three, closing, is going to deal with the timing of the closing, what is required to be done at the closing. And as you’ll see, depending on the timing and how a transaction is structured, ⁓ what might be happening before a closing. Articles four and five is going to deal with the

representations and warranties that each of the parties are going to make. Typically, you would see the representations from the seller in Article 4, representations from the buyer in Article 5. Article 6 is our section on covenants. These are obligations that occur in the future. So people often confuse representations, warranties, and covenants and like use them almost interchangeably in terminology. There are actually three very distinct things.

⁓ Let’s say distinct representations and warranties are distinct representations and warranties versus covenants are very distinct. ⁓ Representing a representation is a statement of facts as of a moment in time. So you’re saying as of today, I am asserting that such and such is true. A warranty is a statement of fact that is future looking. So when a manufacturer warranties that their product is going to work for a year.

They are making a statement of fact as of today with regard to something that will happen in the future. Representation is you’re saying as of today or backwards looking. A covenant is not a statement of fact. A covenant is a future obligation of a party. it’s things that starting from today, the day we’re signing this agreement and going forward, these are obligations of buyer and seller vis-a-vis this transaction. And then finally, our section on indemnification.

Another good word for indemnification is your remedies. ⁓ This is the rights of the various parties should something go wrong. If somebody breaches the agreement in some way, or if somebody does something that they weren’t supposed to do. ⁓ So that’s our basic overview of the skeleton of the agreement. As I said, almost every typical purchase agreement is gonna, if not follow this exact order, they will all have these different sections or different components.

⁓ So let’s start going down this road. And we’re going to start with Article 2, purchase and sale. So as I said, purchase and sale is going to literally cover, it’s going to have a basic description of the transaction itself. What is being bought and what is it being bought for? ⁓

And obviously, we know where it’s not always so simple as, I’m buying your business for $10 million. This is where we are going to set out the specific type of transaction that is being conducted. And so when I say, what are we buying? Typically the fundamental threshold question on any transaction is what are we buying? Are we buying the stock of the target company? Are we buying the assets? Possibly we’re doing a merger, although, you in private.

Company transactions, closely held companies, mergers are pretty rare. So it’s not something that we’re really going to focus on today. But just have in mind that that is a third option and there are actually more options that are kind of hybrids between the various things that we’re to talk about today. But general high level focus is going to be asset sale versus stock sale. And the corollary to that is what are we going to give?

So that comes down to what is our purchase price? And we’re going to get into a little bit more detail on the various ways that a purchase price can be comprised. So as I said, fundamental question is going to be stock sale versus asset sale. And we’re going to assume here that we’re talking about like a full buyout of an entire company here. ⁓ You could in theory have a situation where somebody is making a

in that minority investment or even a majority investment, but they’re buying something less than the entire company. So we’re not really gonna be talking about that today. We’re going to assume in a stock sale that the buyer is buying 100 % of the stock or membership interest if it’s an LLC of the business. We’re going to assume if it’s an asset sale that this is a full enterprise, we’re not just buying a division of a company, we’re buying the whole mothership.

Presumably we are going to be buying substantially or all of the assets of the target business. So when it comes to understanding the difference between a stock sale and an asset sale and why a buyer may favor one versus the other, spoiler alert, you wanna buy assets, but we’ll get into why. ⁓ We’re gonna focus on three overall concerns to think about.

⁓ The first is the legal structure. So we’ll get into a little bit of just mechanically the difference between how one works versus how the other works. ⁓ We want to very much understand the treatment of assets and liabilities, specifically liabilities, because as a buyer, ideally you want to avoid liabilities of the existing business. And then, of course, we also want to understand the difference between how taxes will be affected by

our transaction structure. So in terms of the deal structure itself, here are some what I think are helpful pictures that I found on the internet that kind of lay out what happens on the two different types of transactions. So stock sale is for most people the simplest one to understand because almost all of us have at some point owned stock, whether it’s in our companies that we own today, but more likely

you own some form of stock on a public security market. So if, for example, I am a shareholder of Apple and I own a hundred shares of Apple and I want to sell my stock to Gershon. Now that’s not typically what would happen. I would typically just sell it on the public market, but just to make this simpler, if you look at our stock sale picture, so we have target shares, is another word for that is what you could call shareholders. So if I’m the shareholder today, I own the shares of the target.

Now in a stock sale, what happens is the acquirer, in this case Gershon, would send money to me, exchange for which I would send the shares to him. So the shares of Apple are exactly the same today as they are tomorrow. Everything contained in the shares of Apple are exactly the same as today and tomorrow. The only difference is that today the owner of the shares is Avi and tomorrow the the owner of the shares is Gershon. Very, very simple. An asset sale is a little bit different.

As you see from the picture here in the asset sale, the shareholder again owns the target. However, the asset sale is really not a transaction between me and Gershon. It is a transaction between Gershon as the buyer and the target company that I own. Because when a business is owned by an entity, all of the assets, all of the liabilities, everything that makes up that

business are housed inside the entity. I am merely the owner of the entity. I don’t have anything in my own name. ⁓ There’s good reasons for me to still be party to the transaction for other reasons, which we’ll get into, but fundamentally the transaction is happening between the target and the buyer. The target here is the seller. And what happens is that the target is going to ship off its assets to acquirer. Buyer ideally is either

has an existing entity or forms a new entity in order to consummate this transaction. And the buyer entity is then going to send the money to Target. Now, Target is presumably going to, if not immediately, then shortly thereafter, distribute those funds up to their shareholders because the shareholders are the ones who ultimately want the money. ⁓ But fundamentally, this transaction happens at the entity level.

And the reason why that difference is important is because of the way that assets and liabilities get treated in the two different types of transactions. So as I kind of tried to explain with a stock sale, in a stock sale, there is no change in terms of the ownership of the assets of the underlying business. So.

If I, as I said, if I own Apple and let’s just, you let’s get rid of the Apple analogy. ⁓ I have a business, know, Sienenski incorporated is a consulting firm and we have assets. have, you know, we have goodwill. We have a customer list. have employees. We have furniture in our office. We have rights under contracts, under leases, any stock sale. All of that is staying exactly where it is. It is not moving at all today. The company is Sienenski incorporated.

tomorrow the company will be in Sineski Incorporated. The only difference is that instead of it being owned by Sineski, it’s going to be owned by Morgulis or Morgulis. I don’t know how pronounce your name. Let’s go back to Gershaw. So the only thing that’s happening is the ownership up top is changing. Everything down below stays exactly where it is. It is not changed. And that means that all of the assets, all of the liabilities simply by operation of law,

by just staying where they are now belong to the buyer. ⁓ And the key there is going to be the liabilities. On an asset sale by contrast, it works completely different because we are physically, not physically, physically moving all of the assets from let’s say, Sienensky incorporated now to a new entity called Sienensky 2 incorporated.

we get to pick and choose what we wanna move. We don’t have to take all of the assets. We can take only some of them if we want. And we don’t have to take any of the liabilities. And that is really, really crucial. So in every asset purchase agreement, you are going to have a section on assets and liabilities that spells out essentially what are four categories, purchased assets and excluded assets, assumed liabilities and excluded liabilities. And this allows a buyer

To go through the assets and liabilities of a business and come to an agreement with a seller and make a determination about what we’re taking and what we’re not taking. So, there could be that you want every single 1 of those assets, but there might also be an asset that is not really relevant to this business. ⁓ The most common thing you’ll see is that there are, you know, I’ve heard a rumor that sometimes some small businesses will have assets that.

You know, are technically not necessarily business assets, but they are titled in the business’s name, like, you know, somebody’s car or, you know, certain memorabilia. And like, I know no one would ever, you know, they taxes or do anything like that. But like, I heard this might have happened on 1 or 2 occasions. ⁓ And typically stuff like that are not things that a buyer is going to buy in an and a transaction. Right? They don’t want the owners personal assets. There might be other.

you know, assets in there that really, you know, sometimes we’ve seen that like, you somebody has some sort of like property investment and they just like ran it through the business and it has nothing to do with the business. ⁓ So it’s important for everyone to identify those assets and make sure that those are not being sold as part of this transaction because that’s not what this deal is about. And as I said, the more important part is the liabilities. The fundamental starting point for a buyer is we want to buy none of the liabilities. We want none of those to transfer.

And that will usually be the default is that any liabilities that are not expressly written as assumed stay behind with the seller and remain seller’s problem. Any debts, any lawsuits that may exist for the past? Yes, Gershon. Question. I once heard that if you transfer all the assets under some situations, liabilities can automatically transfer because you can’t like completely gut a business. Is that for real?

So there are certainly certain categories of liabilities for which we say a concept of successor liability applies. ⁓ we’re gonna deal with those in a little bit, but ⁓ to answer your question, the answer is yes. There are certain types of liabilities that cannot be escaped. The most common one is taxes, right? The government is not letting anyone get away with taxes just because you sold your business.

So if there’s a tax liability ⁓ and you sell your business, buyer can be held liable as a successor. The same is the case for environmental. You see this very frequently in real estate transactions that buyer would step into historical liabilities of the seller. ⁓ You also see it with all sorts of employee and employee benefit liabilities. Again, the policy reason there being that

want to protect employees and we don’t want some, you know, there was some pension that got set up and you can’t sell the business and now, you know, the seller disappears and the liability goes away. And there are ways to protect against that. the better than having a way to protect against the liability is to never have any claim that the liability is yours. So, you know, if you do an asset sale, and the reason why you want to do an asset sale is

If let’s say a customer has a lawsuit because they bought a product from seller a year ago and today it killed somebody and they run into court and they, who are they gonna sue? They’re gonna sue everybody, right? They’re gonna sue the seller, they’re gonna sue the seller’s owner, they’re gonna hear that the business got sold, they’re gonna sue the buyer, they’re gonna sue the buyer’s owner. And the best thing that a buyer is able to do in that circumstance is to go into court and say, hey judge, this has nothing to do with me. You see here, they bought this product from,

XYZ Inc in 2022, we’re actually ABC Corp and we weren’t even formed until 2024 when we bought this business. This has nothing to do with us. And I would say 95 out of a hundred times, you’re gonna get that thrown out immediately because you’re not the party to the lawsuit. You haven’t been properly brought into this lawsuit. It has nothing to do with you. The other important things that you want to think about and that are

more important when it comes to an asset sale is the retitling of certain types of assets ⁓ and any consents that go along with that. Most often this is going to be in the context of a contract. ⁓ Think about your lease, right? Your lease has a provision in there that says you can’t assign it to somebody else because your landlord did a credit check on you. They vetted you ⁓ as a tenant. You can’t just call up your landlord one day and say, by the way,

I sold the business, here’s your new tenants. Landlord is not gonna be okay with that. So when you sell your business, you’re gonna have to go to your landlord and tell them in advance, you’re gonna have to get their consent and make sure that they sign on to the assignment of the lease to the new buyer. Same will often be the case with various customer agreements, vendor agreements, and other contracts that you may have, that a seller may have that your attorney, that’s part of the diligence process are going to review those contracts and see

You know, is there anything in here that will require the involvement and consent of a 3rd party in order to transfer title to certain assets when it comes to pieces of equipment that might be least same thing applies certain vehicles. You have to have them retitled in the name of the new entity. So that’s just some additional components that might make an asset sale a little bit more complicated, but.

the ability to essentially walk away from those liabilities makes those extra hoops you have to jump through well, well worth it. And then finally, we’re going to talk about the tax implications of the two types of transactions. And again, here’s a situation where the general rule of thumb as a buyer is going to be you want to buy assets. From the seller’s perspective, the tax treatment is very simple.

