Avoid Common Pricing Structure Mistakes When Selling Your Business

 

Negotiating a purchase price for a business is more complicated than haggling for a new car. Most business sales have at least some portion of the price paid after closing.  This raises two questions for the seller - How much am I owed and can I collect it?  We see several common mistakes that business owners make when answering these questions.

 

Using Earn Outs Incorrectly.  

 

An "earn out" is a pricing structure where some or all of the purchase price is contingent upon the business hitting certain performance goals after closing.  A properly used earn out typically overcomes two roadblocks to reaching an agreement on purchase price.  Many disagreements over purchase price arise from disagreement over probability of certain outcomes.  For example, a seller may assert that the business is worth 10 million dollars because it will sell 50 widgets next year.  Buyer may say the business is worth only 8 million because it does believe the business will sell 50 widgets.  An earn out can bridge this gap by making the 2 million dollar difference in purchase price contingent on the business selling 50 widgets.

 

An earn out may also allow the seller to capture value from the acumen or resources of the acquirer.  If a target company has struggled because of lack of capital, market presence or other factors, acquisition by a larger company may increase profitability.  A earn out may allow a seller to capture this upside by providing an additional upside contingent on the business hitting performance metrics that exceed past performance.

 

There are a number of risks associated with an earn out for a seller.  It is often difficult to track whether a business has met its performance goals, particularly when the target business is integrated into an existing operating business.  "Creative accounting," in particular, overhead allocation, can make it appear as if a business is not performing or hitting its marks.  Detailed provisions addressing the purchaser's accounting practices help to reduce risk but such provision are fertile for disagreement and post-closing litigation  

 

Not Knowing Your Purchaser.  

 

If you are "taking back paper" - slang for accepting a promissory note in the place of a cash at closing - in a transaction, you are acting as a bank for your purchaser.  Just like a bank, a well-advised seller should conduct due diligence on the potential buyer to evaluate its ability to make good on its promise to pay.  This includes reviewing the purchaser's financial statements, cash flow, other debts and ability to obtain money from other sources.  A more generalized inquiry into the purchaser's business track record is also important.  How long has the purchaser been in business?  Has the purchaser ever declared bankruptcy or does it have judgment against it?  Is the purchaser highly leveraged?

 

Not Acting Like A Bank.  

 

A bank does not lend money without the borrower putting up collateral to back up its promise to pay; you shouldn't either.  The prudent seller treats the buyer as a bank would.  Without adequate collateral, a seller may have a successful lawsuit against a judgment-proof entity or individual.

 

Of course, not all collateral is created equal.  Clients who want to get the price they negotiated for their businesses like to see letters of credit, mortgages on real property and personal guarantees from the owners (and their spouses) of corporate buyers.  Relying solely unsecured promissory notes from recently formed entities or a security interest in the assets of the business just sold is a recipe for disaster. 

 

No transaction is without risk but thoughtful negotiation and good advice can help to minimize the chances of turning a happy time into a sore subject.

Better Options for Day Traders

The day trading business continues to grow.  As individuals who engage in day trading begin to realize that it can be a career rather than a rewarding hobby, they often begin to consider ways in which they can make the business more profitable.

 

The average individual who invests in the stock market is, from an IRS perspective, an “investor.”  There are strict limits on investors’ ability to deduct losses and the investment expenses they incur.  Since these individuals are merely investing rather than operating a business, they are limited in their ability to deduct losses against taxable income.  Further, investment-related expenses cannot be deducted against income unless those expenses are very high – in excess of 2% of the taxpayer’s adjusted gross income.  Even then, deductions for the expenses relating to the investments may be limited after calculating the taxpayers’ alternative minimum tax (AMT).

“Traders in securities,” on the other hand, have the opportunity to deduct greater amounts of losses and the expenses relating to trading.  The IRS sets a high bar for someone trying to qualify as a trader.  Traders engage primarily in frequent, speculative trading activity, seeking to profit from short-term price fluctuations in the securities traded rather than from dividends, interest or capital appreciation.  Their trading activities must be substantial and carried on continuously and regularly.  In short, a trader devotes a significant amount of time to trading activities and the activities should further the trader’s livelihood.

There is no requirement that traders operate as sole proprietors.  They can form business entities that may offer greater liability protection, provide salaries for themselves and other employees and take advantage of retirement planning opportunities.  Depending on the state where you reside, there may be additional advantages to establishing a business entity in a different state.  Coupling these benefits with the abilities to deduct greater amounts of losses and expenses can result in significant advantages for traders.

Navigating the tax and corporate rules that govern this area can be challenging but they rewards can be substantial.  It is advisable to seek guidance from experienced attorneys and tax professionals who can assist you with determining whether you can qualify as a trader and the appropriate way in which to establish your business venture.   

A “Playbook” for Difficult Negotiations

We routinely advise and prepare clients who are entering difficult or complicated negotiations.  Entering an important negotiation or one with an unfamiliar subject matter can be stressful.  We remind our clients that good negotiators are not born good negotiators; even the worst negotiators can improve with a few simple strategies.  Here are ten we have used successfully throughout the years.

