Purchasing a Business with Seller Financing

It is often the case that a purchaser of a business does not have the resources for a full cash sale and will request that the seller finance some of the purchase price. This can be advantageous for both parties, but requires that the parties consider a number of issues, as we highlight in this article.

Advantages to the Seller

While many sellers are initially reluctant to consider financing the sale of their business due to the risk that the purchaser will not pay as agreed, sellers who do engage in self-financing deals typically find that they can obtain a higher price for their business. In addition, by financing a percentage of the purchase price, a seller increases the pool of potential purchasers, making it easier to locate a buyer for their business. Finally, some sophisticated buyers will refuse to consider the purchase of a business without some level of seller financing because they want the seller to have some “skin in the game”, which indicates to the buyer that the business is viable.

Advantages to the Buyer

The advantages to the buyer are generally more obvious. First, a seller-financed sale permits the buyer to consider purchasing a business valued at a price point beyond their own immediate resources. If the buyer negotiates a reasonable interest rate, they can avoid unattractive sources of financing, such as use of credit cards or lines of credit to purchase the business. Finally, if the buyer is seeking a bank or small business loan to cover some of the purchase price, the lender will often desire seller financing of some percentage of the costs, which indicates to the lender that the seller believes in the soundness of his or her company.

What Terms do Sellers Typically Desire in Exchange for Financing?

While each situation is unique, a seller’s note often carries an interest rate which is at or below current bank rates, depending, in part, on the perceived level of risk or other assurances that the loan will be paid in a timely manner. In addition, sellers will usually require some or all of the following terms as conditions of seller financing:

• Resumption of control of the business for default on the loan;
• Buyer assets as security, such as real estate;
• Buyer’s personal guarantee.

Since the seller’s obligations are typically fulfilled upon execution of a note, his or her greatest concern when providing seller financing is that of the buyer defaulting on the loan. In order to mitigate the impact of such a situation on the seller, he or she will typically wish to include terms permitting him or her to retake control over the business in the case of default by the buyer. This typically occurs within 30 to 60 days of an uncured default. The seller may also require periodic reports from the buyer with regard to the financial stability of the company until the loan balance is satisfied. For companies which utilize a substantial amount of inventory, sellers sometimes seek provisions requiring that the buyer maintain those inventories at or above specific levels.

When it comes to collateral to secure the loan, sellers are typically most interested in using the buyer’s real estate as security, which allows the seller to foreclose on the property in the event of the buyer’s default. However, if the buyer does not own real estate or has little equity in their property, then stocks, inventory or other assets held by the business are all commonly used as security in seller financed transactions. Some seller financed transactions do not include any assets as security, but may include the owner’s personal guarantee, meaning that if the company defaults on the loan, the owner’s personal assets can be reached to satisfy the debt.

Whether any of these or other conditions are required by the seller will often depend on a number of factors, including the relationship between the parties, the amount of financing being provided by the seller, the length of the loan, and the level of risk to the seller if the buyer defaults. If the seller is financing a fairly small amount of the purchase price, which is scheduled to be paid within a relatively short time frame, and the level of risk of default is fairly low, then the seller may simply rely on his or her remedies at law, such as a breach of contract claim, which could be brought if the buyer defaults. This, along with a provision providing that the buyer pay the attorneys’ fees and costs to pursue such a claim are typically quite effective in preventing a buyer from defaulting on a loan. In general, there are many methods which may be utilized to ensure timely payment on the loan.

Common Legal Documents in a Seller-Financed Transaction

Depending on the circumstances, there are several legal documents that should be drafted in a seller financed sale of a business, including:

• Letter of Intent setting forth the preliminary framework for negotiating terms of the sale;
• Purchase or Sales Agreement including the final negotiated terms of the sale;
• Promissory Note;
• Security Agreement or Deed of Trust if real property is used as collateral;
• Any applicable lease or transfer documents, such as vehicle and real estate title documents;
• Bill of sale transferring title of other business assets to the buyer;
• Non-Compete Agreement if not included in the Purchase or Sales Agreement;
• Bulk Sales documents if inventory is included in the sale; Click here for information on California Bulk Sales Laws;
• IRS Form 8594;
• Employment Agreement if owner remains a consultant or employee of the company following closing of the transaction.