When you sell stock, you get long-term capital gains treatment, assuming you held the stock for more than one year, an amount equal to your gain on the stock over your basis taxed at long-term capital gains. And the same thing is going to apply for a buyer. The buyer is going to acquire a basis in the stock and

Will not have the ability to recover its purchase price until it liquidates the business ⁓ and. The most important principle in terms of. How tax affects economics is. That an asset sale allows the buyer to start recovering their purchase price immediately, ⁓ depending on the types of assets, but because when you buy assets, you get to.

take a step up in the basis of the value of the assets because when you sell assets, the IRS doesn’t view it as a sale of a business per se, they view it as a sale of the individual assets. So I’m not selling you the business, I’m selling you the tables and chairs of the office and the goodwill and the rights under this customer contract and the rights to employ this group of employees. And all those different assets are kind of viewed by the IRS as separate sales.

they are therefore taxed at an amount based on the type of asset that they are. So we generally speaking divide assets into different types. We have our capital assets and we have our depreciable assets. The capital assets such as your intangibles and your goodwill get taxed at the more favorable rate. Your depreciable assets get taxed at the higher rate. So depending on

the type of business that you have and the types of assets that the business that you’re acquiring is comprised of that will impact the exact tax rate. Usually what you end up with is some sort of hybrid between the 20 % capital gains rate and the 37 % ordinary income rate. It’s not gonna be exactly one or the other, but if you have a business that veers more towards those capital gains assets, the seller might pay 22%, whereas

When if it’s more of a business with harder assets, ⁓ it might be on the higher end. But because of the step up in basis, because of the buyer’s ability to start depreciating certain types of those assets immediately and deducting them against their gains, the asset sale form is highly advantageous to a buyer. So because of the ability to…

walk away from those liabilities because of the advantages on the tax side to buying assets. The starting point almost all the time for a buyer is going to be, wanna buy assets. Now that’s not always possible. First of all, as we said, there’s always a lot of very zero sum elements to this. So the reasons why an asset sale are good for a buyer also makes a stock sale good for a seller. So a seller may wanna say,

I want to just be done with this. You’re taking the assets, you’re taking the liabilities, you’re buying the stock, period, the end. I’m not interested in an asset sale where I’m going to have to, you know, wind down and deal with stuff afterwards. Seller might say, I want my long-term capital gains. I don’t want to deal with this whole allocation and figuring out one of my different types of assets and potentially pay more. I always assume that when I sell my business, I’m going to sell the stock. I’m to just pay capital gains on the whole thing. And that’s what I’m doing.

⁓ And depending on your leverage or negotiating power, you may or may not have the ability to dictate the structure of the transaction. There are workarounds to solve for both of those issues. And sometimes there are elections that you can make under the tax code, such as 338 H10 or 336 E. There’s something called an F-RE-ORG. And these all give you the ability to create a

transaction as an asset sale for tax purposes while still treating it as a stock sale for all other purposes, such as corporate purposes and legal purposes. But, you know, generally speaking, if we’re we’re using one or the other, you know, the stock sale is going to be more advantageous for the seller and asset sale for the buyer. In addition to your seller saying, I want to sell stock when we just talked about consents, it could be that a asset sale is just not practical.

Think about a scenario where you’re buying a business that has hundreds of contracts and 75 of them need consents to assign it to a new party. Now, maybe you’ll be able to go out and get all those consents, but that seems like a lot of work and it just might not be practical. There also could be specific types of permits or government approvals that simply are not transferable. And it could take months, if not years, depending on the organization and when you have to deal with certain government.

bodies, it could take a really long time to get the approval. And you may want to just go forward with your transaction. And that means you’re going to have to buy the stock because that’s where the permit is. That’s the entity ⁓ that is approved. That’s the EIN that’s on record. And you just might not have any choice. So yes. I want to just add one thing. And this is your talk. So correct me if I’m wrong. But we once had a client who was looking to

potentially purchase a business and they had workers comp experience that had been building up for a long time. And they felt that that was a reason why they would buy it, even though they knew there were liabilities and skeletons in the closet. didn’t go through the transaction in end anyway, but they, at least that’s what they told me at the time. They’re like, if we want to get the benefit of this experience of the workers comp experience that won’t trade had built up like enough body of work that it

it impacted their rates favorably. Correct. And if they were starting from scratch, even if they did somehow manage to transfer the contracts, they would end up having to charge much more or pay much more and therefore they’d lose money or be not competitive. Yeah. I mean, I don’t know a lot about workers comp. So I’ll just kind of grant your premise that that’s how it works. if that’s how it works, then that makes sense, right?

there could be benefits to stepping into an existing company. I’ve also seen situations where an existing company has an easier time getting financing than a new company because if it’s history now, ⁓ that shouldn’t typically be the case because you should be able to show the bank that you’re taking over a going concern and that the revenue is basically then going to be and cash flows should be imputed to the new company. But depending on your underwriter, they may just look more favorably at, you know,

a company name that has this history versus a buyer that’s starting from scratch. ⁓ OK, so for most, the most important part of the agreement is going to be the purchase price. ⁓ And we’re going to talk quickly about how we get to a purchase price. How do we, know, how much do we pay and how are we going to pay it, right? Two parts. in terms of how we determine how much to pay, ⁓

It’s really not my area of expertise. You’re gonna probably wanna speak to someone like Gershon or to someone who’s an investment banker or broker or someone who’s in the business evaluating companies. But typically what we see is most common is a multiple of EBITDA is used to determine a purchase price. ⁓ will vary largely based on the industry that you’re in, the size of the business.

Most typical is you see something in the range of four to eight times a multiple of EBITDA. Depending on the type of business and your type of buyer, you might use a multiple of revenue. One X revenue is the most common that I see. You also are going to want to factor in some sort of public research in terms of what are similar companies selling for the same way that a real estate valuation consultant would look at, you

What are other properties in the neighborhood selling for? You wanna know what is a consulting business or a medical practice or a pharmaceutical company that does this type of revenue, this type of sales, this type of profit, what is that going for? Because as I said, the multiples, the variations can be different depending on geography, depending on industry. You also, depending on what type of buyer you are, this is more when you’re on a

you know, on an add-on transaction or a corporate inquirer strategic, you have to think about potential synergies because you are not just buying necessarily this business for itself. There may be other things that this business brings to the table that fits into your existing business. ⁓ It’s not just that, you know, okay, they have a great business and we’re going to just acquire that cash flow. We may be able to grow the pie because we have other products, other services that we can sell now to a new customer base, maybe

This company has some piece of IP that we can incorporate into one of our existing offerings. And that makes the company worth even more than how it looks on paper. ⁓ So that might also factor in. In terms of paying the purchase price, what are we going to give our seller? ⁓ Most common is we’re going to give them cash, right? But we also can frequently give them some sort of property. When we talk about property, what we are typically talking about is some sort of equity

either in the buyer itself or somewhere in the buyer enterprise, what is called rollover equity. Very, very typical in the private equity context and becoming more and more typical in all sorts of &A contexts, especially as the price of capital gets more and more expensive over the last few years. ⁓ The ability to pay with something other than cash is very enticing to a buyer.

There are, it’s also beneficial to seller in many ways because A, they get to defer taxes on any things that they take in equity and they don’t have to pay any tax on it until they liquidate that buyer stock. Number two is it gives seller potential upside. If seller believes in their buyer’s theory of the case, they think that this buyer is going to add value, whether it’s through infusion of capital, whether it’s through synergies, whether it’s through,

professionalizing their business. The business that today is worth $25 million may very well be worth $50 million in three to five years. And frankly, that is what, if you’re selling to private equity, that is what they’re betting on. So this gives the seller the ability to take a piece of their ⁓ purchase price proceeds and roll it over, let it ride, and see if it can grow into even more. Similarly, buyers are often looking to

pay whatever amount that they’re paying in cash sometime other than today. ⁓ For two main reasons. Number one, if you’re a financial person, obviously you understand fundamentally a dollar today is worth more than a dollar tomorrow. So to the extent we have an ability to defer the time when we have to pay a portion of our purchase price, that is financially beneficial. Number two is it provides you some sort of protection and whether

We have our deferred payment being paid under a promissory note, whether it’s that we have money that is put in escrow or whether we make a portion of the purchase price subject to an earn out, which means that it’s not guaranteed. It is only paid if certain conditions are met, usually financial metrics about the business. That gives the buyer, as I said, protection because they have the ability to

have money that’s available in the case something goes wrong. So if it turns out that this business is not what seller said it was and you have a claim against the seller, you don’t wanna have to be in a position where you have to go chase them and say, hey seller, pay me back my money. You wanna be able to say, good thing we have this escrow over here with $3 million in it that we can make a claim against or good thing that we have a promissory note or an earn out that is supposed to be paid next year that we can basically say to the seller, hey, that $2 million that we were supposed to pay you.

we’re not paying it to you because we have a $2 million claim or we’re only paying you a million because we have a million dollar claim. ⁓ There is also typically going to be an adjustment component to your purchase price. ⁓ The two main types of adjustments, and you kind of think of this as the, you’re like kind of like your paycheck where you have the number at the top, which is the enterprise value. And then there’s the number at the bottom, which is what we’re actually paying. And

those get adjusted either upwards or downwards ⁓ based on A, the cash and debt in the business, because most transactions are structured as what we call cash-free, debt-free, especially on a stock sale. On a stock sale, you would almost never assume long-term debt and you would almost never buy cash. I mean, it doesn’t really make sense to purchase cash, right? ⁓ It’s just, you know, I give you a dollar and you sell me a dollar. doesn’t really…

Make any sense? So cash is typically going to always stay with the seller. Debt is always going to stay with the seller. And those get adjusted from the purchase price. So to the extent there is any cash left in the business, on a stock sale, seller doesn’t have to pull the cash out. We just increase the purchase price by the amount of the cash. And similarly, we would deduct for the amount of debt that is on the books. The more common and more complicated adjustment that we have to deal with is with respect to working capital.

And the reason there is that buyers typically want to expect that when they buy a business, they don’t have to now write another check to fund operations of the business. They want to buy a business that’s viable and that runs itself based on its cash flows and working capital. So early on in the process, you’re always going to want to determine

what is the working capital that this business needs? Usually you do that by determining some sort of trailing average, six months, 12 months, 18 months, and look at the history of the business and what does this business need on an average monthly basis to fund operations. And the seller is going to be expected to deliver a business that has working capital equal to that target average amount. If at closing the working capital is insufficient,

there will be a credit towards the buyer and a reduction of the purchase price. And likewise, if the seller over delivers, they get a credit and purchase price goes up. And the working capital is usually done as an estimate at closing and then gets trued up, but they’re 90 days, 120 days down the road. ⁓ As always, I’ve front loaded the majority of this presentation. It looks like we’re… ⁓

running low on time, so I’m going to try to make sure we get to some of the rest of this. The next section in your transaction document is going to be deal with the closing. ⁓ It’s a pretty mechanical section. It mostly just has like a list of items that needs to be delivered at closing. This is gonna be, and this is where you’re going to cover the various other transaction documents other than the purchase agreement itself.

