Selling or Buying Small and Medium Sized Businesses in San Jose through Asset Sales

An asset sale is a common method for transferring business ownership. It involves the business entity selling its assets to a new entity organized by the buyer rather than the business owner selling his or her ownership of business entity (its stock if organized as a corporation or its membership interests if organized as a limited liability company). For business purchase and sale transactions in San Jose, as elsewhere, precisely documenting the transaction and having the information to adeptly resolving legal items as they arise without jeopardizing deal momentum are key factors for a successful outcome. San Jose business attorneys such as DPA Law PC can help guide your management of the business asset purchase and sale process.

Understanding Asset Sales

In an asset sale, the selling owner causes the business entity to sell and transfer specific business assets and liabilities to a new entity owned by the buyer. This involves a detailed agreement which, when done properly, clearly indicates which assets and associated liabilities are and are not being transferred to and assumed by the buyer. The assets acquired may include tangible assets like equipment, inventory, and real estate, and intangible assets such as customer lists, certain contract rights, trademarks, and other intellectual property together with the business’ goodwill as a going concern.

Generally, buyers favor an asset purchase and sale transaction over buying the seller’s ownership of the business entity itself.

Advantages for Buyers

Selective Purchase: Buyers have the opportunity to selectively purchase the business’ beneficial assets. This level of control permits minimizing risk to a degree by acquiring only those assets that are beneficial while largely (but not entirely) avoiding unwanted and unknown liabilities arising from the business’ past operations and legal history.
Depreciation Benefits: Assets acquired in an asset sale can usually be depreciated from their fair market value at the time of purchase regardless of the depreciation previously taken by the seller – a so called stepped-up tax basis. If the business is heavy on tangible assets – equipment, real property, paid off vehicles, product components and tangible work-in-progress – depreciation from stepped-up basis can lead to significant future tax savings.

Certain Potential Disadvantages for Sellers

Potential Tax Implications: In an asset sale transaction, the seller may encounter less favorable tax consequences compared to selling his or her ownership of the business entity as a whole. Gains on assets held for less than a year are taxed as regular income, while assets held longer than one year are subject to long-term capital gains tax treatment.
Transfer Complexity: Compared to transferring the business entity as a whole, the process of selling individual assets often requires more planning and more granular agreement drafting. This includes identifying the particular liability associated with each asset to be transferred and assessing whether any asset is subject to transfer restrictions. Certain assets – like key service contracts, customer contracts, and leases may by their terms be expressly nontransferable. Certain other assets may need to be separately valued, while the transfer of legal titles, registrations, or key licenses can be administratively burdensome. Experienced business law attorneys such as DPA Law PC know the legal and deal mechanisms to minimize and overcome transfer obstacles.
Potential for Residual Liabilities: Generally, in an asset transaction, the buyer only assumes – in whole or in part – the selling entity’s liabilities associated with the particular assets acquired and, generally, only with respect to such liabilities that first arise from the business’ operation after the closing date. This can leave the seller with greater residual liabilities than preferred when compared to the transfer and sale of the business entity itself. The allocation of liabilities and mechanisms to protect a party post-transaction from under arising under liabilities assumed or retained by the other party are often heavily negotiated items.

Market Considerations for Asset Purchase and Sales in San Jose

San Jose is home to approximately 66,000 businesses employing more than 439,000 workers. The vast majority of these are privately held small and medium sized enterprises. According to Forbes, San Jose is among the best cities in the U.S. for small businesses characterized by high average annual revenues, a skilled workforce, and an active market for resale of businesses.

Asset Valuation and Business Brokers

Business brokers participate in the majority of business purchase and sale transactions in the greater San Jose area. As intermediaries, they make a market for business sales transactions by assessing a business’ general market value and listing it for sale. Brokers leverage their personal networks and market knowledge with subscriptions to databases with information on prior sales of similar businesses.

The more active brokers are also generally well connected with one or more business bankers at banks active in funding business acquisitions through Small Business Administration (SBA) loans. They brokers also generally tend to be reasonably diligent and compliant with standards for ethical conduct and fiduciary duties imposed by California’s Business and Professions Code. Such compliance can become sensitive when, as is often the case, a broker acts as a dual broker representing both buyer and seller in the same transactions.

Contracts and Agreements

Drafting and reviewing asset purchase agreements is a precise task. These agreements should, among other things, clearly delineate the financial and payment terms of the sale – including any seller carryback financing, the assets included and excluded from the sale, the liabilities retained by seller and those assumed by seller, the warranties and representations made by seller with respect to the business and its assets as well as the duration they survive post-closing, reciprocal indemnification covenants and by whom (the buying or selling entity and/or their controlling owners), the limitations on remedies post-closing, and the precise conditions that must be satisfied or waived before the seller or buyer is required to proceed to closing. There is no single articulation for any of these items, but multiple variations often along a continuum from being pro-seller to pro-buyer.

That said, the business broker’s industry association provides brokers with template form business purchase and sale agreements for use in asset purchase and sale transactions. Because they are templates and brokers are not attorneys, these forms are of the check-the-box / fill-in-the blank format. A largely one-size fits all template can work well enough for many asset purchase and sale transactions. It can also work well enough in other transactions for many of the items that should be addressed – but not all items.

