What do I need to know before I buy or sell a business?
Buying or selling a company (commonly referred to as mergers and acquisitions or “M&A”) is one of the most significant and complex decisions a business owner will ever face. Navigating this process requires careful planning, thorough due diligence, and experienced legal guidance.
This article outlines the key legal steps and considerations for M&A transactions, including how to structure the deal, what documents to prepare, and which certificates or regulatory clearances may be required specifically for Texas businesses.
Phase 1: Pre-Offer Preparation and Due Diligence Readiness
Before any offer is made, the parties must lay the groundwork for a successful merger or acquisition. For a seller, this phase is about maximizing value and minimizing risks that could derail a deal. For a buyer, it’s about initial research to inform the offer.
Assembling Your “Deal Team”: Both sides need a team of trusted professionals, including:
M&A Legal Counsel: To draft, review, and negotiate all contracts, and manage legal due diligence.
CPA and Financial Advisor: To manage financial and tax diligence, and prepare valuation and purchase price calculations.
Preparing for Diligence (Seller): A seller should begin preparing a “data room” with organized financial statements, tax returns, key customer and vendor contracts, employee agreements, intellectual property registrations, and corporate records (e.g., minute books) of the target company. A buyer will request these documents during the diligence phase, and taking a proactive approach streamlines the process and instills confidence in a buyer.
Confidentiality: Before sharing any sensitive information, a buyer must sign a Non-Disclosure Agreement (NDA). This legally binding contract protects the seller’s proprietary information, regardless of whether the deal closes.
Analyzing Structure: Asset Sale vs. Stock Sale
A critical early decision for both parties is determining the transaction structure. The two primary structures are the asset sale and the stock sale, and the choice significantly impacts tax obligations and liability exposure. The final decision often comes down to the negotiation leverage of each party and the need to balance these competing interests.
Comparing Asset Sales and Stock Sales
Buyers typically prefer an asset sale due to the ability to “cherry-pick” assets and assume only specified liabilities, offering a cleaner break from the seller’s historical legal risks. They also benefit from the favorable step-up in basis for tax purposes.
Sellers typically prefer a stock sale because it simplifies the closing (e.g., no need for numerous contract assignments) and usually results in better tax treatment with a single-level of taxation at the owner level.
Phase 2: Drafting and Negotiating the Letter of Intent or Term Sheet
Once initial interest is established, the buyer will submit a proposal, often in the form of a Letter of Intent (LOI) or a Term Sheet, to outline the parties’ agreement on fundamental terms before committing resources to a definitive purchase agreement.
While the names are often used interchangeably, there are subtle differences in convention and presentation between an LOI and a Term Sheet:
Letter of Intent: Usually drafted in the form of a letter from the buyer to the seller. It often includes introductory and concluding formalities and may be written with more narrative prose, making it feel more like a formal proposal.
Term Sheet: Usually presented in a more concise, bulleted or outline format. It focuses on the economic and structural points and is often favored by financial buyers (e.g., private equity funds) for its brevity and efficiency.
In Texas, either format is acceptable and both are commonly used. Regardless of the format, the core function of both documents is identical: they set the foundational terms for the transaction and serve as the initial blueprint of the deal.
Binding vs. Non-Binding Terms
The LOI or Term Sheet is generally non-binding regarding the ultimate purchase obligation. However, it must clearly set forth the proposed deal terms, which typically include:
Purchase Price: The proposed price, including payment terms and mechanisms for any escrows or holdbacks.
Transaction Structure: A proposal on the transaction structure (e.g., asset sale vs. stock sale).
Closing Timeline: The anticipated timeline for the transaction.
The document must clearly specify which provisions are legally binding. The most notable binding clauses typically are:
Confidentiality: This clause reinforces the protections established by the prior Non-Disclosure Agreement.
Exclusivity: This provision is vital for the buyer, as it requires the seller to cease all negotiations with other potential buyers for a specified period. This gives the current buyer the necessary time and confidence to invest in the detailed due diligence process.
It is essential to have legal counsel review the LOI or Term Sheet before signing. Even non-binding terms create strong expectations that are difficult to change later in the negotiation process. Legal review ensures that the binding clauses (especially exclusivity and confidentiality provisions) protect the client’s interests and that the structural terms align with the client’s overall tax and liability strategy.
Phase 3: In-Depth Due Diligence
The diligence phase is critical in any M&A transaction. It helps uncover hidden issues, verify representations, and ensure that the buyer is making informed decisions while giving the seller a chance to demonstrate transparency. With diverse industries and complex regulations at play, this process often involves collaboration between legal, financial, and operational experts to mitigate risks and pave the way for a successful transaction.
