Legal Considerations When Selling Your Business

by Janice L. Miller

Selling a business requires careful planning in terms of its legal, financial, and operational aspects. Whether you are a founder looking to exit, a shareholder seeking liquidity, or a corporate entity shifting its strategy, it is essential to ensure compliance with corporate laws and protect your financial interests. Mistakes during this process can result in costly legal disputes, regulatory scrutiny, and liabilities after the sale is completed.

To successfully navigate this journey, sellers need to understand the legal landscape that governs business transactions. Here is a non-exhaustive list of some key legal considerations for selling your business, whether you are a small business owner or managing a mid-sized enterprise.

Sale Structure: Asset Sale vs. Stock Sale
The transaction’s structure sets the foundation for the entire sale process. Sellers and buyers must decide whether the deal will be an asset sale or a stock sale (equity sale)—each with its implications for taxation, liability, and business continuity.

Asset Sale
In an asset sale, the buyer acquires selected assets and assumes certain liabilities, while the seller retains ownership of the legal entity. It allows buyers to cherry-pick desirable assets and minimize exposure to potential unknown liabilities. However, sellers may face double taxation in asset sales if the business is a C corporation. The entity is taxed on the sale of its assets, and shareholders are taxed again when proceeds are distributed. For example, if a company sells its intellectual property, customer contracts, and inventory separately, each asset may be taxed differently—some as ordinary income and others as capital gains.

Buyers have the advantage of greater control over which assets and liabilities to assume, as well as a reduced risk of inheriting unknown liabilities.

Stock Sale
A stock sale transfers ownership of the company’s shares or membership interests. It allows the buyer to acquire the entire entity with all its assets and liabilities. Stock sales tend to be more advantageous for sellers.  They generally result in capital gains treatment and limit post-sale tax exposure. However, buyers may hesitate to pursue stock deals due to the risk of inheriting hidden liabilities. When Google acquired YouTube in 2006 for $1.65 billion, it opted for a stock sale, allowing Google to assume ownership of YouTube’s platform, intellectual property, and user base while also taking on potential legal liabilities, for example related to copyright infringement. In this case, the sellers have the advantage of capital gains treatment (lower tax rate) and simpler transfer of business continuity. The buyers will face challenges in inheriting all existing liabilities and may struggle to resolve past compliance issues.

Before deciding on the sales structure that works best for your business, consult with corporate and tax attorneys and tax advisors at the beginning of the process to determine which one aligns most closely with your financial and operational goals.

Due Diligence: Preparing for Buyer Scrutiny
Due diligence involves the buyer thoroughly investigating every aspect of the business to assess its value, risks, and compliance history. Sellers should conduct pre-sale due diligence to identify and address potential red flags before they become deal breakers.

Key Areas of Due Diligence

• Corporate Governance: Ensure that articles of incorporation, bylaws, shareholder agreements, and board resolutions are current and accessible.
• Financial Records: Prepare audited financial statements, tax returns, and cash flow analyses to demonstrate the economic health of the business.
• Contracts and Agreements: Review vendor, customer, lease, and partnership agreements for assignability and change-of-control provisions.
• Intellectual Property (IP): Verify ownership and protection of patents, trademarks, copyrights, and trade secrets.
• Regulatory Compliance: Confirm compliance with industry regulations, employment laws, and data privacy standards.

In 2020, Visa announced its acquisition of fintech startup Plaid for $5.3 billion. Visa’s due diligence uncovered concerns about potential antitrust implications and data privacy compliance. These concerns led to increased regulatory scrutiny,  causing the deal to be abandoned after the DOJ filed a lawsuit.

Valuation and Purchase Price Allocation
Determining the proper valuation is necessary, as it affects the purchase price and allocation among the business’s assets. Purchase price allocation (PPA) can impact tax liabilities for both buyers and sellers.

Methods of Valuation

• Earnings Multiples: A multiple of EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization) is often used for service-based or SaaS businesses.
• Asset-Based Valuation: For asset-heavy businesses, valuations are based on the fair market value of both tangible and intangible assets.
• Discounted Cash Flow (DCF): A DCF model estimates future cash flows and discounts them to present value to determine the business’s worth.