⁓ So again, in terms of roadmap, this is where you want to think about what else do we need? Is there going to be a new lease that we’re going to enter into? Do we want to put in place employment agreements or equity arrangements for management? Do we need some sort of transition agreement for, you know, maybe there’s some component of the business that can’t be transferred right away and we need to figure out how that’s going to be managed during the interim. The most important consideration for this section, the closing section is

whether or not the transaction is going to be conducted as what we call a simultaneous sign and close or as a bifurcated sign and close. A simultaneous sign and close is the more simple version and for pretty much any transaction, I would say let’s say under $100 million ⁓ is almost always gonna be the norm. And that just means the day we signed the purchase agreement is the day that we close. It all happens at the same time in one shot.

By contrast, a bifurcated signing close is what is more common on a real estate deal, right? Think about when you bought your house. You signed a contract and then, just based on you seeing the house, and then you have to go get financing, you hire an inspector to do diligence. So in a bifurcated signed and close, we signed an agreement today with an agreement to close in the future. And it’s a real binding agreement. However, it’s subject to conditions, meaning

seller is going to have obligations for how they operate the business in the interim and what we call our interim operating covenants. ⁓ Very important because if you’re agreeing to buy a business, you want to make sure that seller is going to conduct the business and your ordinary course that they’re not going to do anything differently. In the meantime, they’re not going to start selling off key assets or firing key employees. You want to make sure that the business that shows up at closing is the same business that we agreed to buy. The main reason why you would want to

do a bifurcated sign and close is, as I said, if there are financing considerations ⁓ and some lenders want to see an executed purchase agreement before they will sign a commitment letter, you may also require various consents and you just want to have the ability to sometimes, sometimes you want to announce the transaction and start telling people that it occurred. So you want to have a signed binding agreement so that you can do that. ⁓

I mentioned the hundred million dollar threshold. It’s actually a little bit higher, but I remember the exact number. If you need to get antitrust approval under the Hartscott-Rodino Act, which applies to any transaction over a certain size, that requires as well that you have a signed purchase agreement and then you have, I think, 30 or 60 days to go get that approval to make sure the transaction can proceed.

The representations and warranties are almost always the largest section of the transaction. If you have, let’s say, a 50 page purchase agreement, you will often see that 25 to 30 of those pages are comprised of the reps and warranties. And the reps and warranties are in many ways the most important section because this is where the seller goes on the record about what the business is and what it isn’t.

The reps and warranties, a good way to think about them is that they’re kind of your backstop to your due diligence. So you sign a letter of intent and that’s when the seller is going to start opening its books and showing you its records and telling you about everything about business, the good, the bad and the ugly and give you an ability to do quality of earnings on the financials, ⁓ review all their contracts, look to see if there’s been any litigation, any problems, any customer complaints, all of these things will be.

uncover during due diligence. ⁓ The problem with due diligence, or I guess what would say, where due diligence is lacking is that your due diligence is only as good as what your seller gives you. When we’re dealing with private companies, there’s no public record of anything. You can’t go out and say, OK, we’re going to go. There’s no website where you can go and say, give me all of the contracts that this company is party to and tell me.

all the problems that they have. You’re relying on the seller, the shareholders to own up to that stuff and produce it to you. Now, in a perfect world, would, know, I’m sure we’re all comfortable with the honor system and we don’t need any of this, but unfortunately that’s not the way the real world works. So what the representations do is they require the seller to back up the due diligence process by putting in writing what they’ve produced.

So for example, you wanna know that seller has not been sued in the last three years, right? Cause I don’t wanna buy a company that gets sued all the time. So you’ll run your litigation searches. You’ll ask your seller to tell you, give me copies of any complaints of any letters that you’ve gotten from lawyers, any lawsuits that have been filed. ⁓ And you’re hopeful that they’ve complied.

But what you wanna do in the purchase agreement is actually have seller put in writing, we’ve not been sued during the last five years, three years, 10 years, we’ve not been party to any lawsuits. During the last three years, none of our employees have made a claim of sexual harassment or discrimination. We’ve filed all of our tax returns and paid all of our taxes, things like that. So we kind of, I like to think of this process as three stages.

You have your due diligence where you review everything, then you have your representations and warranties where the seller makes these statements. And then you have your disclosure schedules, which get attached to the representations and warranties. And that is where the seller does one of two things. Either they provide lists of things. So you may have a representation that says, set forth on schedule A is a list of all of our customer contracts.

Set forth on exhibit B is a list of all of our employees and their salaries and their job title. You also would put on the disclosure schedules if you’re a seller, the exceptions to any of your representations and warranties, because I’ve yet to see a business that is able to make all of the representations cleanly without any exception, right? In a perfect world, a seller would be able to say, we’ve had no litigation, we’ve had no complaints, we’ve had no problems.

But in reality, a seller needs to be able to say, have had no complaints, we’ve had no litigations, we’ve had no problems, except for the litigations, complaints, and problems that we’ve listed on exhibit C of the schedules. And that’s where it all ties together. So you have your diligence, you have your reps, and then you have your schedules. And the job of the buyer and his advisors is to make sure those all line up and that what we saw in due diligence is consistent with what?

seller is now vouching for on the schedules because if there is something that a seller represented that was not true, buyers going to want to have the ability to get compensated for that. Our representations are typically grouped into different categories. We have our fundamental representations, we have our legal representations, and we have our business representations. Our fundamental representations, we call them that because they are

fundamental to the business, fundamental to the transaction. Things like seller actually owns the business that it’s selling. It didn’t sell it to somebody else last week. The shareholders of the company are the three people that were claiming there’s no fourth person out there who’s going to show up next year and say, hey, I was an owner in this business and I’m entitled to a piece of the action. ⁓ The seller entity actually has title to all of the assets that it’s selling. There’s no.

significant asset that is actually in some other entity that is in the personal name of one of the shareholders. The assets are not subject to any liens. There’s nobody else out there that has any sort of claim on anything that has to do with this business. Again, these are what we call fundamental. And the implication of them being fundamental is that typically they will survive indefinitely, which means no matter when buyer discovers that there’s a breach of one of these representations,

And no matter the amount, buyer should be able to be made whole. Whether even if it’s in 10 years, if it turns out you didn’t really own the business, essentially a breach of a fundamental representation is another word for that is fraud. ⁓ So those will typically have the longest legs and the greatest ability to recover under. ⁓ Then we have our legal representations, which have to go towards.

compliance with laws and these are the ones that as Gershaw mentioned earlier, at least some of these is where you may see successor liability. So you wanna be extra sensitive to these and this is why often on transactions, you will see a whole bunch of specialists get involved because these are, we’re gonna be very sensitive to a potential environmental issue or an employee benefit issue because of the successor angle.

And then finally we have what we call our business representations. These are things that, yes. We’re running short on time. Does it make sense to continue this another time or should we just hold Q and A till 12 o’clock and wind down by then? I’m happy to do either. I’m happy to make myself available for another time if you think that makes sense. But yes, we are running low on time and there is more stuff to talk about. So it’s all super interesting and very valuable.

We could also just continue like I am available. So it’s really up to you. Okay, so I got a 1230 no problem Well, I’ll stay and listen everyone we We generally wind these things down by noon. So we don’t want to hold you forever if any of you are interested in the In the recording so that you can get the rest of it reach out to Brittany. We are recording this and We can get you the recording

I’m going to put up the poll now so that people, if you can answer that, that’s great. then whoever is able to stay, I will be staying. So ⁓ we’ll continue and we’ll all be in one place. Same price. Same price. Look at that. Buy one, get one 50 % off. ⁓ So I just put the poll up and I guess we’ll continue in a minute.

Do we want to answer any questions in the internal before? yeah, that’s a good idea. Any questions up until now? We have one question, at least one question in the poll in the.

in the chat. Have you seen situations where non-union companies purchased a union company through an asset purchase in order to not take on the liabilities? Yes. My understanding is that it’s impossible to get around. is. So I’m not sure what you mean by impossible to get around. ⁓ You can do. There’s really.

Well, I wanted to make sure I understand your question right. So in a pension situation, there, if you sell the business, it will be treated as a withdrawal from the pension funds and withdrawal liability can become due. There are ways to structure a transaction as an asset sale when there are union liabilities. There’s a section of ERISA called section 4204.

that allows you to, allows the buyer to assume the pension liability, ⁓ requires certain obligations. I think you need to post some sort of bond. You need the buyer needs to agree to continue contributing to the fund at the same rates for I think five years. ⁓ Seller remains secondarily liable to the fund. There’s a whole, there’s a bunch of hoops you have to jump through, but.

an asset sale can be done in a union context. Is there a way to basically just shut out the union and the pension and make everyone walk away from the liabilities? No. ⁓ And more so on the seller side, meaning a seller can really never get away from potential liabilities of the union because they are party to the CBA and agreed to

Apply with the CBA and make contributions to the union and they’re going to be liable for the withdrawal from the pension fund. If your question is, a purchaser avoid assuming. The liabilities, ⁓ the answer is yes. However, if they’re going to be hiring the union employees, then the union is going to require that you assume the CBA and take over that contribution.

obligation under the pension fund. So I’m not sure if that answers your question, because I’m not sure if I completely understood it. So it doesn’t have to be a stock purchase. ⁓ It can be done as an asset purchase, but the asset purchase would almost certainly be done in a way so that the buyer is taking over the obligation. So I’m hoping I answered that. But if not, feel free to ask again or ask it differently.

Is there any other questions? didn’t see any. Okay. So we’re talking about reps and warranties and our last category is our business representations. And these, know, unpredictably, they go to things that are more relate to the operations of the business, ⁓ the profits and losses reflected in the financial statements. ⁓ It’s very important.

from the outset to, and this is why you wanna hire someone like Gershon as soon as possible ⁓ because financial statements are only as good as the paper they’re written on, right? You need to understand the financials. You need to dig into the financials. And very crucially, you need to understand the methodology that is used to reach the numbers in the financials. ⁓

both from an accounting’s perspective, are they on cash basis or accrual basis? Are they done in accordance with GAAP? ⁓ Depending on the size of your business, of the business that you’re buying, the buyer will want the seller to essentially represent that the financial statements were prepared in accordance with GAAP. So that way we can make sure that we understand what these numbers mean. To the extent they’re not done in accordance with GAAP, what you would typically see is,

something to the effect of this is again where the schedules come in, you would say the financials are prepared in accordance with GAAP except that set forth on schedule blank where we explain our accounting methodology. And that’s where the seller might say something like, we’re not in accordance with GAAP except we recognize deferred revenue in some weird way that is not in accordance with GAAP or we depreciate this type of asset in a certain way that again is not in accordance with GAAP.

