“You have no idea how expensive it is to look this cheap” – Pennsylvania Uniform Fraudulent Transfer Act

Everyone loves a bargain and businesses and individuals that deal in distressed assets really love cheap stuff.  But if it looks too good to be true, it might turn out to be very expensive.  If you are considering purchasing the assets of a distressed business, you need to consider the implications of the Pennsylvania Uniform Fraudulent Transfer Act.

The typical situation involves a business with significant debts.  Some creditors have initiated collection actions, others have threatened.  The owners have decided to throw in the towel and want to salvage what value they can by selling the assets at “fire sale” prices to third parties.  The purchaser completes the purchase only to be sued by creditors of the defunct company. The creditors claim that sale violated the Pennsylvania Uniform Fraudulent Transfer Act and want the purchaser to pay them the full value of the assets.

The Pennsylvania Uniform Fraudulent Transfer Act prohibits three types of transfers.  First, it prohibits debtor from transferring assets “with actual intent to hinder, delay or defraud any creditor of the debtor.”  In determining whether a debtor had such “actual intent,” courts look to a variety of factors and there is no bright line test for making such a determination.  The factors include: (1) whether the transfer was made to an insider; (2) whether the debtor retained possession or control of the possession property after the transfer; (3) whether the transfer was concealed; (4) whether the debtor had been sued or threatened with a lawsuit at the time the transfer was made; (5) whether the transfer was of substantially all of the debtors assets; (6) whether the debtor absconded; (7) whether the debtor removed or concealed assets; (8) whether the value received for the assets was reasonably equivalent to the value of the assets; (9) whether the debtor was insolvent; (10) whether the transfer occurred shortly before or after a substantial debt was incurred; and (11) whether the purchaser of the assets subsequently transferred the assets to an insider of the debtor.

Second, the act prohibits a debtor from transferring assets [when] “without receiving a reasonably equivalent value in exchange for the transfer or obligation, and the debtor: (1) was engaged or was about to engage in a business or transaction for which the remaining assets of the debtor were unreasonably small in relation to the business or transaction; or (2) intended to incur, or believed or reasonably should have believed the debtor would have incurred, debts beyond the debtors ability to pay as they became due.”  This provision, known as the “constructive fraud” prohibition, is somewhat better defined then the actual “actual intent” provision, in that receipt of “reasonably equivalent value” renders the debtor in compliance with the provision. 

Third, “a transfer made [] by a debtor is fraudulent to a creditor whose claim arose before the transfer was made [] if the debtor made the transfer or incurred the obligation without receiving a reasonably equivalent value in exchange for the transfer [] and the debtor was insolvent at the time or the debtor became insolvent as a result of the transfer.”

Notice that a purchaser need not know that the seller is insolvent or engaging in duplicitous behavior to be liable for the seller’s debts.  So what is a purchaser to do?  If a deal seems too good to be true, some due diligence is in order.  Why are the assets being sold? Do the public records indicate that the seller has judgments against it?  Are all or substantially all of the assets of a company for sale?  Are the assets encumbered by security interests?

If a transaction raises red flags, there are a number of strategies to reduce the risk but you cannot address unknown risk. 

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.

Assets or Stock: The Form of Purchase DOES Make a Difference

Purchasing or selling a business can be accomplished in a number of ways. While the objective of the transaction is always the same – transfer of ownership from a seller to a buyer – the form of the transaction does make a difference. When it comes to the purchase or sale of a business, the form of the sale has significant implications, not only at the time of sale but with regard to operations going forward.

The purchase or sale of a  business is generally accomplished by either a stock sale or a sale of substantially all of the assets of the company. The form of the transaction has important implications for both buyers and sellers in several key areas:

Liability

Purchasers of stock essentially “step into the shoes” of the seller. This means that the purchaser assumes all of the liabilities of the acquired business – whether known or unknown, whether past or future. Such liabilities may be extensive and include liability for debt or purchases; losses arising from injuries caused by products or services provided by the purchased entity; claims of trademark or patent infringement; and liabilities based on employment discrimination, wrongful termination or violation of wage and hour laws.

Constructing the transaction as a purchase of assets of the company may enable a purchaser to avoid some potential liabilities inherent in a stock transaction. Yet, even asset purchases carry some risk of assumption of unknown liabilities. Asset purchasers may be responsible for undisclosed liabilities if it appears that they have implicitly accepted liabilities, or where there is sufficient continuity of enterprise that the transaction can be considered a de facto merger.

Scope of Purchase

One of the advantages of an asset purchase agreement is the opportunity it affords the buyer to “pick and choose” the assets that the buyer deems most desirable for the business. Obsolete inventory or redundant equipment can remain with the seller, in contrast to a stock purchase that transfers every and all assets owned by the business. Asset buyers, however, must be careful to ensure that the asset purchase agreement has a complete and comprehensive description of all of the assets necessary to operate the business or they will face some unwelcome surprises at closing.

Taxes

Tax and accounting treatment for asset purchases vary significantly from that afforded stock transactions. Purchasers of stock continue to carry assets on the books on the same basis as the seller. Stock sellers recognize a gain to the extent the sale price for the stock exceeds their basis.  In contrast, an asset sale requires the buyer to adjust the basis of the assets that are acquired based on the fair market value. This may result in an increase or decrease in the book value and depreciation for such assets.

What is clear is that no form of transaction – stock purchase or asset purchase – is inherently “good” or “bad.”  Each form has advantages and disadvantages for buyers and sellers and the decision of which form to adopt can be difficult – especially since what advantages one party may be disadvantageous to the other. In many cases, other elements of the transaction can be used to reduce risk and to satisfy the core objectives.