Managing Contracts and Liabilities

Several years ago I worked with a client who was buying a franchised business in the home improvement sector.  The business was marketed as including franchise rights within a multi-state territory.  After a great deal of time and effort by the parties to negotiate terms of agreement, source financing and evaluate financials, we discovered during inspections that the seller’s franchise agreement did not in fact guarantee an exclusive territory.  While the franchisor was willing to confirm an exclusive territory to the seller, we discovered that it was not contractually able to do so, given the form of agreement that the franchisor had been using, and given that other franchisees were not adequately restricted.  Finally, some of the issues we discovered late in the process had previously been the subject of legal action.  Had all these issues been known and addressed early on, the seller and buyer would have saved a great deal in time, fees and expenses, and perhaps the buyer might not have been discouraged from buying the business despite the unavoidable contractual issues.  When these problems arise in the middle of a transaction, it is often too late to save it.

                  Each business has its own categories of key contracts which should be reviewed before the business is marketed.  For a franchise business, the franchise agreement and related agreements with the franchisor will certainly be important.  Key issues will include the remaining term of the agreement, terms for renewals, assignability, required ongoing capital expenditures, territorial protections and restrictions, and many other terms that will be considered carefully by a buyer.  For many service businesses, the length and terms of contracts with customers may be important to a buyer – although on that point, it can be persuasively argued that the goodwill and value of a business exist in its reputation for customer service, and not so much in whether the customers are tied to a contract for a set number of years.   If a source of supply is critical to maintain profitability, the seller should expect the buyer to request the supplier contract(s) and to examine them carefully.  Whatever the nature of the business and its contracts, the point is that the contracts should be examined with fresh, critical eyes, from a prospective buyer’s viewpoint.  Most contractual issues can be addressed, given sufficient time.

                  Leases are perhaps the most common form of contract, and critically important to many types of business.  Location is important for restaurants and retail businesses, and a long-term lease with adequate options will be a strong selling point, as well as a means of preserving the owner’s investment in leasehold improvements.  Favorable lease terms for other types of facilities used in operations, such as a manufacturing plant or warehouse building, will also be positive factors to buyers and important to secure long-term.  At the same time, sellers must balance the length of the leasehold commitment versus the impact on salability.  Other types of leases can be more of a burden to a business that is being sold, and the buyer should not be expected to assume them.  For example, an office lease may be of no interest to a buyer who prefers to work from home or to operate the business from another location.  Leases for equipment or software that are of no use to the buyer will be nothing more than a deduction from either the sale price or the net proceeds, depending upon who will be making the payoff.  The business owner who is contemplating a sale of the business should review all leases and make commitments carefully, possibly shoring up lease terms in some areas, understanding the perspective of a typical buyer and the impact of leasehold rights on value.

                  In preparing for future sale, a business owner should also consider what types of key contracts do not exist, but perhaps should.  In another article we discuss the importance of non-compete or non-solicitation agreements for certain types of key employees.  Many smaller companies also have key contractual relationships that exist only orally or by course of dealing.  This means that there is a “contract” based on prior discussions or historical business practices, but the terms are just not in writing anywhere.  This will be difficult for a buyer to accept, when they have nothing to confirm the terms with a key customer, supplier or other business partner beyond the selling owner’s assurances.  The buyer will be inclined to seek assurances from the buyer or supplier, which the seller will be reluctant to allow until very late in the process.  Is the business highly dependent upon intellectual property licensing arrangements?  Those licenses should be in writing and clear; otherwise, the business will undoubtedly be worth less to a buyer who cannot confirm the terms, as compared to the seller who has grown comfortable with an unwritten course of dealing.

                  Another important issue to address with contracts is assignability.  Assignment is simply the transfer of the contract to the buyer of the business assets in an asset transaction.  (In a stock sale transaction, which is uncommon for smaller business transactions, there is typically not an issue with assignment – the contracts remain with the seller’s company, which the buyer now owns after closing.  However, there still may be prohibitions on transfer of stock or other provisions of key contracts that need to be considered in a stock sale transaction.) Many contracts will not be assignable to a buyer without the other party’s consent, and the terms of the contract governing assignments should be understood early on.  The business owner should consider whether any problems should be anticipated with getting consent.  Many are the business brokerage firms who have seen a business held hostage by a landlord who refuses to allow an assignment, or to give an extended term of lease.  In some instances with smaller businesses, and frequently with larger business transactions, the contracts are so prevalent in or critical to the business that a stock sale transaction is the only viable structure.  These issues should be evaluated and understood before marketing the business.

                  With adequate time and forethought, most contractual issues can be addressed.  Further, the value of a business can be increased dramatically if key contracts are put in writing, are clear, and are of sufficient longevity.  Similarly, the value of the business (measured by net proceeds to the seller) can be maximized if the seller will limit those contracts that a buyer will not want, which will be a drag on the business at the time of sale.  As a final point, contractual issues or problems discovered during a buyer’s inspections, if not previously disclosed, will be magnified.  Even if discovered early, some contractual issues simply cannot be fixed.  However, if these issues are disclosed to prospective buyers during the marketing process and thoughtfully addressed, many can be overcome.  If nothing more, the seller and prospective buyer(s) will not have wasted a great deal of time and expense working on a transaction that will be ultimately detonated by a contractual time bomb.