Risk allocation and the sale of your business

There’s a balancing act that goes on between price and risk

The prospect of increased capital gain taxes has the attention of those considering the sale of their companies. But as of this writing, the proposal in the House Ways and Means Committee requires a business be subject to a binding contract to sell on September 13 to avoid the additional 5% tax.  

So, while it might be too late to do anything about that, it is never too late to focus on other ways business sellers can protect their purchase price. I want to focus on just one—risk allocation—and it’s a big one. 

Risk allocation makes up the bulk of any contract for the sale of a privately-held business, yet most sellers come to the sale process with no appreciation for the issues or the complexities involved.

Buried after mind-numbing pages of “warranties and representations”–promises and assurances the owner makes about the business–are a couple pages of indemnifications.

These indemnifications can go on for years and put the entire purchase price and more at risk. Yes, if you are not careful, you could sell a company for $1 million and then be sued for $5 million. 

The knee-jerk reaction is to say you’ll only sell your company “as is.” That is certainly one risk allocation strategy—the buyer takes all risks—but it will have a huge impact on the price the buyer is willing to pay. There’s a balancing act that goes on between price and risk, so it pays to sell subject to understandable and commercially reasonable risks, so be prepared for what’s involved.   

Those pages of warranties and representations? Be ready to spend hours creating “disclosure schedules” that respond to the contract’s requirements or provide information to keep you from being in breach. 

Sellers are often exasperated by the process of creating these disclosures, especially since they likely already spent hours responding to the buyer’s due diligence requests.  

Keep in mind that your responses to buyer’s due diligence will not likely not be considered in a lawsuit for indemnification—only information in your disclosure schedules will be relevant. 

As for indemnification, there are several opportunities to pare back broad exposures without adversely impacting your purchase price. Time limits are a starting place—how long after closing can a buyer make a claim. Periods of one to two years are much better than no time limits.  

Indemnification caps—your maximum exposure—are another consideration. Caps are often expressed as a percentage of purchase price. For larger private companies, a cap of 10-20% is reasonable; caps tend to increase, however, as companies get smaller, though a cap of 50-100% of the sales price is preferable to no cap.   

Indemnification “baskets” or deductibles should also be negotiated. These provisions are agreements by the buyer not to sue for indemnification until claims exceed some threshold. These are essentially an acknowledgment that “stuff” happens in any business and it is reasonable to accept a modest amount of it—often one percent or less.

Not quite “as is,” but when combined with good disclosure schedules and well negotiated indemnification provisions, they help a seller keep as much of that well-earned purchase price as possible.

Jimthomas13386final Jim Thomas is a business lawyer and director at Minor & Brown, PC with years of corporate and M&A experience in Greater Denver. Most of Jim’s clients are privately-held companies and individuals who look to him as a long-term, trusted advisor, helping with business issues and purchase and sales transactions all over the U.S. He enjoys working in varied industries, representing a wide variety of businesses from formation through exit and succession strategies, and whenever complex issues arise in the business life cycle. He can be reached at jthomas@mb-law.law or 303-376-6026.

(Sponsored content for this article provided by MB Law)

Categories: Business Insights, Legal