⁓ And particularly when you are paying a multiple of something in the financial statements to determine your purchase price, it’s really, really important that you understand the financials and that the seller makes representations about its financials. ⁓ All the other stuff here on the list, ⁓ not as important necessarily as the financials, or at least not as fundamental to what a buyer cares about, but also really, really important to understand.

Here’s a list of all of our contracts. We don’t have any other contracts other than these, because as a buyer, you don’t want to find out that later down the road, there was some contract that was never disclosed and was imported to this business that now you’ve not acquired the rights to. You also want the seller to represent that the contracts are all in effect, that there’s no defaults. There’s no reason to think there’s a default, right? You don’t want to

step into a contract and then find out six months down the road that that customer hasn’t been paying in a year. And now you’ve factored into your financial analysis, the revenues from this customer that are real revenues on paper because we use a cruel method and when we make the sale, we treat it as revenue. ⁓ But if the customer doesn’t pay, that’s not worth as much.

⁓ So I thought according to some financial experts. Yes, Giles, did you agree with that? Yeah, if they don’t pay, it’s not revenue. That’s my position. But there’s something related to this that I, something you said a moment ago, that I once heard, was at a conference, we’ll give Anshin a shout out prior to COVID. And they had these people talking about buying and selling businesses. It was an &A conference. And they said, it’s very easy to agree on the multiple.

The question is, what are you applying that multiple to? And that’s where all the real debate happens. Like we could all agree on four times, but if we don’t look at accounts receivable the same way, you think they’re gonna pay and I think they’re not, then what is that 4X applying to? Whether we multiply by four and that’s where all the fighting. Yeah, yeah. happens there, right. It’s it’s what is actually EBITDA, right?

⁓ In this business, and that’s where you want to have that rigorous quality of earnings done on your target because that’s where you’re going to discover things like. Add backs and deductions that should be made to even ⁓ based on, as I said, things that are sometimes included in the business in the financials that aren’t really part of the business and therefore should be removed. ⁓

That’s where you may also find that there is a heavy customer concentration. You’re buying this business that has $25 million of revenue. But if half of that revenue is coming from two customers, then you’re putting, as a buyer, a lot of your eggs in those two baskets. And you’re relying on the fact that you’re going to be able to keep those customers. ⁓ And depending on whether or not your seller is sticking around and the relationships going forward, that’s not necessarily a sure thing. ⁓

⁓ Especially if one of those customers is seller’s brother-in-law or seller’s college buddy who’s giving him the business because why not? And now that there’s a new owner, maybe he’ll continue, maybe he won’t. And customer concentration adds risk for a buyer. So it’s really, really important to do that analysis properly, make sure you understand the financials of the company that you’re buying. ⁓ And then as we say in the reps and warranties,

make sure that seller is willing to stand behind those financials. A seller that’s not willing to stand behind their financials ⁓ is a major, major red flag.

⁓ Okay, so that takes us through our representations. And these are the representations on the seller side. Buyer will typically make representations as well. Those are usually gonna be fairly plain vanilla. It’s gonna be kind of like the stuff that we talked about, the fundamental representations. know, buyer has the authority to enter into the agreement, et cetera, et cetera. To the extent that there is a rollover happening, seller may want

some additional representations, because if you’re essentially telling them part of your consideration is the right, the opportunity to invest into the buyer business, then the seller has the decent right to say, well, then you need to tell me things about your business that I’m now acquiring 5 % of, or whatever it may be. So the buyer reps might get a little bit more.

out depending on the situation, but usually they’re going to be pretty insubstantial.

Okay, so next we are going to move to our covenant section. As we said before, these are the future obligations of the parties. ⁓ Generally speaking, we’re going to separate these into two main categories, the ones in the top and the ones at the bottom, the ones at the top, these first three, ⁓ we colloquially refer to these as restrictive covenants. These are essentially negative covenants. These are things that the sellers are not allowed to do.

And this is good time to bring this up. So I mentioned earlier that even in an asset sale, you’re likely going to want the individual owners to still be party to the transaction, even though they are not really fundamentally part of the transaction, right? The fundamental transaction is occurring between the seller entity and the buyer. However, both because of confidence and also because of representations, which I should have mentioned that they are, and when we get to indemnification,

you want the individuals on the hook personally as well. So you want them individually making the representations and warranties and being on the hook for indemnification, just because as a practical purpose, if you have a claim, you wanna be able to assert that claim against somebody other than the seller LLC or corporation, which pretty quickly after closing is not gonna have any real assets. Certainly by the time a claim arises,

You could bring the biggest claim in the world against seller corporation. If there’s nothing there, you’re out of luck. So therefore you want to have the right to go after the individual seller and you want them to be on the hook. Same concept goes with covenants. You think about your non-compete. It’s not that I care whether or not your corporation is out of the marketplace competing with the business now. I care if you, the seller who has the reputation, has the goodwill who people know.

has all the relationships, it’s you who I don’t want competing with me. So it’s an absolute must that the individual sellers are party to the agreement for purposes of these covenants. So non-competed and non-solicit. So most of, this is a very, probably the second most important part of what you’re buying, right? You’re buying a business. So you’re buying the assets that come with the business. But on top of that,

What you’re really also buying is putting the seller out of business. You want exclusivity on this business. You don’t want your seller opening up a new business the next day that competes with you. That is a fundamental part of what you are paying him for. ⁓ So you are always going to have some form of non-compete. When we talk about a non-compete, we talk about three main different components.

⁓ in terms of what the non-compete applies to, what it restricts. We talk about the scope, we talk about geography, and we talk about duration. Duration, simple. How long does this last? How long is this restriction? ⁓ Most common starting point is five years. Five years, I would say, is probably also the most common endpoint, although depending on the situation, it can be negotiated shorter.

very infrequently do I see it go longer than five years. But I would say three to five is really where you’re gonna end up with, I think five being the most common. Next is geography. Again, pretty straightforward. Where does it apply? If you’re a buyer, you want it to be anywhere, right? That’s, know, in an ideal world, you cannot be in this business anywhere in the world. ⁓ Now there are issues with

There could be issues with enforceability ⁓ and there will likely also be issues with getting a buyer, a seller to agree to that ⁓ and whether or not it makes sense. And those kind of always go hand in hand. So typically what you want to think about is where has seller been in business and where is buyer going to be in business? And those are most crucial. So if this is a business that has been operating in the entire Northeast, then obviously you want the Northeast to be covered.

If buyer has specific plans to expand into the Midwest or buyer, know, this is a strategic add on and buyers already in the Midwest. Same, same idea. You don’t want them competing with you, whether or not you can, you can extend it to places that, you know, are not really contemplated is a kind of a deal by deal basis. I mean, I, you know, when I’m on a buyer side, I typically want to see us start out as having a geographic scope that covers the entire United States.

In 2025 with e-commerce and all that sort of stuff, again, depending on the type of business, it’s not what it once was to expand to a new market. It can be done fairly easily depending on the business that you’re in and you really don’t want to see your seller out there competing with you anywhere where you might potentially be doing business. ⁓ In terms of scope, that is going to often be the most

heavily negotiated in terms of what are they not allowed to do? ⁓ And this is where it’s really important for us to define what is the business? ⁓ What is the business that is being sold? It is particularly important from a seller’s perspective, at least, if they are selling you only a division or a component, ⁓ or if they are in adjacent businesses that are doing something similar, the seller is going to want to be really careful to make sure that they are not

prohibiting themselves from continuing their other businesses, right? If I have a business in related, in a same vertical, but it’s not part of this business per se, like, I sell car parts, but then I also operate a body shop and I’m just selling you the car parts business, you’re not buying the body shop. So you don’t get to tell me that I can’t fix cars, I just can’t sell parts anymore. So very important that those get negotiated and…

very specifically drafted to, you really to protect both sides, just to make sure that everyone is on the same page in terms of what the settler is allowed to do and what they are not allowed to do. Crucial question in terms of enforceability. I know a lot of people have probably seen that there’s been, you know, developments in the law that, you know, non-competes are fading away. There was, you know, there’s attempts in jurisdictions, including the last administration tried to.

ban them on a nationwide level. regardless of whether or not these individually hold up, there’s definitely a cultural trend against non-competes. ⁓ Importantly, almost nobody is seeking to eliminate non-competes in the context of a sale transaction. So when we talk about non-competes being banned, we’re almost always talking about them in the context of an employer-employee relationship. ⁓

It would essentially, kind of for the reason we just talked about, it would almost destroy M &A activity if you ban non-competes in this context because who in their right mind would buy a business from someone if the person’s allowed to continue in that business? For a certain product, maybe you would, but anything that’s like a service business, you would never buy a consulting business or a law firm or a medical practice or anything like that if the doctor can just go.

start a new practice the next day and say, hey, everybody, come see me at my new office. Stop going to my old office. It just wouldn’t make any sense at all. Non-solicit is a… How does this work with someone leaving? Leaving…

There’s someone who I know, let’s not get too specific. There’s someone I know who was kind of like a partner in the business, not my business, but sort of a partner in the business and then left. Is he able to just tell all his clients, come with me? I’m- what contractual obligations are in place. ⁓ If he has a restriction against that, then certainly he’s-

gonna be challenged for doing that. ⁓ Barring that, I mean, it would really, I’d say, depend on the facts and circumstances. You could conjure a case for something like torches interference with our business ⁓ and that sort of stuff, but it’s gonna depend on the facts. It’s gonna depend on how these customers got there in the first place. What did the person actually do? Because while we’re talking about soliciting,

Soliciting has a very specific meaning. It means that I solicit you. It doesn’t mean that I do business with you. ⁓ And buyers want to prevent all of it. So when, if we’re on the buyer side, we want to see a provision that says, I’m not allowed to solicit your customers, but I’m also not allowed to even do business with your customers. And the reason for that is that solicitation is very hard to prove. ⁓

you could claim, I didn’t solicit them, they called me. ⁓ And how are we going to establish that bar? Obviously, you could do depositions and discovery and all that stuff, and maybe you’ll uncover something, but it’s a lot easier to just say, I don’t care who solicited who, I don’t care how you ended up in business, the point is you’re in business now with each other, and I want to prevent that. ⁓ So we would say, no conducting business, I’m on the employee side, you wanna say no solicitations and no hire.

Same reason. I don’t want to have to start digging into, know, did they just respond to an add on indeed and ended up with you or did you poach them? That’s gonna be really expensive and possibly impossible to prove. So I just want a restriction. You can’t hire my employees. Confidentiality is, you know, pretty straightforward concepts. You have a seller who’s been involved in this business for 25 years. They know everything about the business.