During diligence, the buyer conducts a thorough investigation and analysis of the target company’s financial condition, legal status, operations, and potential risks by meticulously reviewing the seller’s business records. Key areas to focus on include:
Legal & Corporate: Review of the target company’s formation and governing documents, capitalization, and litigation history.
Financial & Tax: Verification of earnings, review of accounting practices, and tax compliance.
Operational & Commercial: Assessment of key personnel, customer concentration, and physical assets and review of material contracts (especially those needing third-party or change-of-control consents), licenses, and permits.
Lien Searches and Clearance: The buyer must ensure that the assets being acquired are free and clear of unassumed third-party security interests or liens (such as tax liens, mortgages for real estate, or any liens filed under the Uniform Commercial Code (UCC)).
Remedies: If liens are discovered, the closing is typically contingent upon them being properly released. The most common solution is for the seller to provide pay-off statements from the creditors (e.g., banks). The buyer then uses a portion of the purchase price at closing to pay these outstanding debts directly to the creditors, ensuring the liens are simultaneously released as ownership transfers.
Texas Certificates
For Texas entities, parties will typically request certain certificates from the Texas Secretary of State or Texas Comptroller to verify an entity’s compliance with certain state requirements. These certificates are typically provided at or shortly before closing as a closing deliverable.
Certificate of Fact (Certificate of Good Standing): Issued by the Texas Secretary of State and verifies that the entity legally exists, is authorized to conduct business in Texas, and includes details such as the entity’s formation date, type, and current status. Both the buyer and seller are typically responsible for obtaining their own Certificates of Fact to confirm their legal status and good standing at the time of the transaction.
Tax Certificates: Issued by the Texas Comptroller and verifies that applicable state taxes have been satisfied. The type of tax certificate required varies depending on the structure of the transaction.
Certificate of Account Status: Required when a Texas entity terminates (e.g., merges or converts into another entity). Confirms that the entity has paid all applicable state taxes (primarily franchise taxes) and is otherwise in compliance with Title 2 of the Texas Tax Code.
Certificate of No Tax Due: Requested when an existing business or its assets are being sold. Provides broader tax clearance confirming that all applicable state taxes (e.g., franchise, sales and use) have been paid.
This is a critical document for M&A transactions in Texas. Without it, the buyer would be liable for any previous unpaid taxes of the seller. This concept is referred to as successor liability. Both buyer and seller must jointly submit a request for this certificate prior to closing to ensure the buyer is not accountable for the seller’s outstanding tax debts.
Diligence findings often drive the final deal terms. If a significant issue is discovered (e.g., pending litigation or an expired key contract), the buyer may demand a price adjustment or require specific indemnification provisions in the final contract to cover the risk.
Phase 4: Negotiating the Purchase Agreement
The purchase agreement is the definitive, legally binding contract for the transaction and details every term and condition for the sale, including the purchase price, payment structure, closing date, and any warranties or contingencies. Negotiations require careful attention to detail to ensure that both buyer and seller clearly understand their rights, responsibilities, and protections.
Skilled legal counsel is essential at this stage to tailor the agreement to the nuances of the transaction, address potential risks, and help both parties reach an agreement that facilitates a smooth and successful transfer of ownership. For entities in Texas, the parties must ensure that all documentation complies with relevant state laws (e.g., Texas Business Organizations Code (BOC)), including those governing corporate formation, consents, and real property transfers.
The Purchase Price
The purchase agreement should outline how and when the final purchase price is calculated and paid.
Calculation: The initial valuation of a target company is rarely the final price paid. The price is usually calculated by taking the enterprise value (i.e., the gross market value) of the target company and making adjustments as of the closing date:
Cash and Debt Adjustments: The purchase price is typically calculated on a “cash-free, debt-free” basis. This assumes the seller will retain all cash and pay off all indebtedness (e.g., bank loans, capital leases) of the target company at or before closing. The purchase price is therefore reduced by the amount of the target company’s outstanding indebtedness and increased by the amount of cash remaining in the business at closing.
Working Capital Adjustment: This is the most common post-closing adjustment. The parties will initially agree to a target amount of net working capital (i.e., current assets minus current liabilities). If the working capital at closing is below the target, the purchase price is reduced; if it is above, the purchase price is increased. This ensures the buyer receives enough short-term capital to run the business immediately post-closing.
Transaction Expense Adjustment: The final purchase price is also reduced by the seller’s unbudgeted transaction expenses (e.g., investment banker fees, seller-side legal and accounting fees) that remain unpaid at closing. This ensures these costs are borne by the seller, as negotiated, and do not become a post-closing liability for the buyer.
Purchase Price Allocation: In an asset sale (or any deemed asset sale for tax purposes), the parties must agree on how the total purchase price is allocated among the acquired assets for tax reporting purposes. This allocation determines the buyer’s tax basis in the assets, which impacts future depreciation and amortization deductions, and the seller’s gain or loss on each asset.
