A buyer of a business never knows for sure what it is getting until after the closing. How does a buyer minimize the risk of overpaying for a business?
Well, in addition to kicking the tires (due diligence), the buyer wants the seller to make representations and warranties about the business; especially about the books and records. These representations and warranties if materially true should help minimize the risk that the buyer overpays for the business.
But what if a seller representation and warranty about the business is not true? And the business is worth less than the agreed purchase price?
If that is true and the buyer has paid the purchase price in cash at the closing, then the buyer will have to make a claim against the seller for the overpayment. That may be difficult. The seller may deny that the representation and warranty was inaccurate, or the seller may not have assets available to repay the buyer.
How can the buyer minimize those risks? One solution is to escrow a significant amount of the purchase price in an escrow for a period such as 18 months. Another solution is to defer payment on a portion of the purchase price and give the buyer the right to set off against the deferred purchase price and withhold from the seller an amount representing the buyer’s damages suffered from the seller’s inaccurate representation and warranty.
The buyer here agreed to buy the seller’s business for $1,175,000. The buyer paid $175K in cash at closing and delivered a $1 million note to the seller for the balance. The note gave the buyer the right to set off against the note payments and withhold those note payments for any damages the buyer suffered from inaccuracies in the seller’s representations and warranties.
After the closing the buyer claimed that the books and records of the business were not accurate; and that the business was worth less than the agreed purchase price. The buyer stopped making note payments to the seller under the setoff provision in the note.
The seller sued the buyer in a New York state court to recover the balance due on the note. The buyer defended itself saying that it had the right under the note and purchase agreement to setoff its damages against the note payments and withhold those amounts from the seller.
The trial court agreed with the buyer.
This case is referred to Borremans v. Gardner, Docket No. 651772/2018, Motion Seq. No. 001, Supreme Court, New York County, (March 18, 2019) https://scholar.google.com/scholar_case?case=16415870042329832312&q=%22membership+interest+purchase+agreement%22&hl=en&scisbd=2&as_sdt=2006&as_ylo=2017
A buyer often wants the right to setoff any loss the buyer suffers arising out of the seller’s breach of the acquisition documents against any obligations owing to the seller under a note or other obligation such as payments for a noncompetition covenant.
The seller often resists; especially on the grounds that the buyer should not have the power to decide if the seller breached the purchase agreement. A common compromise is a requirement that the buyer can’t exercise a setoff right if the seller denies the breach until the matter has been resolved in binding arbitration. However, the buyer may not agree because there might not be much deferred payments available by the time the dispute is resolved by arbitration.
By John McCauley: I help businesses minimize risk when buying or selling a company.
Telephone: 714 273-6291
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