You obviously don’t want them going out in the marketplace and telling anybody anything that’s proprietary or confidential about the business you just bought. So those are negative restrictive covenants. Then we have our affirmative covenants, our ⁓ obligations going forward that parties have to comply with. You may see some concept of a transition period. ⁓

depending on your seller, depending on the business. you’re in a strategic add-on situation, you may not need this, right? If you were just essentially buying a customer list and just expanding a territory, you may be perfectly fine with your seller going away at closing as long as you have his head of sales or whoever. Or maybe not even, maybe you’re just, we got this. ⁓ But in many situations, you want some sort of time period that the seller

is at a minimum available to you. ⁓ Now, you may have that under some sort of employment agreement or consulting agreement, depending on your business deal, but you may also wanna just have that as an obligation under the purchase agreement itself, that for a period of three months, six months, nine months, after closing, seller is going to assist with the transition of customers and the business. There might also be…

As I said earlier, there might be specific assets or specific components of the business that are not transferable or for practical reasons doesn’t make sense to transfer. Last year I was on a transaction that was supposed to close on like November 28th and to transfer all over the employees onto new buyers payroll and benefits and all that sort of stuff on November 30th was going to be just like a massive administrative shit show.

And it was, everyone agreed, just like it didn’t make sense to do that. The best time to really have the transition of the employees was going to be January 1st of the following year. So what we did is we built in a transition period where the employees stayed with the seller for that last 35 days. They were on seller payroll, seller benefit plan, seller everything, and buyer just cut a check to seller to basically cover the cost ⁓ of all of that ⁓ employee costs.

⁓ So, you know, that’s, you know, a perfect example of a transition arrangement where seller is still running a piece of the operations. In this case, payroll and employee everything, you know, HR, but buyer still owns the business. ⁓ When it comes to employees, that’s also a very important difference between stock sale and asset sale. In a stock sale, like everything else, employees stay where they are. They remain employed by

the same employer. In an asset sale, the employees all are terminated at closing by the seller. And then depending on your business deal, usually are hired by the buyer. Now, buyer may or may not want to hire everybody. This is often going to be a point of contention. You have sellers that care and you have some sellers that don’t care.

Every seller cares about liabilities and there’s all sorts of things that have to be done, whether it’s under worn or with regards to benefit plans or accrued vacation and PTO and various other things that are beyond the scope here that need to be done correctly in order to make sure that no one is assuming liabilities that they don’t want to. But there’s also just many sellers have the concern of they want to do right by their employees and they want to make sure that buyer commits to hire all of the employees, give them the same.

salary and benefits at least, commit to keep them employed for some period of time. None of these are statutory obligations under the law. These are all would-be contractual obligations that a buyer would either agree to or not agree to. And it will depend on what the business deal is. Sometimes you’ll see that a buyer will agree to hire at least 90 % of the employees.

or they’ll literally make a list sometimes. I’ve seen transactions where there’s a list of, we’re hiring everyone except for the eight people on the schedule. agreeing either we don’t need them, we don’t want them, or what happens a lot is these are people that are on payroll that just happen to be related to the sellers that are not necessarily providing value to the business that the buyer wants to pay. ⁓ So those are typically employees that you would see a buyer say, we don’t need those people.

understanding what’s going on with those people also ties into the value of the business and what what it’s going to look like from a profitability standpoint going forward. If you have any amount of people who are not contributing to the business, the business might be worth more. You might be willing to pay more, ⁓ might be willing to pay more for it. on the other, depending on the type of business, the employees are the asset, right? You know,

like we were talking about service businesses, that’s the main asset is the people that are the revenue comes from you having this group. ⁓ If you’re, you you’re some businesses, the sales team is, you know, this, have a rock star sales team and that’s what makes this business run. ⁓ And if we don’t have those people locked up, there is no business or at least the business is not what we think we’re buying. So, and that’s why you will frequently see the inclusion of employment agreements for key employee, the creation of an equity plan to incentivize, you know,

key core members of management, whether that includes the seller or not, there might be a CFO, a head of sales, a head of operations who are crucial to the future operations of this business. And you wanna make sure that they are locked up, that they’re incentivized to keep producing and that they’re kind of on board with buyer’s vision to grow and improve this business and make it even more profitable. ⁓

In terms of taxes that it really, that really just goes more to who is responsible for certain types of transfer taxes who’s responsible for filing tax returns for certain periods. ⁓ Not not something we need to dig into in great detail. And finally, we come to our indemnification section, ⁓ which is where we lay out the buyer. I mean, it’s really both sides, but.

Typically we’re talking about the buyer because the buyer is usually gonna be the one, if there’s a claim, they’re gonna be the ones who have the claim. Indemnification provides the rights and the mechanisms under which buyer can be compensated and made whole in the event that seller reaches the agreement in some way. And the two main ways that a seller can breach an agreement, number one is they breach a representation. ⁓

they made a representation about their business and it turns out that that was not true. So they said, you know, our financial statements are prepared in accordance with GAP. And it turns out that they prepared them in some other way and completely misrepresented what their EBITDA is. And you paid 6X at 3 million EBITDA, you gave them $18 million. And now that you run the numbers correctly, you realize that EBITDA should have only been 2.1 million and you now think they owe you $6 million.

So that’s a breach of rep. Similarly, if they tell you, you know, all of our customer contracts are in effect, none of them are in default, turns out you call up the new customer and say, hey, good news, new buyer in town. And they’re saying, new buyer, we’re not doing business with you. You you guys sold us faulty product last year and we told the seller and they never fixed it and we’re terminating our contract. So same thing. Now you were counting on.

$800,000 of revenue from this customer because you had a good valid contract with them, except it turns out you didn’t have a good valid contract with them because seller breached it last year. So seller is in breach of a representation. A buyer is going to have a right to be made whole. Other thing that a seller can breach is the covenant. Seller has an obligation to not compete with the business, not solicit customers, not solicit employees, but they do.

You want to have a right to be made whole. You also will want to have some sort of equitable right to be able to go into court and get an injunction to prevent the action. So that’s a separate category. But in terms of your right to be made whole, you’ve now interfered with my business, caused me loss of revenue, and devalued it. So I have a right to bring a claim against you and get paid. And again here, who is responsible?

very, very crucially, you want to have the individuals on the hook. mean, now, if you have a corporate seller and they have, you know, other divisions that are remaining and they have significant assets, there can be situations where you don’t need the individuals. When we’re talking about buying a closely held company, almost always you’re talking about a situation where they’re going to liquidate the corporation shortly after closing. So you need to have those sellers there to go after.

Now, you’re also going to often have, as we talked about earlier, you’re to have your escrow, you’re going to have your deferred purchase price, you’re going to want to have the ability to go after that money that’s sitting there, but depending on the size of your claim, the escrow may or may not cover it. you know, typically you’re going to see an escrow of 10 to 20 % of the purchase price. You may have a claim up to 50 % of the purchase price. Although we’ll talk about baskets and caps in a second.

The, when we think about indemnification, we, this is kind of like an exercise of the five W’s. So it’s the who, what, where, when, why, except not really the why or the where. So it’s the who, what, when. So the who is the company and the shareholders. The what, what are they indemnifying you for? For breaches, right? The when is, we talked about earlier, the difference between the fundamental representations and other representations. Your fundamental representations,

the fraud-like representations. We really own this business. The company has title to the assets. You’re typically gonna see those lasting indefinitely. For a minimum, they’re gonna last as long as the statute of limitations runs. When it comes to all the other representations, those are usually gonna have a finite survival period. Most common range is between six months and 24 months with a year kind of being a good sweet spot, 12 to 18 months.

which gives buyer that period of time to kind of suss out whether or not there are any problems with the business after closing. Frankly, to the extent that there’s a significant claim and a significant problem, it usually will be discovered fairly quickly. It’s pretty rare that this time period runs and it’s like three years later that you discover that there’s like some customer issue or employee issue that was not disclosed. So it’s usually fine.

⁓ But it’s, you know, obviously the longer that buyer can extend that period, the safer it is, the more time it has to make sure that it got what it bargained for. ⁓ There are typically going to be limitations. I just mentioned earlier caps and baskets. ⁓ A basket is a word that is often used in &A. It’s kind of similar to the concept of a deductible ⁓ in an insurance context.

A buyer, a seller is often gonna say, sure, I’ll indemnify you, but like, don’t come nickel and dime me for ticky tack stuff. Like, don’t want, you can’t bring a claim against me for $500. There’s going to be a threshold at which once we pass that threshold, you could start asserting claims. Usually you see it around 1 % of the purchase price. So anything that’s immaterial, you’ll start accruing those damages, but until they cross that level, you’re not allowed to assert a claim.

cap is on the other side of that. It’s the maximum amount that you could go after. And that is always going to be heavily negotiated. A seller wants to have some certainty that there’s an amount of their money that is completely safe. And whether or not they’re going to agree to a cap of the purchase price, which is if I’m a buyer, that’s what I want it to be. But you often will see it compromised at something like 50 % of the purchase price or 25 % of the purchase price.

It really depends on the size of the deal as well. The larger the deal, the lower of a cap on a percentage basis that you can agree to because ⁓ if you have a $10 million deal, there’s more likely to be a 50 % claim on a $10 million deal than on a $1 billion deal. So caps are very important. And crucially, fundamental representations will typically not be bound by the caps. So when we said before, you know,

They’re not bound by time. They’re typically also not going to be bound by these caps and baskets. there’s no, hey, I sold you the company, but I didn’t really own it. But you’re capped at 50 % of the purchase price. No, get the hell out of here. If you committed fraud and you sold me a business you didn’t own, I’m coming after you for the whole thing and more. Also my lawyer’s fees and whatever other costs I had, because you committed fraud, ⁓ you’re not going to be able to ⁓ avail yourself of any sort of cap. ⁓

The last thing to mention here is the concept of representation and warranty insurance, ⁓ which has become incredibly popular in the last five, 10 years. ⁓ It is something that has become basically a staple of deals over a certain size. I would say, I can’t remember the last 50 million plus deal that I did that did not have representation or warranty insurance. And it’s becoming even more common.

on smaller transactions as volume increases and insurers are becoming more comfortable insuring those deals. And what it does, it’s a really phenomenal product because it essentially ensures the breach of representations and warranties in a transaction. So rather than going after the seller for a breach, buyer goes after an insurance policy that covers up to a certain amount. Now policy obviously costs money,

the insurance policy is going to engage its own law firm, that’s going to do its own due diligence and that’s going to cost money. So it can increase the upfront costs of a deal, but it makes everybody sleep a lot better and make sure that there’s money available in the case of a breach. ⁓ It’s also great for a buyer because it eliminates a lot of tension because frequently buyers will not even

go after sellers or don’t want to go after sellers because it’s just like not a good look and it’s not good for business. Especially if you’re like, you if you’re a private equity buyer who’s like a serial acquirer of companies, you really don’t want to get a reputation for being a buyer that sues their sellers because then, you know, the next group of sellers are going to sell to a different fund. ⁓ This kind of allows you to have your cake and eat it too. You don’t need to bother your sellers. You don’t need to insult them. You don’t need to…

affect their bottom line, but you can still get made whole because there’s an insurance policy in place. ⁓ So thank you. Thank you for bearing with me. I’m sorry if it went a little bit longer than people expected, but I think we covered a lot. This was valuable. ⁓ Certainly I would expect that there are questions. I’m happy to take those now if there are, but you can also feel free to

reach out if there’s something you wanna talk about in greater detail. I’m happy to be a resource for anyone who is thinking about a transaction or just wants to learn a little bit more about anything we talked about today or any other related &A topic. ⁓ I’m happy to send my slides to Gershon and he can share them with the recording. that’s all I got. Please do, please send the slides to Brittany and I thank you all for joining. We had a few people request that story.