Payment Structure and Financing: The agreed-upon purchase price can be funded through a variety of sources:
Cash: A lump sum payment funded by the buyer’s existing cash reserves or third-party financing (e.g., from a bank or private equity lender). If the buyer is using third-party financing, the closing is often conditioned upon the buyer successfully obtaining this financing.
Seller Financing: The seller provides a loan to the buyer for a portion of the purchase price, usually secured by the assets of the company being sold. This often signals the seller’s confidence in the business’s future success. The timing of payments from the buyer may defer gain recognition on the transaction, but any interest payments received would be taxed at ordinary rates.
Buyer Equity: The buyer issues its stock or equity interests to the seller as a portion of the purchase price, rather than just paying cash. The equity that the seller receives is commonly referred to as rollover equity. This provides the seller with ongoing ownership in the combined or acquiring entity, often used to align incentives for post-closing growth and can offer deferred capital gains tax treatment.
Earnouts: A portion of the purchase price is contingent on the business achieving specific financial milestones (e.g., revenue or EBITDA targets) in the years following the closing. This mechanism is used to bridge valuation gaps and can incentivize the seller to assist in the business’s post-closing performance.
Timing of Closing and Implications
The parties will need to agree on when the transaction becomes effective (i.e., when the transaction will close). This can either be on the date the parties sign the agreement or at a later date.
Simultaneous Sign and Close: All documents are signed and the money and ownership change hands immediately. In this scenario, representations and warranties are only true at the moment of closing, and interim covenants are usually unnecessary. This timing is typically used in smaller, less complex deals.
Staggered Sign and Close: The documents are signed first, but the transaction is not effective until a later date. The period between signing and closing requires robust interim covenants governing the seller’s operations to ensure the business is preserved, and the parties must certify that all representations and warranties remain true as of the closing date (a “bring-down” condition). This timing is typically needed for complex transactions requiring regulatory approvals, third-party consents (e.g., from lenders or key customers), or financing.
Representations and Warranties
Representations and Warranties (R&Ws) are factual statements made by the parties. Both buyers and sellers typically attest that they are in good standing legally. The seller’s R&Ws typically concern the condition of the business (e.g., that the financial statements are accurate). The buyer’s R&Ws typically concern their ability to close the deal (e.g., having the necessary funds).
Disclosure Schedules are attached to the Purchase Agreement and are used by the seller to qualify or limit their R&Ws. For example, if an R&W states, “The Company is not in breach of any material contract,” the seller would use the disclosure schedule to list the specific material contracts where a breach has occurred. Disclosures prevent the buyer from later claiming a breach of an R&W for a matter of which they were specifically informed prior to signing.
Breaches of R&Ws (other than scenarios disclosed on the Disclosure Schedules) often trigger an indemnification claim post-closing.
Covenants
Each party will make certain promises about what they will or will not do both before and after closing.
Interim Operating Covenants (for Staggered Sign and Close Agreements): Govern how the seller must operate the business between signing the Purchase Agreement and closing (e.g., operating in the ordinary course, refraining from extraordinary expenditures).
Tax Covenants: Critical for defining responsibility for taxes of the target company post-closing. They typically specify:
Which party is responsible for preparing and filing tax returns for the target company up to the closing date.
How taxes attributable to the pre-closing period will be calculated.
How tax refunds or credits received post-closing, but attributable to the pre-closing period, are handled.
Restrictive Covenants: Post-closing agreements are often included to protect the value of the acquired company. These typically include:
Non-Competition (Non-Compete): Restricts the seller from engaging in a similar business for a set period within a defined geographic area. In Texas, these must be reasonably limited in scope, time, and geography to be enforceable.
Non-Solicitation (Non-Solicit): Prevents the seller from poaching the acquired company’s employees or clients for a specified duration.
Conditions to Closing: Specific requirements that must be met before either party is obligated to close the deal (e.g., receipt of third-party consents, no “Material Adverse Change” in the business, and the truth and accuracy of all R&Ws).
Indemnification
The indemnification provisions govern how the seller will compensate the buyer for unknown or undisclosed liabilities relating to the business prior to closing and how the parties will compensate each other for losses arising out of breaches of R&Ws or covenants.
Survival Periods: Specify the duration during which a party can bring a claim for a breach of an R&W (typically 12-24 months). After this period, the R&W expires and no losses can be recovered. However, certain representations, including the ownership of stock and the authority to transact, are considered to be “fundamental” representations and typically survive indefinitely or for the applicable statute of limitations. The representations included as a fundamental representation are typically negotiated between the parties.
