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hi my name is Aaron tenor welcome to buy sell basics have been representing businesses in buy sells for 30 years I've handled hundreds of buy-sell agreements I'm an attorney and a partner with gray Duffy LLP and this is the second in a series of webinars on buy sell basics the first webinar was about three different kinds of I sell agreements if you missed it you can view it at our website wwlp.com the next three webinars will be about stock sale and purchase agreements shareholder agreements and real property purchase agreements this webinar is about asset purchase agreements let's get started most buyers prefer asset a purchase agreement so for stock purchase agreements because it's a way to avoid assuming the sellers liability when you buy stock you're buying all the assets and liabilities when you buy just assets you can pick and choose what liabilities you want but the limited exposure is not automatic it's the result of a carefully crafted agreement and properly handled transaction from start to finish and this is where we lawyers come in it's our job to mitigate risk so today I'm going to talk about how we do that in the asset purchase process from negotiation through closing how an asset purchase agreement is set up and some of the more important provisions that help to prevent liability so I sometimes first hear about of I sell and I get a phone call asking me to review or draft a non-disclosure agreement a nondisclosure agreement is just an agreement that a buyer will be asked to sign or a potential buyer will be asked to sign agreeing not to talk about or disclose the fact that the seller is thinking of selling or any of the information that the seller will provide to the buyer for review and deciding whether or not he wants to buy the dealership often there's a broker involved when there's a nondisclosure agreement and make sure if you're a buyer dealing with a broker that the broker has the authorization of the seller I got a call once from a client telling me that a broker was trying to sell his dealership and he had not authorized him to do that why would a broker do that because they think that if they can get a buyer lined up they can then go to the seller and the seller will agree to pay them a big commission to bring them that buyer we had to send the guy a cease and desist letter if you're dealing with a broker who doesn't have authorization from the seller you're going to waste a lot of time and money the way you find out if they have authorization is you ask to see a copy of their agreement with the seller or you ask to talk to the seller directly if they won't let you do that it's a big red flag in other cases I just get a call from the client who tells me they've already agreed on a purchase price and they need me to draft a purchase agreement what they're talking about when they say they've agreed on the purchase price is goodwill the goodwill number also known as blue sky the goodwill is the value of the intangible assets of the dealership such as name recognition or customer relationships and most of the value of the dealership is in the goodwill or of any any business most of the clients I represent our auto dealership so I'm going to give a lot of examples about auto dealerships but I do handle other buy sells for other types of clients as well so I'll talk a little bit about that as well so the easiest way to determine goodwill is by taking a multiple of net income after reserved for taxes it's kind of a simplistic way to explain how it's determined but it's usually a smaller multiple for a service business a larger multiple for a retail business for example for a service business it would typically be one to one-and-a-half times earnings for auto dealerships it used to be two to three times earnings pretty consistently but when the publicly traded companies came in and started buying up dealerships the multiples when it lay out there now they're anywhere from three to ten times earnings even among different types of dealerships different makes the multiples can vary greatly you'll get a much higher multiple for a Mercedes dealership or a BMW dealership and you'll get for a Mazda or Subaru or VW dealership for example and even within a single make the multiple might vary for example a Toyota dealership might typically bring a multiple of six times earnings for goodwill in California however years ago I had a client who was selling his dealership and he was asking six times earnings and everybody look who looked at it so that they were scared to pay that number because it was a really large number when you did the math because he was a really good operator it was very profitable and people looking at it didn't think they could necessarily duplicate his profitability so they weren't as eager to do that but economy was a little soft at the time as soon as the economy started to firm up he was able to get what he was asking for conversely if a operator is not very good I've seen Toyota dealerships that you know earn five hundred thousand dollars or less it's pretty uncommon but it happens and it's almost impossible to find a Toyota dealership to buy for under 10 million dollars so if somebody's looking at a Toyota dealership and it's got very low profitability and they think they can bring it up to you know earning a couple million dollars a year then they might be willing to pay 10 15 or even 20 times earnings for that dealership because of what they think they can do there was a time when nobody would pay for a dealership based on anything other than what the current operator was doing at the time but those times have changed and now buyers seem to be more willing to pay for things they wouldn't have years ago so in addition to the goodwill