Why You Should Review Your Important Contracts Before You Sell Your Business

Due Diligence

A company’s key contracts represent a valuable business asset. Thus, it’s crucial that the contracts remain in force as a business changes hands from the seller to the buyer when the business is sold.

As I’ve written elsewhere on this blog, the sale of a small business is usually structured as either an equity sale or an asset sale. In an equity sale, the buyer purchases the equity from the owner(s) of the company being sold (commonly referred to as the target company) — stock in the case of a corporation and membership interests in the case of a limited liability company. The business is transferred to the new owners, corporate or limited liability company entity and all, and the target becomes a wholly-owned subsidiary of the buyer. There is no change in the status of the target entity itself, and its contracts, assets, and liabilities remain with the entity.

In an asset sale, specified assets are transferred from the target company to the buyer, while the corporate or limited liability company entity remains in place and continues to be owned by its equity holders. The assets transferred might be all or substantially all of the target’s assets, or they might be more limited in scope. Similarly, some or all of the target’s liabilities might be transferred to the buyer or retained by the target company, although most of the liabilities often stay with the target. The contracts of the target company are transferred to the buyer by assigning the contracts to the buyer.

Anti-assignment and change of control provisions

It’s common for commercial contracts, leases, and other agreements to include anti-assignment provisions, which prohibit assigning the contract. Of course, this is exactly what you do in order to transfer the contracts to the buyer in an asset sale. In addition, bank credit agreements, distribution agreements, and other contracts often contain change of control provisions. A change of control is what takes place when a deal is structured as an equity sale. So whether you structure the deal as an asset sale or an equity sale, the sale of the business could be a breach of a target’s important contracts — which is not a good situation.

That’s why it’s important for the buyer and seller to review the target’s important contracts early in the transaction process to determine whether such provisions exist.

Anti-assignment provisions

In an asset sale the target’s contracts are transferred to the buyer by means of assigning the contracts to the buyer. The default rule is generally that a party to a contract has the right to assign the agreement to a third party (although the assigning party remains liable to the counter-party under the agreement). However, contracting parties often want to have the right to control who they do business with, so they include a clause in their contracts that prohibits the counter-party from assigning its rights or delegating its duties under the contract absent prior written consent.

These provisions pose a problem in the context of an asset sale. Because the target doesn’t have the right to assign a contract containing an anti-assignment clause absent its counter-party’s agreement to permit the assignment, the target is dependent on the counter-party’s willingness to agree to the assignment. The failure to obtain consent to assign a material agreement could jeopardize the transaction as the buyer is likely to refuse to close if it won’t receive the benefit of a contract that is important to the business.

The process of obtaining consents can be time-consuming and should be started at the earliest practical moment. It’s not unusual for a counter-party to extract some value in exchange for agreeing to the assignment. Sometimes the counter-party is somewhat opportunistic and sees a chance for a windfall. In other cases, the need for the target to obtain consent for assignment is an opportunity for relief from a disadvantageous agreement. In such cases where the contract is advantageous to the target (e.g., if the target is able to purchase products from a supplier at prices below market under a long-term supply agreement because it locked in low prices and the market prices have subsequently risen), the counter-party will often be unwilling to consent to the assignment of the agreement absent concessions.

The need for obtaining consents from counter-parties is often obviated in the context of an equity sale, because equity sales don’t require the assignment of contracts to the buyer. In an equity sale the target’s assets, including its contracts, are not transferred to the buyer; rather, the entire corporate or limited liability company shell is transferred to the buyer with its assets and liabilities remaining intact. Sometimes the only way to accomplish a transaction is to structure it as an equity sale if it’s not possible to obtain consent to assign a crucial contract.

Change of control provisions

The target’s material contracts should be reviewed early in the process even when the transaction is structured as an equity sale, because change of control provisions, which have the same effect as anti-assignment provisions, are triggered by an equity sale. Such provisions are common in contracts where the counter-party requires a great deal of control over who its does business with. Change of control provisions are common in credit agreements, where the borrower’s financial wherewithal is crucial to the lender; commercial leases, where the tenant’s financial stability is an important aspect of its ability to pay rent over the course of the lease; and distribution agreements, where a manufacturer is dependent upon the skills of current ownership and management to distribute its products in a particular territory.

Material contracts that contain change of control provisions require the parties to deal with the counter-party to the contract because the provisions will be implicated in both asset sales and equity sales.

Due diligence implications of anti-assignment and change of control provisions

Sellers should review their important contracts for anti-assignment and change of control provisions before taking their company to market. If an important contract contains such a provision and the counter-party is not willing to agree to the transaction on reasonable terms, the deal will look much different — and less attractive — to the buyer. It’s good to know early in the process that there’s a problem so the seller can plan accordingly, and so it can devise a strategy for overcoming the challenge.

Buyers should review the target’s material contracts to identify anti-assignment and change of control provisions as part of their due diligence efforts. It would be imprudent to hand over the purchase consideration when the buyer would not have the benefit of one or more crucial contracts.

Whether a transaction is structured as an asset sale or an equity sale, the buyer and seller should pay close attention to anti-assignment and change of control restrictions in the target company’s important contracts. Failure to do so could delay or endanger the closing of the transaction or even leave the buyer with less of the business than expected. That’s a recipe for trouble.

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