The Ghost in the Deal

One of the most significant acts you will ever take as a business owner is to buy or sell a business. In order to buy or sell successfully, you need to understand the difference between formal legal rights, and practical negotiating leverage. Generally, the mind set of most business people runs along the following lines: Cliche 1: negotiating leverage determines the basic economic structure of the deal (how much money for the business, how long to pay on the Promissory Note, etc.) and that structure becomes reflected on paper in legal agreements which the parties are legally compelled to follow. In my estimation, that assumption is frequently inaccurate to the point of being just plain risky, in the same way that driving a vehicle without insurance is just plain risky.

The short explanation of why the first italicized statement is risky is captured by the following rule-of-thumb, which is so common it is also a cliché: Cliche 2: law suits are so time consuming and so expensive that no business owner ever wants to start that process.

Comparing the first cliché (negotiating leverage and legal agreements), to the second (never litigate) reveals the problem. The only way a lawyer can ‘make’ anyone do anything – like follow a written agreement – is by starting a lawsuit, which violates the second cliché. But this contradiction is rarely contemplated by business people buying and selling businesses – rather, they retain the belief that somehow, the law compels people to act in certain ways, even without a lawsuit – the “ghost” referred to in the title of this article. Business deals are made without the deal-makers thinking about how it will be enforced, because they believe that putting it in writing is self-enforcing – but nothing in a business deal is self-enforcing. Agreements are kept and followed because it is in the parties’ interest to do so, and lawsuits to compel performance are initiated only when all else fails.

That’s where negotiating leverage comes in. Negotiating leverage is not only a reflection of whether a particular buyer is more motivated to buy, or the seller is more motivated to sell. Leverage also plays through the entire transaction, from initial investigation of the business – the due diligence period – through the entire time period when payments are being made, often through a Promissory Note calling for monthly payments over a period of several years.

At the very beginning of a transaction, the prospective buyer should have most of the negotiating leverage, and it ought to be used to obtain as clear a picture as possible of the real economic value and problems of the business to be acquired. Negotiate a period of time (the due diligence period) adequate to do an exacting investigation of the seller’s business. Examine bank statements, especially the primary business checking accounts for at least the previous twelve months, customer lists (if possible, call a few customers), vendor and trade creditor accounts, business tax returns, business borrowing (how much and when), etc.

Even if the business being purchased generates substantial cash revenue, the cash has to be going somewhere – the buyer needs to find out where, how much, how often. At the beginning of a deal, the buyer has little invested but his or her time and has a lot of options (there are always other businesses to buy), so leverage is simply a matter of the buyer saying “I need to see these documents, or there is no deal.” Whether a letter of intent is used, or a negotiated purchase agreement, a seller’s failure to provide complete documents for review is almost always going to constitute a legally adequate and practically effective reason for a buyer to walk away from purchasing a business whose prospects are being exaggerated.

Once the business terms are negotiated, and adjusted to reflect any discoveries about the business the buyer may have made during the due diligence period, then leverage begins to shift. If the buyer is satisfied with the business, the seller has to be satisfied that the buyer can make the initial payment on the purchase price when the time comes to close the transaction, and can continue to operate the business effectively to continue making the payments which are typically required as part of the purchase price. This is where the seller has to show foresight – if the buyer cannot come up with the initial payment, the transaction isn’t going to close at all. In large mergers, companies often demand a ‘break-up’ fee if a proposed merger fails to happen. A seller may well bargain for a type of break-up fee if the buyer fails to come up with the initial cash to close. However, at least the seller has the business back, albeit that it probably has not been run as aggressively as it might have been.

But what if the buyer doesn’t run the business effectively after the deal closes, or doesn’t make timely payments on the Note? The deal may also call for the seller to have access to business records, collect certain open accounts receivable, or require other types of participation and disclosure from the buyer, but what if the buyer doesn’t cooperate? Does the seller have any negotiating leverage left? Legally, one thing the seller can do in Pennsylvania is bargain for ‘confession of judgment’ clauses on the Promissory Note. Confession of Judgment clauses are powerful because they allow a judgment to be entered without a lawsuit, but the rules regarding execution on a confessed judgment are complex.

Another substantial type of bargaining leverage a seller may retain is the right to demand mediation, or arbitration, or the right to file a preliminary injunction with an award of attorney’s fees possible for the prevailing party, to compel a meeting of the parties or disclosure of business activity. The important issue for the seller is to think about enforcement and leverage to make the agreed-upon events happen without a lawsuit, before the purchase agreement is signed and the deal closes. The seller should start by asking himself, ‘how realistic are my requirements of the buyer after he or she gets the business – what are my steps if the buyer isn’t cooperative?’ The idea is to have some ‘in-between’ types of remedies – more substantial than merely asking the buyer to cooperate and sending unpleasant correspondence if he or she does not, but less drastic and expensive than engaging in full-scale litigation.

The same forethought is required of the buyer, if obtaining the seller’s cooperation after the deal closes is important (e.g., if the seller has to stay on to consult and assist and work with customers, or if the seller has agreed to a non-compete provision which is important). Since the buyer usually has continuing payment obligations under the Note, often simple negotiation can permit the buyer to withhold payments (a setoff) if the seller is in substantial breach of his or her post-closing obligations.

As a sage once said of marriage – and I say of the purchase and sale of a business – proceed in haste, repent at leisure. Optimism is a wonderful business characteristic which you can retain, without sacrificing the foresight necessary to protect yourself. Once the potential problems are identified, usually skilled negotiation will bring about a business posture that allows either party to bring pressure on the other to perform what was already agreed to, without the necessity of the ‘big, expensive lawsuit.’