the fixed assets will also have to be purchased and fixed assets include furniture fixtures and equipment sometimes they can include leasehold improvements as well inventory will be purchased in any business and in an auto dealership the inventory would be new vehicles used vehicles and parts and accessories inventory and work-in-progress which would in a dealership be for example service work that's in the middle of being completed but not done as of closing also customer contracts and many by sells or can be a big number and auto dealerships they don't end up amounting to a lot because they're often many cars that have been sold and not delivered yet as of closing it might be two or three but in some businesses customer contracts can make up a big part of the value of the business especially in a service business whether a buyer is using or sellers using a broker or not the buyer is going to want to see the sellers financial statements probably for the last three years financial statements are typically the only thing delivered before a purchase agreement is signed some buyers rely on them more heavily than others some have their own processes and they'll just look at the number of cars sold which you can usually see on a financial statement and some of the other numbers but won't rely too heavily on it they'll fund their own process with those numbers to see how much profit they would make others will rely heavily on the financial statement if you're relying on a financial statement you need to look closely because they're not everything is going to be stated there for example if the dealership is leasing the property at below market rent its not going to show up on the financial statement if the buyer is going to be assuming the leaf the buyer is going to want to look and see if the lease is going to be expiring in a year or less or if it's a long term lease if it's a long term lease they're getting the value of that lower fair market value if it is a short term lease they're going to be paying higher rent soon enough and they may want to calculate the net income using a higher rent value which would reduce the net income and give a lower number when you multiply it by the multiplier to determine goodwill I could do a whole webinar on how to value a dealership even though I'm not a valuation expert but that is not the point of this webinar so let's move on letters of intent are often used at the beginning of a buy-sell process just to make sure the parties have agreed in principle on what the terms of the agreement are they're generally not intended to be binding agreements to buy or sell they can be if they're not written properly but that is not the point of them the point is to have a binding obligation to negotiate in good faith on the term stated in the letter of intent when a buyer comes to me and tells me they're buying a dealership one of the first things I do is I have them form a new entity and the new entity will be the buyer on the purchase agreement the new entity is funded it sets up a bank account and then that bank account is funded with the purchase price that's the way the new entity is capitalized and then that purchase price that's in the bank account will be that money in the bank account will be used to pay the purchase price the whole point of forming the entity is to limit the liability of the owners of the entity so that they have no liability for anything other than what they put in to buy the business then same with operating business down the road as long as the entity is a limited liability entity and it's maintained properly set up properly properly capitalized then individuals will have no liability so that's the first step in limiting liable elodie in the nasa purchase agreement as a purchase agreements are typically set up with several different sections they have standard provisions at the beginning in the end which just identify the parties and give kind of a preamble to what's going to be happening and then at the end the standard provisions are typically notice provisions and maybe attorneys fees provisions and some other things like that but the body of the agreement sets forth the assets that are going to be purchased the purchase price or how it's going to be determined the real estate how that's going to be handled because usually when somebody's buying a business they're even leasing the real estate or they're buying it occasionally they're moving it it'll have a section on contracts that are going to be assumed if there are any in a dealership usually the only contracts that are assumed they're you know the dealer management systems if any or any contract that's you know not a thirty day or less terminable on thirty days or less notice contract long-term contracts are usually assumed but they're usually aren't many auto dealerships and sometimes the players want to assume those and sometimes they don't they're also warranties and representations they're the exception for warranties and rips from the seller and warranties and reps from the buyer and those are just things that the each party is telling the other that they can rely upon in going forward with the agreement an example of a sellers warranty and rep would be that the seller will deliver all of the assets free and clear of liens and encumbrances at the closing an example of a buyer's warranty and wrap and this would be a seller's rep - coming from the seller would be that the buyer has the authority to enter into the agreement and that no other consents are required then there is always a section on conditions - obligations these are things that would not be in a letter of intent this is why you need the formal purchase agreement conditions - obligations are things like if a lease is going to be signed the buyers