The Key Elements to Selling an eCommerce Based Business
This post is Part 7 of a series covering core legal issues for eCommerce and Internet-based businesses.
Selling an eCommerce Based Business
For a number of reasons, buying and selling a business presents many challenges, and each deal is unique. That said, most transactions involve many of the same features and elements.
A lot can happen in a transaction, from the initial discussions through the final closing. It is important that while both buyers and sellers remain flexible, they also ensure the final deal accomplishes their key goals. Transactions involving knowledge-based businesses have additional nuances that must be addressed, to ensure both parties benefit from the transaction. This article discusses some of the special issues presented in these types of deals.
Nuances of eCommerce Business Sales
All business acquisitions involve challenges for both buyers and sellers, but deals involving eCommerce businesses have some unique issues due to the nature of their operations and assets. Some unique challenges involved in the sale of eCommerce businesses include valuation, IP Asset ownership, and key employees.
Valuation
One of the biggest challenges in buying and selling an eCommerce business is accurately valuing the eCommerce business.
Traditional company value calculations involving multiples of revenue or EBITDA may work for companies with a long history, but chances are at least some of those are tied to IP Assets that can expire or be challenged or canceled by outsiders. Typically, the most valuable assets of an eCommerce business are non-tangible assets such as information, data, goodwill, and know-how. Legally, these types of assets are called intellectual property and are characterized as either: trade secrets, trademarks, copyrights or patents (collectively, “IP Assets”).
For an early-stage venture, the IP Asset value may increase exponentially over the next few months or years, so securing a specific present value can be virtually impossible. There is no simple, standard answer to how one should value an eCommerce business. Buyers and sellers will sometimes engage valuation specialists, actuaries, or other consultants to help calculate the estimated value of IP Assets and eCommerce businesses.
To add a bit of clarity to the analysis, at a minimum, eCommerce businesses should prepare a comprehensive inventory of all IP Assets that can be reviewed by purchasers during the due diligence process. IP Asset due diligence is a critical element of an eCommerce business transaction and warrants a separate discussion.
Ultimately, however, the value of any business is the price someone is willing to pay for it. eCommerce business sellers need to understand the value of their IP Assets and company so they can negotiate a good deal for themselves. Similarly, eCommerce business purchasers must ensure that they are acquiring a company that will continue to be valuable following closing.
IP Asset Ownership
It is important for an eCommerce business to own all the IP Assets used by the eCommerce business. However, for some eCommerce businesses, many of their IP Assets were created by the founders and independent contractors. Unless those creators have executed written agreements with the eCommerce business to transfer their rights to the eCommerce business, those individuals – and not the eCommerce business - may own some of the IP Assets. Such a situation could derail a proposed purchase of the eCommerce business.
For example, if a company hires an independent contractor to write some software code for a fee, by law the contractor owns the code they write unless and until they assign the code to the company in writing. Thus, the company should ensure it has an executed copyright assignment or similar language in the development agreement with the developer.
In addition, some of the IP Assets may be pledged as security for loans or lines of credit, may include third-party assets, may be subject to unfavorable licensees, or in some instances the transfer of the eCommerce business could trigger a software escrow release. These encumbrances will affect the ownership of the IP Assets, which ultimately will affect the value of the eCommerce business.
Key Employees
Most of the intangible assets in an eCommerce business are IP Assets, but in some instances the most important assets to an eCommerce business will be a few key employees. Because of their reputation, relationships, know-how, special skills, and creativity, these key employees are extremely valuable to the eCommerce business.
As such, if those key employees leave the company at the close of a deal, the company will likely not be as valuable as it was prior to the transaction – even if the purchaser acquires all the other IP Assets of the eCommerce business.
To avoid this letdown, eCommerce business purchasers will need to identify these key employees and enter into agreements with them to continue their employment after closing. These key employee agreements can be critical for a purchaser, but because they involve future employment of individuals, negotiating these agreements can present several challenges to the transaction.
Although the sale of an eCommerce business may have many of the same elements of other business purchases and sales transactions, eCommerce businesses present some unique challenges that must be overcome to ensure buyers and sellers receive the sought-after benefits of their bargains.
Overview of the Sale Process
As previously mentioned, every business sale is unique. However, most business sale transactions involve similar elements and follow a similar path.