1. Understand your Objectives – It is important to know your own bottom line.  Spend the time to do the financial analysis and talk to the stakeholders within your organization to see what they need to get from the agreement.  It can be easy to lose sight of these objections in the midst of negotiation.  Writing these goals down for your own reference can help to keep you focused.
2. Determine Whether the Negotiations are Recurring – The recognition that you will deal with your counterparty again, either in another negotiation or in the context of an ongoing working relationship, is important.  While this does not mean that you should soften your position, you should avoid a “last-dollar” mentality.  If you “win” too big in a deal, it may make ongoing relationships and future negotiations more difficult.
3. Look for Objective Standards – Attempt to find objective measures of value outside of the negotiation.  Ask yourself how a disinterested third-party might assess risks and assign value.  You might be able to gather objective values by talking to third-party suppliers or purchasers, market data or researching. 
4. Examine Your Starting Point – An extremely high or extremely low offer may offend the other side or may cause them to believe you are not serious.  Keep in mind that counterparty may be more inclined to walk away from negotiations early – before they have invested substantial time and money in the negotiation – if they feel your starting point is unreasonable.
5. Don’t Lie – Lying in negotiations has little chance of improving your position and has serious risks.  Maintaining your credibility is critical in negotiations; once lost, it is difficult to reclaim.  Trying to keep lies straight is mentally taxing and distracting.
6. Negotiation is Key – Some back and forth is desirable.  If an offer is accepted early and negotiations are settled very quickly, it may lead to questions about the success of the outcome.  Many people need negotiation to make them feel as if they have received a fair price.  Do not start a negotiation with your bottom line.  Allow the process to give the other side confidence they have found your bottom line.  On the other hand, avoid offers that increase your previous proposal by a miniscule amount.  They are a waste of everyone’s time.  Proposals should be substantial enough that it makes an impact on the opposing parties’ response.
7. Avoid Bidding Against Yourself – Never let the opposing party force you to bid against your proposal.  “Bidding against yourself” means changing your proposal before the other has even responded to it.  Negotiating against yourself only ends up changing your offer with no concessions from the other side.  Statements such as, “I have no authority to offer this but would you take $X dollars (which is lower than your last offer)” should not cause you to lower your number.  Make sure the opposing party offers a real proposal before you respond with a real proposal.
8. Explain your reasoning – Explaining your reasoning can help to enlist the other side in helping to reach your goals.  It can lead to a “win/win.”  It can also provide a viable impersonal focus for discussions.
9. Get Comfortable with “No” – Naturally, individuals want to say “yes” – it is socialized and hardwired into us.  Although saying “no” can be uncomfortable, it is liberating and gets easier over time.  Your ability to quickly and definitively say “no” depends on how well you know your own position.
10. Don’t Split the Difference – It is normal when a negotiation is coming to a close for someone to suggest splitting the gap between the two offers in order to settle the deal.  This is unwise since it reveals to the other side that you are willing to settle on a number between the current proposals.  A skilled negotiator will then try to move you from that amount, leaving you with less than half of the difference.

Independent Contractors and “Works for Made Hire”

Use of independent contractors for tasks traditionally performed by employees has become an increasingly popular business model.  Many businesses use independent contractors to produce original works such as software code, marketing materials, websites, CAD drawings, blueprints and designs.  Although a viable business strategy, using independent contractors to create these materials can result in disputes over ownership.

Many businesses assume that, since they paid for the work, they own it.  The United States Copyright Act, however, provides a potentially counter-intuitive answer.

Authors Usually Own What They Produce

As a general proposition, the author of a creative work automatically owns the work without the need for any additional action.  This is true for independent contractors.  For example, if a business were to hire a contractor to produce a sequence of computer code for use in one of the business’s products, the contractor would own the code and be able to use it in any matter the contractor wishes, including selling it to competitors.

Independent Contractors and “Work Made for Hire”

The “work made for hire” doctrine contained in the Copyright Act provides an exception to this rule.  If a creative work is a “work made for hire” the business commissioning the work, and not its creator, owns the work.  In order for a contractor’s work to be considered a “work made for hire,” it must satisfy several conditions: (1) it must be “specially ordered or commissioned” by the business; (2) must fit into one of nine enumerated categories identified in the Copyright Law; and (3) must be produced pursuant to a written agreement that specifically identifies the material as a “work made for hire.”

The first and the third requirements are typically satisfied together.  A well-drafted written agreement that “specifically orders or commissions” a work should also include language identifying the work as a “work made for hire.”  This written agreement will often take the form of an “independent contract agreement” or an “agreement for services.”  Indeed, businesses should already employ independent contractor agreements to cover important issues like compensation, quality of work, delivery schedule and indemnification.

Copyright law further restricts the scope of “works made for hire” to material used: (1) as a contribution to a collective work; (2) as a part of a motion picture or other audiovisual work; (3) as a translation; (4) as a supplementary work; (5) as a compilation; (6) as an instructional text; (7) as a test; (8) as answer material for a test; or (9) as an atlas.  These categories limit the usefulness of the “work made for hire” doctrine for many businesses.

A well-drafted independent contractor agreement can typically overcome these limitations with language assigning ownership of a work from the independent contractor to the business that retained it.  In the event that a work is deemed not to be a “work made for hire,” the agreement would automatically convey ownership of the work to the business.

Conclusions

Well-drafted independent contractor agreements can minimize the risk of ownership disputes over the creative works developed by independent contractors.  Businesses should also consider adding “work made for hire” and assignment language to any form agreements they use with such contractors.

Alternatively, the Copyright Act is much more liberal for works created by employees in the scope of their employment.  Such works are automatically considered “works made for hire” and are not limited to nine categories mentioned above.  Depending on a business’s need for certain creative materials, using employees rather than independent contractors may make sense.