Conclusion

In summary, buyers and sellers both stand to benefit from seller financing. However, it is important for each party to retain experienced business lawyers to assess their situation independently and advise them on how to best protect their interests in such transactions. Even for a simple sale without security, there are many issues to consider which an experienced professional can identify and address. Don’t go it alone, our trusted and knowledgeable business attorneys offer a complementary evaluation for most legal services and work diligently to protect each clients’ interests. Contact us today, you’ll be glad you did.

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When Must an LLC Membership Interest be Registered as a Security in California?

Most business owners and investors refer to corporate stock when discussing “securities”. However, other types of ownership interest fall under the definition of securities pursuant to California law, including a membership interest in a limited liability company (“LLC”). However, not all LLC membership interests fall within the definition of a security, in which case registration of the interest is not required in California. Therefore, it is important to understand if and when your LLC’s interests are subject to registration requirements.

California Corporate Securities Law

The California Corporate Securities Law, § 25019a “security,” in relevant part, as follows:

“‘Security’means any note; stock; treasury stock; membershipin an incorporated or unincorporated association; bond; debenture;evidence of indebtedness; certificate of interest or participation inany profit-sharing agreement; collateral trust certificate;preorganization certificate or subscription; transferable share;investment contract; vertical settlement contract or a fractionalizedor pooled interest therein; life settlement contract or afractionalized or pooled interest therein; voting trust certificate;certificate of deposit for a security; interest in a limited liability company and any class or series of those interests(including any fractional or other interest in that interest), except a membership interest in a limited liability company in which the person claiming this exception can prove that all of the members are actively engaged in the management of the limited liability company…” [Emphasis Added].

A plain reading of this Section of the statute makes it clear that an LLC membership interest is indeed a security, making it subject to registration with the state, unless ALL of the members of the LLC are actively engaged in the management of the LLC. Therefore, where an LLC is manager-managed and not member-managed, or where some, but not all, of its members manage the company, registration of its securities is mandatory.

California Commercial Code

In additional to the Corporate Securities Law, the California Commercial Code also governs whether a membership interest in an LLC is treated as a security. Section 8103(c) of the Commercial Code provides:

“An interest in a partnership or limited liability company isnot a security unless it is dealt in or traded on securitiesexchanges or in securities markets, its terms expressly provide thatit is a security governed by this division, or it is an investmentcompany security. However, an interest in a partnership or limitedliability company is a financial asset if it is held in a securitiesaccount.”

Most LLC’s which operate as a small or family-owned business will not be required to register their membership interests as a security. However, it is important to consider both the Corporate Securities Law and the Commercial Code when determining whether your LLC is subject to registration with the state of California in order to avoid potential penalties and/or legal action by investors.

California Securities Exemption Pursuant to Corporations Code §25102(f)

If the membership interests in an LLC are subject to registration in California because they fall within the definition of a “security” under the Corporate Securities Law, most will qualify for an exemption from federal registration because the interests are not issued through a public offering. In addition, such an issuance will typically qualify for a securities exemption in California under Corporations Code §25102(f). This Section of the Corporations Code provides:

“Any offer or sale of any security in a transaction (other thanan offer or sale to a pension or profit-sharing trust of the issuer)that meets each of the following criteria:

(1) Sales of the security are not made to more than 35 persons,including persons not in this state.

(2) All purchasers either have a preexisting personal or businessrelationship with the offeror or any of its partners, officers,directors or controlling persons, or managers (as appointed orelected by the members) if the offeror is a limited liabilitycompany, or by reason of their business or financial experience orthe business or financial experience of their professional adviserswho are unaffiliated with and who are not compensated by the issueror any affiliate or selling agent of the issuer, directly orindirectly, could be reasonably assumed to have the capacity toprotect their own interests in connection with the transaction.

(3) Each purchaser represents that the purchaser is purchasing forthe purchaser’s own account (or a trust account if the purchaser isa trustee) and not with a view to or for sale in connection with anydistribution of the security.

(4) The offer and sale of the security is not accomplished by thepublication of any advertisement. The number of purchasers referredto above is exclusive of any described in subdivision (i), any officer, director, or affiliate of the issuer, or manager (as appointed or elected by the members) if the issuer is a limitedliability company, and any other purchaser who the commissionerdesignates by rule. For purposes of this section, a husband and wife(together with any custodian or trustee acting for the account oftheir minor children) are counted as one person and a partnership,corporation, or other organization that was not specifically formedfor the purpose of purchasing the security offered in reliance uponthis exemption, is counted as one person. The commissioner shall byrule require the issuer to file a notice of transactions under thissubdivision…”

 

Our business law attorneys will provide more information on this California exemption in future articles. For purposes of this writing, it is important to note that while this exemption will apply to most LLC’s, it does not relieve an LLC from the requirement to register their securities. Rather, a Limited Offering Exemption Notice (“LOEN”) must be filed with the California Department of Corporations within 15 days of the issuance of such securities in order to avoid potential penalties from being assessed by the state.