Purchase Price Allocation (PPA)
IRS regulations require buyers and sellers to allocate the purchase price across different asset classes, including tangible assets, goodwill, and non-compete agreements. Improper allocation can lead to audits and penalties. Disney’s acquisition of 21st Century Fox is a perfect example of this scenario. When Disney acquired 21st Century Fox for $71.3 billion in 2019, they allocated a significant portion of the purchase price to intangible assets, including Fox’s content library and intellectual property. This strategic allocation enabled Disney to optimize its post-deal tax treatment.
 

Employee and Stakeholder Considerations
The sale of a business impacts employees, key executives, and stakeholders in multiple ways. Failure to address their interests can lead to operational disruption, reputational damage, and even litigation.

Employee Contracts and Change-of-Control Provisions: Review existing employment agreements to identify change-of-control clauses that may trigger severance payments, stock option acceleration, or termination rights. For larger transactions, compliance with the Worker Adjustment and Retraining Notification (WARN) Act requires 60 days’ notice before mass layoffs or facility closures.

Non-Compete and Non-Solicitation Agreements: Buyers often require sellers to sign non-compete and non-solicitation agreements. It prevents them from starting a competing business or poaching clients after the sale. Generally, courts enforce these agreements if they are reasonable in scope, duration, and geography, but each state is different so consult with your advisors.

Negotiating the Purchase Agreement
The purchase agreement is the definitive document that governs the terms of the sale and protects the interests of both parties. It typically includes:

• Representations and Warranties: The Sellers make certain assertions about the business’s condition, financials, and compliance status. Any inaccuracies can lead to post-closing claims.
• Indemnification Provisions: Buyers often seek indemnity clauses to protect themselves against potential breaches or undisclosed liabilities that may arise after closing.
• Earnouts and Contingent Payments: A portion of the purchase price may be contingent upon the business achieving specific performance targets after the sale.

Compliance and Regulatory Considerations
Regulatory compliance is crucial, particularly in the finance, healthcare, and telecommunications sectors. For larger transactions, compliance with the Hart-Scott-Rodino Antitrust Improvements Act (HSR Act) is mandatory to prevent anti-competitive practices. Failure to comply can result in substantial fines and delays.

Post-Closing Obligations and Transition Planning
Even after closing, sellers may have ongoing obligations. This includes Transition Services Agreements (TSAs), escrow arrangements, and non-compete agreements. TSAs ensure operational continuity by allowing the seller to provide support during the handover period. For example, Amazon’s acquisition of Whole Foods in 2017 included a TSA that allowed Whole Foods to continue using its existing IT systems and supply chain infrastructure while Amazon integrated its technology platform.

Selling your business is a complex, multifaceted process that requires strategic legal guidance. By proactively addressing these legal considerations, sellers maximize the value of their business while minimizing post-sale risks. Engage experienced corporate attorneys, tax advisors, and M&A consultants to ensure your sale is legally sound and tailored to your long-term goals.

Sources:

Internal Revenue Code (IRC) Section 1060
Purchase Price Allocation (PPA) in asset sales, IRS - Section 1060 Guidance

Hart-Scott-Rodino Antitrust Improvements Act (HSR Act)
Antitrust review for mergers and acquisitions, Federal Trade Commission (FTC) - HSR Act

Worker Adjustment and Retraining Notification (WARN) Act
Employee considerations during mass layoffs or closures U.S. Department of Labor - WARN Act.

Case Law: United States v. AT&T Inc. (2018)
Antitrust considerations in large-scale mergers: DOJ Case Summary

Case Study: Google’s Acquisition of YouTube (2006)
Stock sale and liability inheritance, SEC Filings - Google/YouTube Acquisition

Case Study: Facebook’s Acquisition of WhatsApp (2014)
Indemnification provisions and non-compete clauses SEC Filings - Facebook/WhatsApp Deal

Case Study: Visa’s Abandoned Acquisition of Plaid (2020)
Due diligence and antitrust concerns: DOJ Antitrust Division Statement

Case Study: Disney’s Acquisition of 21st Century Fox (2019)
Purchase price allocation and asset valuation Filings - Disney/Fox Acquisition

IRS Publication 544: Sales and Other Dispositions of Assets, Tax implications of asset sales vs. stock sales, IRS Publication 544

American Bar Association (ABA) Mergers & Acquisitions Committee Reports Best practices in structuring M&A deals ABA M&A Committee Publications.

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Janice L. Miller is the managing partner of Miller Haga in Calabasas and is a highly-recognized legal advisor with over 25 years of experience as an innovative general counsel.  She represents the firm’s clients in business transactions, real estate leasing, entertainment, intellectual property, licensing, and hospitality.