Buyer Beware: Two Major Red Flags When Sellers Push Back

Buying a business is likely the biggest investment you’re ever going to make, and there are certain legal protections that you’ll want to have in place as you begin exploring opportunities.

The letter of intent (LOI) signals to the seller that you’re serious about buying their business, and when done right, it creates a structure for the ensuing stages of negotiations and due diligence to protect both the buyer and the seller — a phase that requires a massive investment of time, money, and emotional capital.

“There is no such thing as a standard LOI,” said Eric Pacifici, a founding partner with SMB Law Group who has extensive experience in M&A for small and medium businesses. If the LOI doesn’t have the proper provisions in place to protect those investments, buyers can become emotional or desperate, and that’s when they begin making mistakes.

During his presentation at this year’s #BossUp conference, he went through the terms of his law firm’s LOI and flagged several key provisions. He also explained that if sellers push back on two in particular it can be a major red flag. 

1. Non-Compete

This is an essential clause, according to Pacifici. “Don’t play games with non-compete,” he said. If the person you’re selling to decides to open up across the street from you, not only do they have the advantage of all their experience and relationships, but now they also have a war chest with what you’ve just paid them in the sale and a “fresh start” meaning all the difficulties associated with the previous business are gone. “They’re going to crush you,” Pacifici said. 

He advises giving yourself five years. “That’s the baseline,” he said. “You need that to get comfortable.” There is also a difference between business sale non-compete (that prevents the previous seller from competing with you) and employment non-compete (that prevents them from hiring key employees). The five years applies to the business sale non-compete. 

2. Exclusivity 

If you’re going through the SBA (the U.S. Small Business Administration) to get a loan to acquire your business you’re looking at a 60 - 90 day process. (He did not comment on the timeline through the Canada Small Business Financing Program, but one might expect that would also be relatively extensive.) In these cases, he said you want to push for a 100-day exclusive negotiating process. During that time, you’re likely going to spend several thousand dollars on financial due diligence, legal fees, and other miscellaneous costs. “You don’t want to work on a deal for 60 days then have the buyer have the right to sell to anyone off the street who offers a higher price,” Pacifici said. 

To secure this, the seller may ask for a deposit, which Pacifici said is no problem provided that the deposit is refundable no matter what. “Lots of deals die after the LOI stage,” he said, “you need to be able to pull that out whatever you find, otherwise it flips the leverage.”

Promissory: A Tool to Avoid Court

Pacifici also noted that most provisions of an LOI are non-binding, legally. Things like the purchase price, as noted in the LOI, are subject to change. Even the binding provisions, like exclusivity, are not worth going to court to enforce since the costs and expenditure of resources will quickly exceed whatever you stand to recover. 

For this reason, Pacifici strongly advocates for buyers to include a promissory as part of their eventual purchase agreement. A promissory is a written notice indicating a legal obligation, in this case for the buyer to pay the seller a certain amount of the purchase price after the buyer has fulfilled certain obligations or the parties are satisfied that the seller is not in breach of the purchase agreement.

“When you buy a business, there just isn’t enough time for you to figure out all the conceivable risks,” he said. “You don’t have time to turn over every stone and find every skeleton, and if you try, you’re going to drive the seller crazy and they’re not going to want to work with you.”

This is where the “Representation and Warranties” section of your purchase agreement comes into play. In short, this section is a legal commitment that the seller has appropriately represented the business and its viability. “Indemnification” is the term for what is owed to the buyer when the seller breaches one of these terms. However, even with a clear-cut case, Pacifici explained that going to court is “insanely expensive.” This is where the promissory becomes a useful tool. 

The example he offered was that of a family business. Imagine you just bought a family business, and after the sale, an estranged relative launches a legal case out of the blue claiming partial ownership of the business. In this case you would be well within your rights to deduct the indemnity in that case — i.e. the financial cost of that (the settlement, the legal cost, etc.) — from the promissory. 

In many of these cases, Pacifici said a good seller’s lawyer will challenge you, but for most deals it pays to be protected by working with a lawyer you trust.

Watch Pacifici’s full session here.

Also, let’s not forget about #ChickenGate

Opinions expressed here by contributors are their own.

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