The challenge for a seller or buyer presented with a template agreement, however, is they won’t necessarily know the alternative ways matters covered could be handled or additional terms the template doesn’t address or doesn’t fully address. This is the case even though these alternative or additional terms, if known and utilized, would facilitate a smoother transaction, more clearly delineate rights and obligations reducing the likelihood of down-stream disputes, or, better protect one party or the other, or both.

This, in my opinion, is where involving experienced and cooperative business contract lawyers like DPA Law PC can provide valuable assistance. Ideally, the association occurs before the form agreement is signed. However, we are frequently brought into a transaction by a seller or buyer after the form asset sale agreement is signed to assist with the negotiation and drafting of seller carry-back notes and security agreements, to clarify and address by amendment matters that are delaying the close – such as negotiating with a less then cooperative landlord, addressing the transfer/assumption of a franchise, providing more complete statements of employment or indemnification rights, working out the details of WIP allocations and credits, coming up with work arounds where there is an obstacle with the assignment of a necessary license or third-party contract, or, resolving issues that arise during post-signing due diligence which sometimes merit a purchase price adjustment possibly with an earn-out as a work-around. In other occasions the SBA lender financing the majority of purchase price will require the participation of borrower counsel during loan documentation and approval process.

Steps to Facilitate an Asset Sale

While the particulars of each transaction will differ, the purchase and sale of small and medium sized businesses in San Jose through an asset sale generally involve certain common steps.

Preparation and Planning: Before initiating an asset sale, it’s likely that the seller will interview and ultimately engage the services of a business broker. The broker generally works on commission charging about 10% of the purchase price. There are some nuances with respect to when that percentage applies to sales proceeds that are not received at closing or are contingent – for instance under seller carry-back financing or under earn-outs. Most brokers can help assess, and, where necessary, guide cleanup of the selling entity’s financial statements that support the business’ valuation.A buyer looking to buy a business may consult a business broker to locate possible acquisition targets. Generally, brokers will assist a potential buyer with respect to that broker’s listings – but often not those of listed with other brokers. If a match is identified the buyer does not pay the broker, the seller would. So, buyers generally establish relationships with more than one business broker letting them know the type of acquisition target that interests them. However, there are buy-side brokers who for a fee will call potential targets on behalf of the buyer and attempt to interest the business owner in selling.
Valuation and Pricing: If one is the seller, a reasonably accurate valuation of the business and, as applicable, of particular assets, requires professional input and market analysis. The seller will generally work with his listing broker for this input. If the purchase price is funded by an SBA loan, the lender will conduct its own valuation.
Drafting Agreements: Comprehensive purchase agreements protect both buyer and seller. These documents should detail the terms of the sale, included and excluded assets and liabilities, warranties, indemnity provisions and the like. Buyer can generally benefit and accelerate the process by seeking review by a qualified business and purchase and sale attorney before signing the broker’s template form.
Due Diligence: Buyers should conduct thorough due diligence to assess the value and condition of the assets and risks associated with the business as a whole. Sellers must be prepared to provide all necessary documentation and disclosures. Informed sellers frequently involve counsel in due diligence review of leases and intangible assets consisting of IP rights, major vendor agreements, major customer agreements, commitments to issue equity interests, and any agreement containing warranties or indemnification obligations. Knowledgeable buyers will also conduct a serious assessment with respect to any worker wage and benefit issues because, notwithstanding, the transaction being structured as an asset and not stock purchase, California courts can, and do, hold buyers liable under theories of successor liability for the seller’s labor code violations.
Funding. Most small and medium sized asset purchase transactions in excess of $1,000,000 are funded in material part by SBA loans. Lenders frequently require that borrower be represented by counsel and often require adjustments or additions to the asset purchase agreement, the negotiation and documentation of which can often best be facilitated by an experienced asset purchase and sale attorney.
Escrow. Regardless of whether real property is being transferred or not, the services of a professional escrow officer should be utilized and will be required if an SBA lender participates. The escrow officer receives and holds the purchase price deposit(s) and closing funds, distributing them after all closing conditions are satisfied or waived in accordance with deal instructions. It also obtain certain clearance letters from state labor and taxing authorities and, if applicable, processes bulk sale notices and claims.
Closing the Deal: Once all terms are agreed upon, the final step is to close the deal and transfer ownership. This involves signing ancillary legal documents including a bill of sale, satisfying conditions for closing, and ensuring compliance with regulatory and funding requirements. It may also involve a hold-back of an agreed portion of the purchase price pending clearance letters from state labor and taxing authorities, resolution of certain specified risk items, or the passage a specified period of time. The hold-back is a fund used to satisfy certain contingent or potential claims arising from the business’ prior operation, which, to the extent not used, gets paid to the seller.

Ensuring a Successful Asset Sale

Selling or buying a business through an asset sale requires careful planning and meticulous legal documentation. While the process is often initiated and facilitated by a business broker, engaging the services of a business lawyer specializing is such matters with the experience to work effectively and cooperatively with all participating parties can help ensure that all aspects of the sale are handled professionally, deal momentum is maintained, and potential risks and liabilities appropriately mitigated.

DPA Law PC offers services are tailored to the needs of startups, private companies, and entrepreneurs handling complex business transactions. Our firm’s experienced attorneys in San Jose, CA, can provide the guidance and support necessary to facilitate a successful asset sale. If you’re considering buying a business or selling your business in the greater San Jose area, contact us today to discuss how we can assist you.