Guidelines for closely-held corporations.

Arthur Wm. ("Bill") Brown, Jr.

It is important for closely-held corporations to develop a plan for succession. One succession alternative would be to sell the business to a third party, thereby converting that "locked-up" wealth into cash or other property. The owners and management of the selling entity (otherwise knows as "Seller") need to understand and plan for the sale process, which may take many months to accomplish. These guidelines can help facilitate a smooth transaction.

Before the sale

Set Goals. The owners of Seller should identify and prioritize up front and in writing the goals which they hope to achieve from the sale (multiple goals may be at play other than just maximizing the sales price).

Assemble Qualified Team. The owners and management of Seller should assemble both their internal team (selected equity owners, key employees, and family members) and their external team (a business lawyer and an accountant, and if applicable an investment banker and specialists in tax, estate planning, valuation, and financial planning).

Clean Seller's House. Seller should, ahead of the process, work closely with its lawyer and accountant to identify and correct (or minimize) potential problem areas in Seller's business.

Estate and Tax Planning. The owners of Seller need to resolve their personal estate planning and tax planning ahead of the start of the actual sale process, such as gifts or transfers.

Implementing the process

Letter of Intent. Seller and Buyer will negotiate (with the help of their respective legal counsel and investment banker) and enter into a written Letter of Intent which sets forth the principal business terms of the proposed sale transaction. Most of the terms of the Letter of Intent should expressly be made non-binding, although some provisions may expressly be made binding.

Due Diligence. After Buyer has signed both Seller's Confidentiality Agreement and the Letter of Intent, Buyer will want to undertake a "due diligence" investigation of Seller and its business (e.g., access to documents and properties). Seller must assess such review's potential adverse effect on its business. Seller may also wish to conduct some due diligence on Buyer.

Structuring alternatives for the sale

Asset Transaction. Key aspects of an asset transaction are: (a) Buyer chooses which assets to purchase and which liabilities, if any, to assume; (b) Buyer may, under the law, be held to assume some liabilities; (c) Buyer receives a step-up in basis on certain assets; (d) Seller pays tax on the gain, and the owners of Seller also pay tax on distributions ("double taxation"); (e) "S corporation" Seller taxable on built-in gains; (f) sales tax on tangible personal property other than inventory; (g) bulk sales law compliance, in some cases; (h) real property valuation reassessment; and (i) Seller's "withdrawal liability" under a union pension plan.

An asset transaction will be a taxable transaction unless the detailed C Reorganization rules under Internal Revenue Code ("IRC") Section 368(a)(1)(C) are complied with, in which case the stock consideration will be received by Seller on a tax-deferred basis (follow the detailed rules, including selling substantially all of the assets for voting stock; consideration must be at least 80% voting stock; any other consideration (called "boot") cannot exceed 20%, and is taxable; Seller must dissolve within one year).

Stock Transaction. Buyer acquires the stock of Seller from Seller's shareholders. There is only one level of tax to shareholders, taxed at capital gains rates. Other issues: real property valuation reassessment; if Seller is an "S corporation", consider an IRC Section 338(h)(10) election to treat the stock transaction, for tax purposes, as an asset sale; all shareholders must sign the definitive acquisition agreement.

A stock transaction will be a taxable transaction unless the detailed B Reorganization rules under IRC Section 368(a)(1)(B) are complied with, in which case the stock consideration will be received by shareholders on a tax-deferred basis (follow the detailed rules, including selling at least 80% of the stock of Seller; total consideration received must be voting stock; no "boot" allowed).

Merger. One corporation merges into another corporation, so that one survives (owning all assets of, and having all liabilities of, both corporations) and one disappears, effective when the requisite agreement of merger is filed with the Secretary of State(s). Typical forms are (a) a "reverse triangular merger" where Buyer sets up a new subsidiary corporation and merges such subsidiary into Seller, with Seller surviving, and (b) a "forward triangular merger" where Buyer sets up a new subsidiary corporation and Seller merges into such subsidiary, with such subsidiary surviving.

A merger will be a taxable transaction unless the detailed rules under IRC Sections 368(a)(1)(A), 368(a)(2)(D), or 368(a)(2)(E) are complied with (in a "reverse triangular merger", at least 80% of the consideration received must be voting stock, with up to 20% "boot" allowed; in a "forward triangular merger", at least 50% of the consideration received must be stock (voting or non-voting), with up to 50% "boot" allowed).

The definitive acquisition agreement

Overview. A "definitive acquisition agreement" defines all of the terms and conditions of the transaction, and has ancillary documents attached as exhibits. It is typically divided into sections as follows: (a) parties, recitals, and definitions; (b) the business deal, including price, payment, installment sale, earnout, held-back funds, and an escrow for such funds; (c) representations and warranties; (d) pre-closing and post-closing covenants; (e) closing conditions precedent; (f) indemnification; (g) termination rights; and (h) miscellaneous.

Representations and Warranties. Seller's representations and warranties "paint a picture" of Seller and its business as of a particular date, and they provide a mechanism to allocate risk between the parties. Seller minimizes risk arising from a breach by adding threshold levels, a "materiality" qualifier, and a "knowledge" qualifier. Multiple parties prefer giving them on a "several" rather than "joint and several" basis.

Indemnification. This section establishes when one party will indemnify the other party, and the procedures and limitations related thereto. The owners and Seller limit their liability by (a) establishing a shorter claim period, (b) establishing a "basket" amount (per case and/or in aggregate) with indemnity only if exceeded, and (c) establishing a "cap" on the maximum liability (on individual claim basis; aggregate basis; per shareholder basis) of indemnitor.

Other selected issues

Hart-Scott-Rodino. When Buyer acquires assets or voting securities having an aggregate value in excess of $50 million, then both Buyer and Seller must file a Hart-Scott-Rodino form with the FTC and DOJ.

Exon-Florio. If Buyer is directly or indirectly controlled by a foreign person, then Buyer and Seller may file an Exon-Florio notice with the Committee on Foreign Investment in the United States.

Filings, Consents and Approvals. Filings need to be made to, and consents and approvals need to be obtained from, third parties (individuals, entities, or governmental agencies).

WARN. Under both federal and California laws, if workers will be laid off, at least 60-days notice must be given in some cases to the employees and applicable state agencies.

Arthur Wm. Brown, Jr. is a Partner in Los Angeles in the Corporate Practice Group at Sheppard, Mullin, Richter & Hampton LLP. He can be reached at 213-617-4163 or at [e-mail].