Selling a Business: Third Party Consents
11 October 2021: Selling a Business
When starting to prepare for selling a business – and selling a business is an event that MUST be prepared for – myriad aspects of the business – from its operational systems, financial condition and organizational structure to the seller’s net proceeds and plans for after the sale – must be considered.
Some of the more basic questions include:
- What’s the value of the business; its most probable selling price?
- Are the financial books in order and comprehensible?
- Are the key employees tied to the business via employment contracts?
- Will the projected net proceeds of the sale provide the seller with the capital to realize their post-closing goals – whether that be a modest retirement or sailing around the world?
But part of the process that we’ve found is often overlooked – and that can derail a deal at the last moment – is a check to see if the sale of the business requires any third party consents.
What do I mean by a “third-party” consent?
I mean that someone – maybe even more than one person or entity – other than the owners of the business must give their consent to the sale.
This condition is not as rare as some think it would be and is true for both professional practices (such as accountancies and legal practices) as well as retailers, service companies and manufacturers.
The sale of almost any business could involve the need to obtain one or more consents from one or more third parties. In fact, it may also be necessary for consent to be obtained in the event of a change of control – rather than total sale – of the business.
For example, if the business owner, in an effort to raise capital for expansion, does so via equity financing, the business owner may end up with less than controlling interest in the business. This could trigger a third-party consent requirement.
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Selling a business – or using equity financing that would affect a change of control – without determining whether any third-party consent is required opens the seller up to potential liability for damages as a result of breaching an existing contract. It could also queer the deal.
In addition, in the example of a sale, the seller is almost always required to provide a specific representation and warranty in the sale/acquisition contract indicating that the assets or shares being sold are free and clear of all third-party claims. Without first confirming that any such third-party consents or approvals have been obtained or are not required, the seller would not be able to provide such representation and warranty. This is where the deal – at the very last stage – is likely to collapse.
While there are multiple potential third-party consents that could be required to complete the sale of a business, the most likely and easiest to understand has to do with the lease.
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Most businesses and professional practices lease their place of business. That means that most businesses and professional practices are party to a commercial lease.
Such leases are rarely assignable without the landlord’s prior written consent. In some cases, the landlord won’t give their consent to assign the lease and a new lease – one with the buyer of the business – must be negotiated with the landlord before a sale can be accomplished.
And, if that’s required, there is no guarantee that the new lease will resemble the existing lease. And if that’s the case, the new lease is likely to have an impact on the business’ value.
If the terms of the lease the landlord wants with the buyer include higher rent, the discretionary earnings of the business – the number on which the business’ value is based – will decrease; a condition that will result in a lower valuation and, thus, sale price.
Stock versus Asset Sale
Now, what I describe above pertains mainly to an asset sale, one in which the assets rather than the entity is sold. A stock sale is slightly different.
In an asset sale, the business assets – but not the business entity itself – are being transferred. Such assets would include contracts that the business is party to.
In a stock sale, the assets and the entity are being transferred. If a contract – the lease in our example – is with the entity, it may not need to be assigned; it will merely transfer with all the other assets because the parties to the lease will not change. (See this post for more on an asset sale versus a stock sale.)
But the need to examine all such contracts prior to selling is equally important in a stock sale.
Because contracts – including commercial leases – are just a likely to have so-called “change of control” clauses that require the outside party to such contracts – such as the landlord in our example – to consent to the change of control (ownership) of the entity that owns the business.
If this happens, the potential downside described, above in an asset sale, exists.
Sticking with our lease example, the landlord could refuse to give its consent based on the buyer’s financial condition or the terms of the acquisition. The landlord could also condition its consent on the renegotiation of the lease. And, as before, such renegotiation would likely impact the value of the business and, thus, the acquisition price and net proceeds to the seller.
The Bottom Line
When starting the process of selling a business, you’ve got to know what ALL the business’ pitfalls and speed bumps are.
Examining every contract that the business is party to early in the preparation process is critical. You don’t want the buyer to discover problems during the due diligence period. Not only does this risk having the buyer start to question everything and looking even more deeply into every nook and cranny, it also risks the buyer’s perception of both the seller and broker as honest and forthcoming.
If you have any questions or comments on this topic – or any topic related to business – I’d like to hear from you. Put them in the comments box below. Start the conversation and I’ll get back to you with answers or my own comments. If I get enough on one topic, I’ll address them in a future post or podcast.
This week’s “Searching” item comes from a single buyer looking for a digital marketing/web design/hosting company (web hosting, search engine optimization services and/or web site maintenance with a mix of project-based revenue such as web site design and development) generating less than $500K in Discretionary Earnings. No geographic limitation. If any of you know of something that might fit, please let me know.
I’ll be back with you again next Monday. In the meantime, I hope you have a safe and profitable week.