condition would be that the seller sign the lease of the closing and the sellers condition would be that the buyer signed the lease to the closing and it's really important to make sure that these documents that need to be signed at closing are prepared and advanced and attached to the purchase agreement when it's signed otherwise you're going to have to be negotiating them once the purchase agreement is signed and if you don't agree on the term and either party can walk away and have no liability because you didn't agree covenants and are another section which include indemnity agreements and indemnity agreements are important because these are provisions that say if if one party has ends up having expense or liability for something that was really the other person's responsibility then the other person will pay for it so something an example that would be if the dealership for the seller would say that he's indemnifying the buyer from dealership operations prior to closing so if they repaired a vehicle and the vehicle was in an accident after closing and somebody sued for negligent repair and they should both the buyer and the seller which often happens because usually the buyer takes the sellers name as part of the goodwill then the seller would be hiring the lawyer and defending the buyer and paying any expenses and fees and damages that arose out of that I want to talk a little bit about allocation of the purchase price because this is a real important part of an asset purchase agreement oftentimes I see parties want to just lump everything together they'll say the purchase price for goodwill and fixed assets is X dollars and the purchase price for inventory shall be determined by the formulas that are typical it's a bad idea because ordinary income tax is going to be paid on the gain from the sale of fixed assets as well as sales tax will be charged on fixed assets whereas goodwill is taxed at capital gains rate so if you lump it all together against who's going to be deciding what the allocation is it's going to be the IRS or the sales tax agency and you don't want them deciding how much you're allocating to fixed assets or goodwill it's real easy to do an allocation to fixed assets you can either allocate it Book value or you can allocate it fair market value and placing and use and have an appraisal done and they can be very different numbers it doesn't matter what the number is as long as you can justify it as long as you've agreed on it and as long as you've both recorded it the same on your tax returns that's real important too and the agreement should say that the parties will both report the allocation the same way that it's stated in the purchase agreement on the tax returns so fixed assets are a big topic not only for the purpose of allocation but also for the purpose of making sure an agreement is enforceable another important provision is one stating that a list of fixed assets will be attached as an exhibit to the purchase agreement it's important because the agreement might not be enforceable if the fixed asset list is not attached why because it's not always easy to tell what's a fixed asset and what isn't for example fixed assets typically include furniture fixtures and equipment but they can also include leasehold improvements as I mentioned well a fixed asset is a fixture or a leasehold improvement or maybe not if leasehold improvements are included and leasehold improvements often aren't included because they're a big number and often they're included in the value of the lease or in the value of the real property that's being purchased so a fixture is something that's affixed to the ground a leasehold improvement is something that the tenant brought in for use in the business and added it to the property to use in their business so safe and reasonable Minds can differ over what's a fixture and what's a leasehold improvement for example stay above ground hoist it's a fixed to the ground it's also brought in by the tenant to use in their trade or business so it could be a fixture it could be a leasehold improvement if the buyer isn't purchasing all these field improvements and all fixtures and there isn't a list attached then the parties could get into an argument at closing over hundreds of thousands of dollars worth of assets that are affixed to the ground and could be fixtures release hold improvements and no judge in their right mind is going to enforce an agreement if they can't tell what the parties agreed to by yourself so if you want an enforceable agreement you better make sure you have a fixed asset list attached successor liability is a big issue in in any buy sell and the reason is if you're buying stock you're going to have success reliability and that means you're going to be responsible for all of the sellers liabilities everything if you're buying assets you don't want success or liability and the only way liabilities are going to be avoided is if you take steps to make sure they are even if you're doing an asset purchase agreement like I said the avoidance of liability is not automatic typically the buyer will have paid more to buy assets than they would have paid to buy stock because they're not taking all the liabilities and so the last thing you want to do is add up end up with success reliability so what are some of the liabilities that are avoided unsecured creditor claims are easily avoided in an asset purchase agreement by simply complying with the bulk sales laws for the state most states have adopted the sales laws and sometimes you don't have to do anything to comply in California if the transaction is over five million dollars you don't have to do anything to comply but you still want to say in the purchase agreement that you complied I get attorneys asking me all the time