Limitations on Indemnification: The parties can negotiate financial limits on indemnification claims. However, these limits typically do not apply to fundamental representations.
Basket (or Deductible): A threshold amount of losses a party must incur before the indemnifying party is obligated to pay. This may be a “tipping basket” (if the threshold is met, the indemnifying party pays for all losses) or a “true deductible” (the indemnifying party only pays losses exceeding the threshold).
Cap (or Maximum Liability): The maximum aggregate dollar amount the indemnifying party can be required to pay for breaches of R&Ws and covenants (for sellers, this is typically a percentage of the purchase price for R&Ws other than fundamental representations, with an overall purchase price cap for all losses).
Representation and Warranty Insurance (RWI): Buyers often secure R&W insurance to cover potential losses from seller’s R&W breaches. This allows the seller to walk away with more proceeds at closing, as the insurer takes on most of the indemnification risk, often leading to lower caps and baskets for the seller.
Post-Closing Dispute Resolution
The parties will need to agree on how to manage post-closing disagreements. Most frequently, parties will agree to arbitration or mediation clauses to minimize costly litigation and preserve ongoing business relationships. The choice of forum, governing law, and procedures should be clearly outlined in the purchase agreement to protect both the buyer and the seller from protracted conflicts.
Phase 5: Closing
The closing is the formal event where the transaction documents are signed. The specific documents required may vary depending on deal structure, industry, and jurisdiction, but the list below represents the core closing package in a typical M&A transaction:
Definitive Agreements: The main purchase agreement, detailing all terms, representations, warranties, indemnities, and covenants.
Disclosure Schedules: Attachment to the purchase agreement, providing detailed disclosures about exceptions to representations and warranties.
Corporate Authorizations: Secretary’s certificate and board resolutions from buyer and seller authorizing the transaction and signatories.
Closing Certificate (or Officer’s Certificate): Certificate confirming accuracy of representations at closing and compliance with closing conditions.
Assignments and Transfers: Documents to assign contracts, intellectual property, leases, licenses, and transfer ownership including bills of sale, stock certificates, or deeds.
Consents and Approvals: Required consents from third-parties such as landlords, customers, suppliers, regulators, or lenders.
Employment and Consulting Agreements: New or transitional employment contracts or consulting agreements for key employees or managers.
Restrictive Covenants: Non-competition, non-solicitation, confidentiality, and similar agreements for key employees.
Financing Documents: Loan agreements, promissory notes, and security agreements related to transaction financing.
Escrow Agreements: Agreement with an escrow agent, if a portion of the purchase price will be held back (e.g., to satisfy certain obligations or R&W breaches).
Closing Statements: Final breakdown of purchase price adjustments, working capital, and transaction costs.
Tax and Corporate Documents: Updated tax clearance certificates and withholding documents (e.g., Form W-9, FIRPTA certificate), affidavits of title, updated organizational/governing documents.
Regulatory Filings: Filings regarding the transaction required to be filed with or obtained by governmental authorities, including securities filings, tax filings (e.g., applicable tax elections), antitrust clearances, and certifications for compliance.
Ancillary Documents: Transition services agreements, earnout agreements, releases, indemnity agreements, intellectual property assignments, license agreements, and stock option plans.
Phase 6: Post-Closing Obligations
The deal is closed, but final responsibilities remain. Both parties often work with their legal counsel and financial advisors to track and reconcile post-closing obligations, manage disputes over purchase price adjustments, and ensure compliance with legal and contractual terms. These obligations ensure the parties honor their commitments beyond the closing date, facilitating a stable ownership transition and reducing the risk of future litigation.
Post-Closing Adjustments: The parties will need to finalize the purchase price adjustments, through which the final price may be adjusted up or down based on the company’s cash, indebtedness, working capital, and transaction expenses at closing.
Earnout Compliance: The parties will need to provide and review financial or operational information and cooperation for earnout calculations and payments, if applicable.
Escrow Release: If a portion of the purchase price is held in an escrow account to secure the seller’s indemnification obligations or to cover the purchase price adjustment, the money should be released to the appropriate party in accordance with the terms of the escrow agreement.
Transition Services: The seller may be required to provide transition services for a set period to ensure a smooth handover of operations, client relationships, and systems.
Buying or selling a business in Texas is a multifaceted process that requires careful planning, detailed due diligence, and strategic negotiation at every stage. Engaging experienced legal counsel throughout ensures that your unique business goals and interests are protected, potential risks are mitigated, and compliance with Texas-specific regulations is maintained. By understanding these key steps and considerations, business owners can confidently approach the buying or selling process with clarity and control, ultimately facilitating a smooth transition of ownership and laying the foundation for future success.
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Disclaimer: This article is for general informational purposes only and does not constitute formal legal advice.