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The business and commercial law attorneys at Gehres Law Group advise and represent clients on a vast array of laws affecting businesses in California. If you are a business owner, contemplating a new business idea, or have questions about a California company, contact us today for your complimentary evaluation, or feel free to browse our website.

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CALIFORNIA’S REAL ESTATE TRANSFER DISCLOSURE STATEMENT

If you are selling or leasing your home, you must comply with the Real Estate Transfer Disclosure Law. That law requires that sellers provide the prospective buyer with a Real Estate Transfer Disclosure Statement (“TDS”). The obligation to provide a prospective purchaser with a TDS is imposed on all owners of real property who enter into contracts to sell, exchange or lease residential property. The residential property subject to this requirement is residential property “improved with or consisting of not less than one nor more than four dwelling units.” California Civil Code §1102 (a). The statute also applies to mobile homes and manufactured homes, as well as to typical residential structures. See California Civil Code §1102 (b).

Specific Requirements of a Real Estate Transfer Disclosure Statement

Section I of the TDS simply requires the seller to provide the buyer with copies of any reports of inspections conducted on the property. Section II of the TDS that the seller make certain representations to the buyer concerning specified aspects of the property. Part A of Section II requires the seller to state whether the property has certain specified items, such as range, dishwasher, smoke detector, oven, trash compactor, satellite dish, and a host of other specified items which cover virtually any appliance or amenity one can think of. The seller must also state whether any of these items are, “to the best of Seller’s knowledge,” not in operating condition.

Part B of Section II requires the seller to state whether he is “aware” of any significant defects/malfunctions in a number of areas of the property, such as interior walls, exterior walls, windows, slabs, ceilings, doors and several other specified items. If the seller is aware of any such defects or malfunctions, he or she must provide an explanation of the nature and extent of the defects/malfunctions.

Part C of Section II of the TDS requires the seller to state whether he or she is “aware” of certain additional items, such as whether there are any environmental hazards on the property, walls or fences adjoining other properties, easements, unpermitted room additions, fill, CC & Rs, flood, drainage or grading problems, and several other conditions affecting the property.

Legal Effect of a Real Estate Transfer Disclosure Statement

The TDS is not a guarantee or warranty with respect to the items the seller must disclose. Rather, it is a tool to enable prospective buyers to decide whether they wish to purchase the property. The TDS requires the seller to disclose only specified things of which the seller is “aware.” Consequently, if, for instance, the property is built on fill, or the walls have lead-based paint on them, and the seller is not aware of these facts, the seller has not violated the law by failing to disclose these conditions.

Purchase and Sale Agreements often include a provision that the property is sold “as is” and with no warranties. Sellers have often attempted, unsuccessfully, to defend themselves from buyers’ lawsuits for failure to disclose significant problems with the property, by arguing the buyer agreed to purchase the property “as is,” meaning, with all its faults.  However, the courts have ruled that an “as is” provision in a Purchase and Sale Agreement is not a defense to a claim of violation of the transfer disclosure law. And importantly, a buyer may not waive his or her right to receive the disclosures mandated by the transfer disclosure law. Any such waiver violates public policy and is void.

So long as the seller discloses problems of which he or she is aware, an “as is” provision will protect him or her from any claims by the buyer that the property contained certain significant defects. That is true not only with respect to defects the seller disclosed, but also with respect to defects the seller did not disclose, so long as the seller was not “aware” of those defects. In addition, if a prospective buyer makes an offer to purchase a property before the seller provides him or her with the TDS, the prospective purchaser may withdraw his or her offer within three days after the TDS is personally delivered to him or her, or five days after the TDS is delivered to him or her by deposit in the mail.

Finally, the fact that a seller has failed to disclose an item he or she is aware of and is required to disclose, does not in and of itself entitle a buyer to rescind his or her purchase of the property. However, it does give the buyer a right to sue the seller for damages. The measure of damages is the difference between what the buyer paid for the property and the fair market value of the property. By this measure, if the value of the property, even with the defects/malfunctions not disclosed to the buyer, is the same as or greater than the purchase price, the buyer will have no damages.