and by cells to wave to agree to waive the bulk sales law I don't want to do that because if I get a call from a creditor after closing I'm representing the buyer and the creditor is attorney says my client has successor liability for their unsecured creditor claim all I have to do is show them that the purchase agreement said they were going to comply that they complied with bulk sales laws and typically that claim will go away because that's the whole point of the bulk sales laws to prevent the buyer from having liability for the sellers unsecured creditor claims if I'm the and I put in the agreement that I waived compliance with the bulk sales laws I've just given that creditor the ammunition to go after my client and collect from him for the unsecured creditor claim secured creditor claims are even easier because there's always a record a public record of secured creditor claims if there's no public record the buyer is not going to be liable for it a secured creditor claim is just a lien against assets of the business so in an auto dealership there's going to be a lien for all of the new vehicle inventory against all of the assets as a business also for equipment if there's the equipment that's been leased there would be a lien filed against that equipment and the lien is just a representation of a security interest so the lender would have a security agreement would file a UCC lien which gives the world notice that it has a security interest and then at the closing we go to search the public records we find all those liens and we make sure they're all released as of closing now you can get warranties and rupturing the seller that everything will be delivered free and clear but then if it's not delivered free and clear if you didn't go do the search and clear all the liens then you're going to end up spending a lot of money dealing with lawsuits and staving off creditors after the fact so you don't have to do that continue the liabilities or things like lawsuits that haven't really come to fruition yet and you can usually do a litigation search to find those the seller can represent warrant that there aren't any but the seller might not even know if one has been filed but not served yet but it's out there and usually they're not a problem unless they affect the assets unless you're buying stock of course which I'll talk about in the next webinar tax liabilities are a big concern because they can add up to a lot of money and it's usually not the income tax that's a problem because most sellers are either S corporations or limited liability companies and those are passed through entities so they don't pay taxes their owners paid a tax so you don't have to worry about the tax unless it's an S corporation of law successful at selection and then it becomes a C corporation and if you're buying from us corporation if you're buying assets then you do need to worry about income tax but you always need to worry about sales tax employment tax and franchise tax because those liabilities in California and I'm sure in other states as well will attach to the buyer even if the buyer doesn't know anything about them even if there's no record of them you can do a tax lien search but it might not show everything so how do you protect the buyer the buyer will get tax clearance certificates if possible prior to closing and they can usually be gotten for employment taxes and franchise taxes sales tax are a little trickier usually can't get them before closing so we hold back money in escrow we estimate what we think the tax will be we might double it or add another 50% of that amount in case there are penalties in case there's an audit after in case there are you know is interest owed and that money is held back in escrow until that tax clearance certificate can be obtained and usually can be obtained within two or three months after closing and then you authorize escrow to pay from that hole back any taxes that are owed if necessary to get that tax clearance certificate factory liability should never be a buyer problem but sometimes it is that are closing once and the factory put in front of my client a document that said my client was going to assume all of the sellers part's account liability and I told them not to sign it because I've never seen that in 30 years and we ended up having to negotiate around that so that can happen environmental liability I'll talk more about that in the next webinar but it's also something that could be a potential problem for a buyer if they don't know about it and so you want to do a phase one customer liability of course you want to make sure customers are taking care of after closing so you want to make sure the seller has to reimburse you for anything that you have to pay out as a buyer to take care of a customer if it should have been the sellers responsibility employee liability and pension liability are a huge issue I'll talk more about this in the next webinar as well but I want to touch on them a little more here because they are often a problem the purchase agreement will always say that all employees will be terminated as a closing and that the buyer doesn't have to hire employees but may hire those it wishes to employ and it will say that the seller is going to be responsible for all employee obligations and not the buyer however if the buyer agrees to even assume one employee obligation it could step into successor liability for all of them I'm talking about wage and hour claims medical benefits discrimination claims wrongful termination claims pension liability to name just a few there's a lot of potential liability there I was at a closing once and I overheard a client telling the the seller that he was going to just assume all the vacation pay for all the employees he was hiring and that