Send that out. usually send out the recording to everyone, but whoever wants slides, we’ll get them that as well. ⁓ thank you, Avi, for a top notch presentation. And, ⁓ I learned a lot. I probably should listen to this again, cause I’m sure there’s, there’s some things I’ll get on the second round. ⁓ and yeah, if anyone listening to this needs help on the financial side of due diligence or needs a CFO reach out to us, we can help. we’ve got an amazing team.

Then we’ll see you all next time. Thank you, Avi. It’s very good. Thank you. Avi, we’re going to see you tonight. I plan to. I plan to be there. All right. Looking forward to meeting everyone. Bye bye. Thank you all.

Speaker (00:00)
All right. Hello, everyone. Thank you all for joining us today. I’m Gershwin Margolis. I am the founder of Imperial Advisory. I want to start by thanking Christine for joining us today. We’re very excited. Thank you, Brittany, for all of your effort and for playing this together. And thank you to all of our guests and our team members.

I only see two faces, so I will thank you both. Thank you, Dean. Dean is one of our CFOs. He has experience in multiple industries and technology, law firms, hearing aids. ⁓ Welcome Stephanie. Stephanie is one of our newer teammates. She has experience in a lot of really good experience in food manufacturing and working with a whole bunch of our clients now. And thank you, Tom. Welcome as well.

Tom has experience in lots of fun stuff, ⁓ especially technology and technology manufacturing. And he’s a military vet, so that’s cool too. ⁓ Okay, so ⁓ welcome everyone. Like I said, I’m the founder of Imperial Advisory. Imperial Advisory is a fractional CFO firm. We go into businesses and…

You know, in a large business, the CFO is one of the most trusted advisors of the CEO. And then a smaller business that perhaps doesn’t have the need for a full-time CFO, bringing on a fractional CFO gives them the same kind of benefit for, you know, a part-time price. And some people would say, you know, it’s a full-time commitment at a part-time price, but you really get a partner to help you grow. You just don’t necessarily need that on a full-time basis.

⁓ we get involved with our clients in many different ways. So we act as a trusted advisor. We do things for them, whether it’s, ⁓ helping them hire the right people on their finance and accounting team. We’re not recruiters, but we get involved in that in scoping out roles. We help with mergers and acquisitions. We help with obviously lots of advisory, but we help our clients run and grow their businesses. ⁓

And then there’s this whole world of things that our clients need, which we don’t necessarily do, but we like to, to be aware of, ⁓ things that we may get involved in, but may not do directly. So, like I mentioned, mergers and acquisitions, when we work on that, we’re probably going to be working more on the financial side. But when the client’s looking to grow, one of the ways that they can grow is mergers and acquisitions. And when you buy a business quite often, part of what you’re buying, and sometimes all of what you’re buying is the people.

And so I was speaking with Christine recently and she was telling me about some of the work that they’ve done recently, helping business owners who are going through transactions and some of the interesting things that come up on the HR side. Imagine if you bought a business and you couldn’t use any of the people in the business for some reason. ⁓ That would probably not be very good. So anyway, Christine runs an HR company. I think it’s

I mean, she lives here on Long Island. believe the company is based on Long Island. I know we, she actually brought us into one of her clients based in Brooklyn. so we got to work together there for a while. That was, that was very nice. and we appreciate that. and she’s a real expert in ⁓ all things HR and we’re very excited to have her here. And without further ado, Christine, take it away.

Thank you so much, Gershon. It’s a pleasure to be here. I’m excited to kind of go through this topic. And I think it’s relevant ⁓ to every business owner and their finance team to really understand what are some of the key areas in HR due diligence that you should be prepared for when you’re starting to even think about ⁓

selling your business or even acquiring another business as a way to grow. I’m just going to share a little bit about myself so people can kind of get to know me on the human side. So I am the founder and principal of Compass Workforce Solutions. I have a lot of HR credentials and my background actually comes out of the Fortune 250.

So I’ve spent a lot of time in venture capital-backed businesses, private equity-owned businesses, a Fortune 250, and education before starting my own firm back in 2009. And now we have a team of 13 people. That little handsome guy in the upper corner, that is my rescue Chihuahua, little pea. So I’m a huge animal lover, and I give him a lot of credit.

for helping me to understand how to interact with people that are in high stress or traumatized by prior experiences because that’s what him and I end up doing at home. Also, my natural behavioral profile is I am a strategist. So a strategist is someone who’s very disciplined, a highly motivated self-starter.

I have a high sense of urgency to get things done and to cross that finish line with my client, but that’s also balanced with a need to understand the details and the facts of the circumstances. I’m naturally curious and analytical and extremely thoughtful. So I tend to ask a lot of questions and I’m fascinated by understanding why people got into the business that they got into. And that’s part of what

makes my work so interesting. A moment on compass. So we are a certified woman owned business. We’ve won awards several times for our expertise and our contributions to the Long Island and the New York community. And our work is focused on key areas where HR actually makes a difference in business profitability, business scalability, and business valuation.

So compliance and operational controls as it relates to people, dealing with workplace conflicts and supporting our clients in developing high performance teams. So we’re headquartered in Long Island. We have quite a few clients in New York, New Jersey, Pennsylvania and Connecticut, but we also have touch points across the United States where our clients do business or have offices.

So we have employees that we service in about 30 states and that rapidly expanded ⁓ during COVID when it just became so glaringly apparent that people could really be productive remotely. So as we launch into this topic of mergers and acquisition and really how to enhance your multiple, I wanted to focus us on this quote by Stephen Covey.

always begin with the end in mind. So a lot of entrepreneurs or business owners start a business or inherit a business from out of a passion or from their family. It’s something that they love to do. And we don’t always think about what that exit is, but that exit is part of your personal net worth.

part of your legacy, it’s part of what you’ve invested years and hours of time that this is your opportunity to really get paid, right? So if you own a business, you know there’s a lot of things you do that you’re not gonna see that money for right now today. But if you do things properly, you do have that opportunity to really enhance that multiple.

And so the M &A environment’s really interesting. I get emails weekly and almost daily from people that want to acquire my business. And also we do a lot of work with clients. So our clients are typically 20 employees to about 250. They’re privately held, they’re family-owned businesses, and they’re also, we do work in the not-for-profit space.

So that is the space where we’re in and there’s a lot of activity in that space right now.

So I’m going to launch into kind of what I’ve labeled the four P’s of acquisition, right? Why do people buy businesses? Well, the first one is relatively straightforward. They’re looking to enhance their profit. The second one is they’re looking to gain a product or proficiency or a service, which they don’t have access to right now, that can enhance rapid expansion.

The third reason is they like the market position of the other company. So oftentimes that email list, that customer list, the positioning in the marketplace, the brand, the name recognition is compelling and enticing. And then last of all, it’s the people, right? If you’re buying a business, people are a prime asset that come along with it.

And so to really be truly prepared to demonstrate the value of your business, you have to be prepared to demonstrate the value of your people, which directly ties to your product, right? Your ability to produce what you produce, that internal knowledge, your proficiency, your ability to deliver an additional skill or service that people don’t have access to right now.

your market position, right? The brand, the messaging, the conversation, all of those things are really centered around your people. And how do you demonstrate the highest value of your people and position it? And sometimes getting this ready takes three to five years in advance of when you’re planning to begin that due diligence process.

to go into a sale. So we’re going to dive into that and I’m just going to focus on key areas that we see a lot of challenges when businesses are looking at going through that transaction. And we’ve done work on the seller side. We recently completed a one-year project with a privately held business that was located in New York, New York City, and California.

and doing all the due diligence to prepare them for a transaction in the next three to five years. But we’ve also been on the buy side of it where we’re coming in when something is an asset acquisition and we’ve prepared to onboard all of the existing employees into the new organization. So these are some of the things that we see. The ability of the workforce to continue to be employed.

So one of the oldest regulations that we deal with is Immigration Reform and Control Act. This goes back to 1986, was signed into law by Ronald Reagan. And this is your I-9 form. This is the form that certifies that an employee is eligible to work in the United States. So if you’re not

If you don’t have good records of this, right, or oftentimes in the due diligence process, when I’m talking to a COO or the office manager or whoever is in charge of employee records, when I say, where are you record keeping your I-9s? The look I get is the I what? What form is that? So,

Understanding this form and understanding the significance of the form and the ability to demonstrate on paper in advance of a transaction that all of your employees are eligible to work now and can be hired into the future is significant. In the current business environment, the current administration is heavily enforcing this regulation using the power of Homeland Security. So these are people that are armed.

They can go anywhere they want to go. They may need a warrant to request these documents, but the current administration is taking this very seriously. And if you don’t have this in place, there’s also significant fines and penalties that businesses can suffer. So anywhere from $2,700 a person all the way up to $27,000.

if they believe that you’re knowingly employing undocumented workers. So oftentimes different industries have different challenges. When it comes to continued employment eligibility, I was on the buy side, right? The sellers acquiring new employees, they had acquired a large private gym kind of in the Long Beach area. This was years before COVID. They were very excited. ⁓ They had

come into a large sum of money, a father and a son, and they were investing this money by buying a business and really creating an ability to continue to earn and grow a business. So we went into this environment and in the process of onboarding employees, out of the 70 something people that work there, 10 % of that population was not able

to continue on and this included people that were doing facilities work. This included people that were manning the front desk. So the buyer was not allowed to bring these people forward and immediately was in a position where seven new employees had to be located that were instrumental to running this particular operation. In the work that we just recently completed,

over the last year, so 2024 until recently, we were working with a distributor, again, located in New York City with a warehouse in upstate New York and warehouses in California, right? So warehouses on both coasts. The warehouse locations had been relocated over the last several years. And when we went to look at the I-9 documentation,

there were no records to be found. So in the process of relocating those warehouses, those paper records and most of the employee files were not able to be located. So we were basically starting from scratch with two warehouses in remote locations, teaching and training frontline supervisors how to complete and verify I-9 documents.

So the fine and penalty in that instance, ⁓ if either one of those companies would have been asked to produce ⁓ I-9 documentation, it would have been in excess of $50,000 just because documents were missing and not able to be produced in the relative timeline. So in industries like construction, warehouse, distribution, gyms, food service,

Generally what we find is these records are missing or incomplete. And then in other types of industries, you have different challenges. So in your STEM industries, right, technology. So tech is very hot right now as far as acquisition. And so what you see there is people that are on a work authorization, they might be on an F1, they might be on an H1B. Are those visas being tracked?

for their expiration date and the next critical event date in order to ensure that those employees are able to be moved forward into the new organization. So again, continued employment eligibility is a key area where time and attention needs to be given and it’s often overlooked. The next area that I’m gonna get into is employment classification. ⁓

So when we’re talking about employee classification, we’re referring to is someone a 1099 or independent contractor? Is someone exempt from overtime? Are they a salaried employee exempt from overtime? Or are they an hourly non-exempt worker? So why does this matter so much? Well, the reason it matters so much is when the

when the buyer is looking at the business, what they really want to understand is the total cost of payroll and benefits. And in a lot of business, this is the number one expense that the business has is payroll and benefits. If people are not properly classified, this number is not accurate. And I’ll give you some examples as to why it’s not accurate.

