One asset that business owners often overlook (and undervalue) is the company’s intellectual property (IP). The World Intellectual Property Organization defines IP as creations of the mind — inventions, literary and artistic works, symbols, names, images, and designs used in commerce. The law recognizes four categories of intellectual property. We’ll spend some time with each of these in future posts, but here’s a quick overview to get started:
Patents protect inventions such as machines or processes. If properly registered with the US Patent and Trademark Office, patents provide inventors with an exclusive right to manufacture and market their invention. Federal patent protection lasts up to 20 years.
A trademark is a name, phrase, sound, or symbol used in connection with services or products. Think of Nike’s swoop or the phrase “Just do it.” Federal trademark protection lasts for 10 years after registration and can be renewed “in perpetuity.” Trademarks can also be established without formal registration. If a company creates a symbol or name it wishes to use exclusively, it can simply attach the TM symbol to identify and protect the mark under common law; however, it is easier (more cost-effective) to enforce federally protected trademarks in court).
Copyright laws protect written or artistic compositions such as books, poems, songs, or movies. A copyright protects the expression of an idea, but not the idea itself. The owner of a copyrighted work has the right to reproduce, sell, perform, or display the work to the public. An author can have a common law copyright without federal registration, but cannot sue for copyright infringement of an unregistered copyright. A copyright lasts for the life of the author plus another 50 years.
Trade secrets include formulas, patterns, devices, or compilations of data that give a competitive advantage in business. Unlike the first three categories, trade secrets are governed by state law. To protect the secret, a business must prove that it adds value to the company and that appropriate measures have been taken within the company to safeguard the secret.
AVOIDING PREMATURE DISCLOSURE OF A PENDING SALE
When selling a business, one thing most sellers don’t want is premature disclosure of the pending sale. Customers may drift away to competing businesses, key employees may look for other jobs because they think the new owner will clean house, and suppliers may tighten up credit terms to avoid getting stuck with unpaid bills.
Any one of those issues can reduce profitability for a business – and since many valuation formulas are based on multiples of net income, even a relatively small dip in revenue can have significant impact on the ultimate sale price. Having all of these issues occur at once can be fatal.
NONDISCLOSURE AGREEMENT (NDA)
For these reasons, most savvy sellers will require prospective buyers to sign a Nondisclosure Agreement (NDA). An NDA, also known as a Confidentiality Agreement, is a contract between the prospective buyer and the seller that prevents disclosure of information about a pending sale or the business itself.
Buyers naturally need to engage in due diligence and get information about the business to help them decide whether to buy it, and if so, for what price. Typically that means reviewing tax returns, financial statements, leases and other confidential information about the business such as marketing and sales strategies, the identity of key customers and suppliers and other sensitive business information.
SIGNING THE NDA
In order to access this information, buyers must sign an NDA. The NDA requires that the buyer treat the information received as confidential. Usually the buyer is allowed to share the information with its attorney, accountant and other professionals involved in the transaction but not with anyone else. In many cases, the NDA requires the return of confidential information documents within a very short period of time if the buyer chooses not to go forward with the sale.
Using an NDA not only can help sellers preserve confidentiality about a possible sale, but it also is a wise precaution to prevent trade secrets and other potentially useful information from falling into a competitor’s hands.
Most small business owners soon find out that it’s difficult to get credit in the name of their company without providing a personal guaranty. A personal guaranty is exactly what it sounds like: the business is allowed to buy supplies on account, or borrow money from a lender, but the owner must promise to pay the creditor in full from his or her individual assets if the business can’t do so.
Personal guarantees are common in many business transactions such as credit applications, real estate leases, bank loans, and bank lines of credit. To be enforceable, a personal guaranty must be in writing and signed by the person who is guaranteeing payment on behalf of the business.
As with other written contracts, it is important to read the guaranty carefully to understand the liability of the guarantor and any requirements that the creditor must meet before demanding payment on a debt. But a contract is a contract, and the creditor is legally entitled to enforce a personal guaranty according to its terms. This means the seller may remain legally responsible for the business debt even after a sale of that business.
Most sellers don’t want that liability because they will no longer control the success or failure of the company. This often results in negotiations with the buyer to take on financial responsibility for the guaranty. But the personal guaranty is a contract between the seller and the original creditor, so any release of the seller requires written consent from that creditor.
Savvy creditors will not release the original guarantor unless assured that the new buyer is at least as financially sound a risk as the seller. And even if the buyer has a greater ability to pay, the creditor is not required to agree to release the seller, so it is common for a seller to retain at least some personal liability for debts of the business.
In cases where the creditor won’t agree to release the guarantor, sellers often request an indemnity and hold harmless clause that obligates the buyer to take full responsibility for payment of any amounts that might become due under the personal guaranty. Keep in mind that a hold harmless agreement is little more than a written promise to pay. If the buyer lacks the financial ability to do so, the seller may still have to make payments under the guaranty.
Before agreeing to a hold harmless agreement in lieu of a release from the creditor, the seller should conduct appropriate due diligence regarding the buyer’s ability to pay. If the buyer is a separate legal entity, it may be appropriate to require a personal guaranty from the principals of the entity. If the buyer is an individual without sufficient assets to allay a seller’s concerns, the seller may wish to request a personal guarantee from a third-party instead.
ALLOCATION OF LIABILITY
Regardless of how the terms are negotiated, it is critical for the seller and buyer to identify all personal guarantees relating to the business and have a clearly documented agreement regarding allocation of liability for those guarantees.