Other Remedies for Misrepresentation by a Seller

The Real Estate Transfer Disclosure Law is intended to add to, and not supplant or change previously existing law. Thus, if the seller, for instance, makes intentional misrepresentations to the buyer concerning the property, and these misrepresentations are material, and not simply minor, the buyer may rescind the purchase contract, so long as he or she does so promptly upon learning of the misrepresentation.

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The attorneys at Gehres Law Group are experienced in real estate litigation as well as business litigation, and provide a free initial consultation to those who have been sued, or are contemplating filing a lawsuit concerning a real estate matter. Browse our website for more information about our San Diego business lawyers or contact us today for your complimentary evaluation.

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California Successor Liability

If you are purchasing an existing business or even the assets of a business in California, it is important to consider to what extent your business will have exposure to successor liability following the purchase. California successor liability laws are significantly broader than those in some states, so being informed and taking steps to mitigate your company’s exposure beforehand is critical, especially in higher risk industries.

What is Successor Liability?

Successor liability simply involves the imposition of liability against a successor company for the debts and liabilities of a predecessor. This usually occurs following the sale of a business or a merger of two entities. For example, if your new or existing business purchases the equity interest (shares or LLC membership interest) of a target company, or merges with a target company, the surviving entity will typically be liable for the target company’s past and future debts and other liabilities. See Corporations Code Section 1107(a). While a successor’s liability to creditors can be mitigated in some instances through compliance with California bulk sales laws, most of the obligations of a predecessor will remain with the successorfollowing these transactions. Click here for our discussion on California bulk sales laws.

Ways to Avoid Successor Liability

A purchasing business owner may consider one of several options to avoid the imposition of successor liability, including:

1) The owner of an existing business may create a separate subsidiary to purchase the target business. This option places the acquired liabilities in the subsidiary to avoid exposure to the parent company. This option is, of course, available only for existing companies, not new businesses, and does nothing to prevent successor liability from being imposed on the subsidiary; or,

2) The purchasing company may include certain legal provisions in the purchase agreement which shifts liability back to the seller. This choice is feasible where the selling entity survives the purchase or where a selling company’s owners have the financial ability (and are willing) to indemnify or otherwise compensate the purchasing entity should any predecessor liabilities arise following the sale or merger; or

            3) A purchasing business might also avoid the imposition of successor liability by purchasing only the assets of a target business. However, this is not a foolproof solution as discussed below.

Imposition of Successor Liability Following a Sale of Assets

While the general rule is not to impose liability on a successor business following an asset sale in California, there are a number of exceptions, as explained by the Supreme Court of California in Ray v. Alad Corp. (1977), 19 Cal.3d 22:

            “[T]he rule states that the purchaser does not assume the seller’s liabilities unless

(1) there is an express or implied agreement of assumption,

(2) the transaction amounts to a consolidation or merger of the two corporations,

(3) the purchasing corporation is a mere continuation of the seller, or

(4) the transfer of assets to the purchaser is for the fraudulent purpose of escaping liability for the seller’s debts.”

In the Ray case, the Court added a fifth basis for imposing successor liability–strict tort liability for a defective product. In the context of an asset sale, California courts have been somewhat creative in finding ways to impose liability against a successor where a party has clearly been injured and there is no available remedy against the predecessor, so it is not safe to assume that a purchase of assets alone will provide adequate protection against successor liability.

Successor Liability to Governmental Authorities

Successor entities in California can also be held liable for obligations of the predecessor with regard to various governmental authorities debts, if not already paid by the predecessor. Following are examples of amounts the purchaser may seek todeduct from the purchase price as reimbursement for payments to the appropriate governmental entities.

• Contributions to the California unemployment fund, employment training fund and unemployment compensation disability fund, plus any interest and penalties.
• Franchise and income taxes, plus any interest and penalties
• Sales and use taxes

As an alternative, the purchasing business may seek to obtain, prior to closing of the sale or merger, confirmation from these governmental entities that the predecessor’s obligations have been fulfilled.

Conclusion

In conclusion, individuals or entities who are contemplating the purchase or merger of an existing business must be aware of the real potential for successor liability being imposed on their company following the acquisition of a business or its assets. Often, a combination of the options discussed here will provide the best protection for a purchasing business against the imposition of successor liability. Assessing the level of risk and determining which of the available avenues are ideal in any given situation should be done by an experienced professional. The business law attorneys at Gehres Law Group, P.C. are adept at identifying these risks and mitigating them as much as possible in a variety of situations. Contact us today for a free evaluation or browse our website for more information.

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