So for example of 1099s and independent contractors, independent contractors, the business is not paying for any benefits or taxes. There can be a 30 to 50 % increase per 1099 if that person was to be on payroll. And the types of things that we see that bring this into confusion is people are getting a W-2 and a 1099 in the same year.

because maybe they’re in sales and both parties, the employer and the employee say, well, if I get my commissions on a 1099, I don’t have the same tax obligation. Okay, that is a huge no-no. That is a huge red flag to have an individual that is getting a W-2 and a 1099 in the same tax year. And that person is also an employee.

Yes, Gershon, you have a question. Yeah, quick question on that last point. Is it that it’s sometimes legal, but rarely and it’s a red flag, or is that automatically? Is it inherently impossible or are there cases where it’s OK, just you’re asking for trouble when you go down the If someone is an employee, they’re always an employee. So that is the rule of thumb. OK. ⁓

you can’t give compensation on a 1099 and it also gets into certain benefit violations. So for example, if you have a retirement plan and total compensation is eligible for a match or a safe harbor, right? You’re not recognizing that comp and now you have an ERISA violation. So one of the things that you need to think about is

when you sell a business, right? The goal is to take that money and to go home and enjoy and to sleep peacefully at night. But just because you’ve sold the business doesn’t mean that your liability is over. So when we’re talking about look back periods on things like wage and hour, they can be significant. for New York state, for example,

is six years, okay? Connecticut is two, New Jersey is two, and Pennsylvania is three. So every state is different, federal is three. So you really want to understand just because you sold it and closed it, the officers or owners of that business have continued liability. And where this oftentimes comes into play is if an employee

does not survive that transaction, meaning there’s not a job for them. They don’t perform well in the new company. They’re not a cultural fit. They’re not going to move forward. Their recourse, oftentimes under financial duress, is to figure out a way to get money from the former employer. So these are important and significant things. So who can be a 1099?

is sometimes a bit of a moving target, right? The Department of Labor and the IRS agree to disagree. So we typically recommend that all businesses really look at what the Department of Labor is doing. And in May of this year, the DOL, the federal DOL clarified their enforcement guidelines and they are using something called the Economic Realities Test. So,

At the bottom line, what the economic realities test means is if that 1099’s revenue, their majority of their revenue is coming from that business, the economic reality is they are not an independent business. They are not an independent contractor. They are not generating enough revenue outside that they would survive.

without that business. So there was some real interesting case law several years ago around strip clubs, right? And if you’re ever wondering what your business has in common with a strip club, I’m going to share it with you. If the facilities and the location and the equipment and the machinery that 1099 is dependent on that, right? So think about strippers. They’re reporting to a specific location, even if they don’t have

a strict reporting time, but they’re reliant on the marketing efforts. They’re reliant on the facility. They’re reliant on the different licenses that that business has, and they’re using that location to generate revenue. So if your 1099s are primary, if they don’t have an opportunity to make a profit or a loss, if they’re not investing,

in their own team or their own equipment and they’re relying on your facility, they’re not a 1099. So I’m going to move on to classification, right? Exempt versus non-exempt, because this is another big area where we see a lot of misunderstanding. So we recently took on a distribution company that’s on a PEO on one of the big ones.

They have 34 employees and everyone is paid on a salary, including the warehouse and the mailroom employees. Okay, this is not possible. They’re not using any type of time tracking or tracking of hours and record keeping. And these people are also not passing the salary basis test. So to be exempt from overtime, it’s a two part test. My baseline salary,

that doesn’t fluctuate, I’m guaranteed this amount every week, regardless of how many hours I work, and then my job duties test, both have to pass. So each state has the ability to set a higher salary threshold than federal law. So we’ve recently seen movement on the federal salary basis test, right? It was supposed to go up January of 2025.

then a Texas court threw it out, now we’re back down to the $6.84 a week is the salary basis test. But if you’re in New York, that salary basis test increased in January to $12.3750. That means in order to be exempt from overtime, you have to pass the job duties test and be making no less than $64,350 a year.

in base compensation and salary. So there’s a lot of companies where we go in and this is not the case. People are on salary for $500 a week, 650 a week, 900 a week. They’re not passing that salary basis test. So it’s really important to understand what is that salary basis test in the city and state that that employee is working.

So some states follow federal law, quite a few states do not, California does not, and different states have different requirements around who can be a salaried professional or a salaried person. So that’s significant. Again, why does this matter so much? Because if I’m buying your organization and I’ve got someone who’s coming over that was making $500 a week,

I don’t know what that employee is going to cost me in my new environment. You’re not tracking hours and you’re not passing the salary basis test. Also, you’ve got that look back period where if that employee doesn’t survive the transaction, you’ve got to wage an hour claim. And that can be significant because it has the backwards look.

back to two years, three years, or six years, right? Federal is three, New York is six, California is six, ⁓ with interest and penalties. So you’ve sold the business, but if you know anything, you’re not sleeping well at night. So this is a big area where there’s a lot of missteps and a lot of cleanup. And we spent a significant amount of time in the last distribution company. They

We started out with 119 employees at inception. We actually ended up with 98 employees. And in order to defend your classification, you also need to have a job description, right? So where’s that documentation? And my final point that I want to drive home is, what is the value of your workforce?

So can you demonstrate the value of your workforce, meaning your key employees, your leadership team? What’s their background? What’s their education? How long have they been with you? So for a lot of the clients that we work with, the record keeping system is not thorough. You don’t easily have access to create or to demonstrate these bios. What about the rest of your employee population?

How many of them are from Harvard or from Wharton or from West Point? Who has a master’s degree? Who’s project management certified? Who’s got their HR credential? Who doesn’t? ⁓ And in certain sectors, right, technology, medicine, accounting firms, or CPAs, this record-keeping requirement, if you can’t produce it, you’re not able to demonstrate

the value of your workforce, or you’re gonna struggle to put it together. So you’ve invested a significant amount of time and training and developing people, you’ve got to capture that information so that you can share the full value of what they’re worth. So what am I really talking about? At the end of the day, it all comes down to record keeping. And to be brutally honest,

If this is what your records look like, you’re doing better than 70 % of the clients that come to us looking for help and guidance. We see records of employee files in garbage bags because they’ve recently moved, especially from COVID where, you know, people went remote. What happened to all those pieces of paper?

So were they uploaded into the HRIS? Are they floating around in somebody’s email inbox and never to be saved or organized? We talked about companies moving and relocating and not really paying attention to where are the employee files? Where are the I-9s? Where are all these records? So a lot of times what we hear is, well,

we can’t find it. I guess those got lost in the transition or we relocated offices or like I shared with you, we moved the warehouses and I guess those files just didn’t make it in the transition. And then you also have people that have gone through some type of natural disaster, right? So we just had ⁓ Milton and Helene in Florida, right? We’ve had September 11th in New York. We’ve had Sandy where

Hundreds of thousands of employee files and all types of business records were destroyed if they were on paper if they were in boxes if they were in file cabinets When you’re moving to an online system, you’ve got to have a strategy for migrating the old files So we just took on a client in New York City ⁓ They have 58 employees they’ve been around since 2004

They moved from one HRIS to another, also in the middle that everybody went remote during COVID. And the last five years of employee records are sort of MIA. And we’re going through the former HR person’s email inbox for onboarding documents, for offer letters, for all different types of credentials.

that can’t be located. So these are the common things that people do, right? So just a little reminder, now is the time to invest and organize, right? We’re talking about employment eligibility is critical, often overlooked by the company that is thinking about selling. Employee classification, 1099 versus exempt or non-exempt, again.

payroll and benefits is often the number one cost of operating a business. And then the value of your workforce, the credentials, the degrees, the certifications, the investment that you’ve made in training and development, are you able to demonstrate this ⁓ about your company? So I did leave. think I’ve left ⁓ time for questions.

If you have a very specific fact, specific question, or you want ⁓ an online ⁓ Zoom or Teams consultation with me at no charge, you can scan the QR code and spend 15 minutes with me picking my brain or asking your specific question. Otherwise, there, Gershon, are there questions in the chat that are coming in that people have? ⁓

I have one comment in the chat, but it wasn’t really a question. So far, no. But we can turn that over to the people here and see. See who’s got a question. I know that I learned a lot. I found this very interesting. I asked my questions as we went along. But.

Well, let’s go around who anyone have any

anything that they.

that they want to know? Well, I have a general question. I have a client that hired someone to be the president of the company as a 1099. And I was reviewing the 1099 agreement. I practice a little law my my majority of time and Christine, we spoke years ago about ripple and, and talent engagement and all that kind of stuff. But my question about

the client’s president is the president signed, she signed a 1099. And there was a provision within the agreement that said that she couldn’t bind the company because she was a 1099. So the attorney for the company was trying to be, I think, kind of cute because how can a president, how can you have a president who’s an officer of the company not be able to bind the company? But I know why the agreement stated that.

even and I guess my question is, even if you have a provision that says the president can’t bind the company, practically speaking, you know, she signed she signs small contracts all the time without talking to the the chairperson and the CEO. Is that a red? that be a red flag? Or, you know, you can call yourself a 1099 if you want. But in in actuality from from a from a function perspective, you’re you’re not

Well, mean, and it also, if you think about it from an acquisition standpoint, does that mean that all of those contracts under non-binding are going to be null and void? And if the customer wants to get out of it, they can get out of it. It’s not binding. So it usually is a best practice not to allow a 1099 to bind an organization without.

a second signature like general counsel or finance. But if you think about the definition of a 1099, it doesn’t really seem to fit a president’s role because their ability to use judgment and discretion and drive the organization. I mean, are they doing this on a fractional basis? No, full time.

Right. And she reports to the board. Right. And then you also have the question of ERISA violations, right? So what benefits is she not getting that she should be entitled to, and also the potential litigation in a transaction if she doesn’t continue on? And there’s certainly someone who acquires that business is not going to maintain her as a 1099.

I find that, you know, there’s this thought that people have, especially people that practice contract law and not employment law, that if both parties agree, anything can be solidified in writing. And that is not the case with employment law. There are very specific rights that the employee cannot waive. Workers comp, statutory benefits like tax contributions.

⁓ your social security, your Medicare, overtime, unemployment. So it gets really ⁓ sticky. So that sounds like a little bit of a nightmare, quite honestly.