is not what the purchase agreement said so I told them no we don't want to do that because you could potentially end up with all of the liability so you got to make sure that you're following the terms the purchase agreement there's a reason it's worded the way it is so instead all he really had to do because he really wanted to give employees the benefit of their vacation that they had accrued is have the seller pay the vacation pay at closing and negotiate with each employee just like you would any other employee if they have a vacation coming up and they want to take it let them take it just know paying for it they already got paid by the seller so there are ways to deal with those issues and you can rely on warranties and reps for a lot of these things but sometimes people hide their assets I've heard of people giving them to their spouse the situation where I heard about that the spouse ran off with the assets which can happen I've heard about people putting them in diamonds under the mattress you know so the warranties and ruts and indemnity obligations are only as good as the person making them you may be better off with a hold back for things that you know about once the agreement is signed and in escrow the announcement will be made to all the employees of the sale factory approval will be obtained due diligence some of which I've already talked about will be done and I'll talk more about that in the next webinar employees will be interviewed by the buyer just like they were interviewing any other employee and seller shouldn't be given away private information about employees either without employee consent I mean this is something I see sellers doing all the time and they shouldn't be doing it there's no and the privacy laws for buy sell you should be treating those that buyer just like anybody else calling for a job reference on a prospective employee they're hiring and then you resolve any issues that come up during that escrow period and they're always resolvable at closing everybody comes together new vehicles are inventoried parts and accessories are inventoried documents or signs there's always a bill of sale and assignment assumption of contracts it's going to be a lease or purchase agreement it might be closing simultaneously and they'll be a deed to transfer the land corporate resolutions day after documents all kinds of things it's just a few of them I've listed liens are released if they haven't been already on assets and sometimes money will have to be paid out of escrow or they'll have to be an agreement in escrow to pay off those liens in order to get the releases and then the purchase price is determined and that's a big job for the buyer in the seller they have to sit down and looking at the purchase agreement go through and determine what the purchase price is based on the formulas without in the purchase agreement for each car and for the inventory usually there's an inventory service that comes in and does the parts inventory but for cars the flooring lenders are going to count the cars but the parties have to have somebody there to actually calculate the purchase price and that's a big job so often they forget about it so in summary the point of an asset purchase agreement is to avoid liability the process usually starts with negotiation of the goodwill a limited liability entity is formed by the buyer then the NASA purchase agreement is drafted and signed the agreement if it's done right describes the assets in enough detail so a judge could tell what the parties agreed to buy and sell if it has an up-to-date fixed asset list that's great if it doesn't it's a problem any documents that are going to be signed at closing should typically be drafted and attached as exhibits to the agreement when it's signed purchase price is going to be allocated in the purchase agreement and then another document will be signed at closing which gets filed with the IRS which is a tax document for allocation of the price the agreement includes warranties and representations conditions to the obligations of the parties and indemnity provisions and some of the most important provisions are those that limit the buyers exposure to the sellers obligations but they're only valuable if the parties follow the terms of the purchase agreement these include provisions that protect the buyer from creditor claims the right to hold that money in escrow for unresolved issues the due diligence provisions that allow the buyer to conduct inspections and those due diligence provisions don't have to be written in such a way that the buyer has an absolute right to lock I see people expecting that all the time and I would never write them that way the buyer should have to be able to justify its reason for wanting out of the agreement otherwise it's not a binding agreement an escrow is open assuming an escrow is used and between assigning and closing due diligence is performed employees are interviewed one at a time and their terms of employment are negotiated closing the seller terminates all the employees the buyer hires those it wants to hire inventories are completed the final purchase price is determined using the formulas in the purchase agreement and closing documents are signed the parties need to understand and abide by the terms of the purchase agreement I can't stress it enough it's so important avoiding successor liability is the point of an asset purchase agreement it will cost both parties a lot more if they don't have an experienced attorney helping them where they don't abide by the terms of the purchase agreement thank you for joining our webinar I hope you found it in the information useful and if you have any questions or comments you can email me at eat enter at grey duffy law comm i hope we'll she is the next one