Yeah, I agree. Christine, I have a question and also on the 1099 topic. You mentioned before that the part of the test of a 1099 is for them to be able to, I think you mentioned to make or lose money. Yes. So how does that roll through to a service business where someone is providing a service? What’s called losing money in a service business where

Right like my attorney Let’s say he’s a solo attorney Um, I think he is well, whatever. Um, he used to be a solo attorney. So he’s So how does he lose money? What does that even mean? Is he my employee? So, I mean Everybody has some level of overhead, right? And so however He is setting his rate because the definition of a 1099 means the 1099 is setting the rate

So let’s just say he’s an attorney, he’s charging you $400 an hour. But for whatever reason, that doesn’t cover the cost of his overhead, his technology, his security, his admin support, his data storage, right? That’s the ability to lose money or to bid on a project, right? To give you a fixed scope of work at a flat rate and lose money.

So there has to be where a 1099 is making some type of an investment in facilities, equipment, support, technology, helpers to do the work. And also a 1099 would not, an attorney might not be integral to a fractional CFO firm, meaning you use him

to support you, but he’s not delivering the day-to-day services. He’s not directly delivering fractional CFO services to clients. That would be integral to a business. So common examples are 1099s brought into construction sites that are doing primary functions like hanging drywall, putting up foundations. 1099s that are

outside salespeople that are selling that business’s goods and services as a primary function with little or no other revenue sources, right? Or, you know, like the example that Noah gave, 1099 in a president capacity. So,

It’s really the economic realities test, which does synchronize up with what New York State says. So if you don’t have other sources of revenue, you’re not available for business with the general public. There’s some type of ⁓ restriction about who that 1099 can work with, right? Is there any type of non-compete?

They’re having to report to work at certain hours. There’s direction or control or training given and then the permanency of that relationship. So is this person working there for a year or for five years? Right? So there’s really six main factors that go into the economic realities test when you’re looking at 1099 classification.

Thank you.

It’s a common problem. Yeah. I know for a lot of the fractional firms, not just CFOs, that 1099 is a frequent route. And the employment attorneys sometimes go for it. But everyone hems and haws about.

I mean, you’re not having a time, but other people. Well, and it depends, right? What is the structure of the business? So like, for example, if the fractional CFO service is a referral service, right? So you provide a business development and there’s some type of ⁓ structure in place, right?

for providing that, then you might have it, then that fractional CFO has to be free to do work for whatever clients they want to, and also open to do business with the general public, right? So, you know, having a presence on LinkedIn, having a website, having some type of, you know, it’s kind of a…

A lot of people don’t do it in professional services, but like a Facebook page or a TikTok that says, this is who I am. You can contact me directly. know, so, and then having that investment in their own equipment, security, technology.

So if you look at different structures like Angie’s List, you’ve got a platform that really is an aggregator of referral services to facilitate the consumer finding someone faster and being able to reference data. But the people on Angie’s List,

are free to get business by putting ads in Clipper or going onto Facebook or walking down the street and getting their own customer. So that’s kind of where that nuance might come into play. Did I answer the question? Yeah. Very helpful. Yeah. mean, a lot of times the things that we deal with in HR, it’s not always black or white. It’s super, super fact specific.

Yeah, I think that’s that’s kind of the key point is really understanding the company that you have the dynamic, the operating costs and having all those records to substantiate why you’re operating the way you’re operating and how much it truly costs you to operate.

Yeah If you ever really want to be you know sold and you want to go through a transaction Right, yeah I know someone who sold a fractional CFO firm and he told me that they the way that they did it I don’t know if this was because of issues like this he sold to an Accounting firm. He told me he shut down

Basically, he shut down his business and everyone left and moved to the new business.

So he left, the clients left, the CFOs left, and they all moved over to the new business. Right. But did he get anything out of it or he just really got himself a more secure job? I think he got, he probably got some kind of partnership at the accounting firm. Yeah. Which, I mean, quite honestly, you probably could have gotten that anyway if you were good. Right. So again, it depends. Like if your intention is

I mean, some people run a business with just the intention to create kind of what’s called a lifestyle business, right? I enjoy this lifestyle. I enjoy the freedom and flexibility. I enjoy the income it brings me, but I’m not really intending to go through a transaction where the business means something without me.

Right. there’s, there’s, I mean, there’s nothing wrong with that.

So that’s why I brought up early on, you’ve got to begin with the end in mind and structure your company in a way that’s going to get you where you want to go, right? And increase that multiple or that investment in what you’re creating.

Right. Yeah. I guess that’s true in many disciplines. It is. that to our clients for our things also. way you’re looking to run a lifestyle business, right? You’re going to invest in marketing differently. You’re going to look to maybe pull more money out in the near term. If you’re looking to build something much bigger that’s sellable, you’re going to invest in things that aren’t necessarily going to make money right away. ⁓

but we’ll build the infrastructure you need so you can sell later.

Right. Or some companies might actually be doing more of an employee stock purchase, right? They’re building up the company to then be managed at some point by the existing employees, which could look a little differently as well. So it’s, it’s important to, mean, you’re raising the issue that you’ve, you’ve got to start planning kind of a minimum of five years out. Right. Right. So that.

that’s sort of the minimum to say, where’s my runway? And where do I wanna be in the next 10 years? So that, right, I’m methodically going through this process.

Because you can accelerate it, but anytime you want to accelerate something, that requires a lot of money behind it. You want to get something done faster, it’s possible. But then you’ve got to put quite a bit of investment into making that happen. And some of the due diligence that we end up doing, usually in my initial conversation with leadership, I can ascertain

what level of risk are we exposing and do we need to bring in a law firm to do this underprivilege? Because anything that I do, my team does is discoverable, right? So when we go through like our initial question set and if people are saying, like I said before, the I what’s, then I start to know that one, you don’t want this to be discoverable

in a due diligence scenario. And two, we don’t want this to be discoverable if an employee brings a lawsuit or any type of allegation within the next statutory limit. So we do it under privilege, which then you’re kind of adding another layer of investment onto that. So. Right. Yeah.

Interesting. Yeah, it is. It’s very interesting. I mean, it’s interesting to me. Let me ask you one more question. was something that unless we’ll let’s see that anyone else have any questions they want to ask Christine.

I have a small question. Go ahead. I’ll ask another time.

So one question I have, Christine ⁓ is if all of the, what is the, in how many cases have you seen the current or the new owner of a business go after the old business owners for like, you said like employee related relations and all that. just, worked for like a small PE backed company, Food and Beverage on Long Island. ⁓

And we had lot of the same issues, the I-9 issues and all that. And we had a lot of problems with employees and I don’t recall that ever happening to us, but just curious, like in your experience, how frequently that happens within like the small business world. Right, so it’s usually the employee. So sometimes I would say maybe like 20%. So I mean,

We’ve had situations in an asset transaction where we’re onboarding new hires and we’re going through a handbook and we’re talking about key policies like sexual harassment. And the employee sitting in front of us said, oh, really? My manager isn’t allowed to do X, Y, And it was the manager at a prior organization. So you have this complexity of, well, that manager’s

coming into the new organization as well. Now immediately as an HR person, I’ve got to do something about it, but the liability sits with the prior owner. So if you follow New York, we now have a three year statute of limitations on sex-based harassment from the last incident. So if the last incident was two weeks before, you’ve got three years of issues and challenges. ⁓

It’s more what generally happens is

You have historical employees that maybe prior ownership has a kinship with, or kind of this connection because they were with the business for a long time, but their skills and abilities maybe haven’t kept pace. And now as the new acquiring business is kind of doing their own due diligence and requiring people to leverage more technology or other types of tools, this employee begins to struggle and may not make it.

Yeah. And if they were improperly classified or, you know, anyone in financial duress, and we see this all the time, owners will say, well, that person’s worked for me for 20 years, they’re never going to do it. And sure enough, if there’s enough financial duress or the brother-in-law moves into their home because that person lost their job or somebody’s diagnosed with

cancer or a child becomes addicted to heroin or opioids and they need money to fix that problem, they don’t, the employee no longer cares about that longevity. They look at you as someone who just went through a transaction, who just got a nice chunk of money and they would like their piece of it. So I would say about 20 % of the time. Interesting. Yeah. Thank you.

Did I Mike? I’m not sure if I answered your question or. This is all very helpful. Thank you. I’m I had some interesting conversations last couple weeks. I’m coming in from like a there’s a patent. There’s a licensing agreement kind of situation and I’m learning now that. You know me guy sitting in my basement. Playing with some kind of system or some patent and then you have these like huge manufacturers.

And, um, in your perspective, do you think it’s smarter to just be an independent contractor as opposed to a, you know, as opposed to a business owner who has to partner or negotiate with other people I’m learning? Uh, yeah, a big, I don’t know, broad question to throw out there. You mean.

So are you asking if you should ever hire employees or not? Yes, sorry. That’s the best way to say it is, I, is it good to be planning in the future thinking about let’s hire, like I need to be planning to train, hire, people, or is it better just to be a solo individual who, who licenses stuff, gets a 5 % royalty kind of thing.

Well, I guess it depends on if you really want to scale. are you like when we talked about lifestyle businesses and creating an income and a life where you enjoy the working hours and the work and the flexibility. ⁓ Is that the intention or do you want to create something that has a value to it that

you know, and I’m not sure what your line of work is, but it’s really, that’s the question that you have to ask yourself. And what is your time horizon? So, you know, a lot of the stuff that you see on social media about people starting businesses to be sold, and that’s the end game to grow it and sell it as fast as they can. There’s a lot of myth to that.

Most of the businesses that are sold for day-to-day kind of businesses, you’re talking 15, 20, 20 years of slow, consistent growth and investment. So I would also think about your time horizon. Some people want to create something they can pass off to their children. Other people have children that have zero interest in their business whatsoever.

Like in the instance of the distribution company that we just did the project on for a year, the children wanted nothing to do with continuing the business that their grandfathers had started. So it really depends what you’re, like we said, you begin with the end in mind of what is your business goal.

Yeah, correct. Yeah, for me, I just want like a lifestyle business. It’s sort of like my own job and I don’t scale it grow it and sell it. So you might want to get like a virtual assistant that does some admin work. Who’s the employee of someone else and all of their? Taxes and benefits are being paid, you know, just to help you and. Yeah. OK, thank you and I booked an appointment to.

Dive deeper for 15 minutes. you for all the philosophy here and long-term thinking is good as opposed to. This is what Gershon I think had as a job title a while back, a business philosopher. So yeah, yeah, I did. All right. Thank you. Thank you all for anyone listening to this now or in the future. You can reach out to Christine. You know how to reach us.

If have any issues getting in touch with Christine, we can help with that. We can help with that too. We have a quick poll here. If you’d take a second to answer, that would be helpful. For anyone listening on LinkedIn, thank you for joining. I didn’t check LinkedIn for questions, but we’re just about out of time. So thank you all, and thank you, Christine.

Absolutely. And Gershon, they’re going to get a five page HR due diligence checklist that takes a deeper dive ⁓ into all of the things that they kind of need to be prepared for. Perfect. Yes. Thank you for reminding me. And anyone listening to this who’s not listening right now, you may be seeing this on YouTube or somewhere else, but reach out to us and we’d be happy or to Christine, and we’ll be happy to get you that HR diligence checklist.

Absolutely. And again, thank you all for coming and thank you especially to Christine for everything. Thank you, Gershon. It’s been wonderful. This is great. Thank you so much, Christine. Really insightful. Thanks, Christine.