Of course, some deals may include additional steps, consolidated elements, or even skipped parts of the process described herein. In addition, some of the elements will occur in a different order. Nevertheless, this article provides a reasonably accurate overview of a deal flow for many transactions involving the sale of IP-based companies, professional services businesses, and other eCommerce business.
Preparing for the Sale
Before an eCommerce business owner can consider selling their company, it is important for them to do some internal “housekeeping.” Typically, this involves gathering a list of assets and determining their value, reviewing company documents and records, gathering financial records, preparing an inventory of intellectual property (IP), and reviewing the eCommerce business’s key contracts.
Because a purchaser will want a thorough understanding of a target company’s financial situation, financial records are an important part of any proposed business sale transaction, including those involving eCommerce businesses. For early-stage companies, of course, these records will have less significance than for eCommerce businesses that have been operating for some time. But, a purchaser will want to see records relating to the capital of the company, operating expenses, debts owed, and taxes paid.
The entity documents and corporate records of the eCommerce business will be important to a purchaser, and must be complete and in order, especially where the sale relates to the stock of the eCommerce business. Regardless of the type of transaction, however, purchasers need to ensure the parties to the transaction are properly empowered by the eCommerce business to enter into and consummate the deal. Moreover, a purchaser must feel confident that there are no potential issues relating to eCommerce business ownership or legal authority that could threaten the purchaser in the future.
For an eCommerce business, having comprehensive knowledge of its IP assets is critical to understanding its overall value. Conducting a pre-sale IP review also permits the eCommerce business to clean house and ensure that all registrations, licenses, and assignments are current, properly executed and recorded – which can help avoid problems that might impede a smooth closing.
Thus, as part of the pre-sale review, the eCommerce business must compile a full and accurate inventory of all IP assets (an “IP Asset Inventory”), which is comprised of both public and non-public IP assets.
Key contracts include those between the eCommerce business and its employees and contractors, vendors, clients, leases, lenders, and shareholders. These contracts represent both assets and obligations for the eCommerce business, and as such a purchaser will want to review them.
In addition, the eCommerce business seller should identify any potential liabilities or other issues and should address them prior to the sale. Once liabilities are identified, the eCommerce business should take action as soon as possible to resolve them. Or, if they cannot be resolved quickly, the eCommerce business should disclose them to the purchaser and determine if the liability can be resolved at closing, will transfer to the purchaser, or will stay with the eCommerce business after the closing of the sale.
In virtually all instances, disclosing a liability or potential liability early in the sale process will be viewed more favorably by a purchaser than one that is discovered later.
Negotiations
Once a potential buyer and seller are identified, the parties will enter into discussions to see if a deal is possible. For these discussions to be productive, the eCommerce business and the potential buyer must share some private information such as sales, expenses, lists of vendors and contracts, and other confidential and proprietary information. As such, the eCommerce business must ensure that the parties enter into a confidentiality agreement prior to sharing such data and information.
Prior to entering into any substantive negotiations with a potential purchaser, the eCommerce business seller should require the purchaser to execute a non-disclosure agreement, or “NDA.” An NDA will ensure that the discussions related to the deal will remain confidential. In addition, it will allow the eCommerce business seller to share business and financial information without worrying that it will be disclosed to others.
Term Sheet
If negotiations go well and the eCommerce business and buyer agree on the key elements of a deal, they should reduce these deal terms to a “term sheet” (sometimes called a “letter of intent”). The Term Sheet will outline many of the main deal elements and will serve as a blueprint for their respective legal counsel in drafting the purchase and sale agreements.
Although the LOI is designed to be merely an outline of the deal, the LOI, once signed by both parties, is a legally binding agreement. Thus, it is important that both parties clearly understand what obligations the LOI creates.
Therefore, in addition to outlining the key deal terms, some key legal issues to be addressed in the LOI include:
A clear statement that the LOI is an outline of deal terms only, and that neither party is obligated to close on the transaction until detailed transaction agreements have been negotiated and executed by the parties
A confidentially statement related to the deal and the specific terms of the LOI
A “no-shop” clause that prohibits the eCommerce business seller from negotiating with other potential sellers for a limited amount to protect the purchaser from a “bidding war”
Sets a proposed closing date and, more importantly, an expiration date for the LOI if the parties haven’t completed all the transaction agreements in time
Due Diligence
Between the time the term sheet has been signed and the closing on the transaction, the buyer will typically want to conduct a thorough investigation of the eCommerce business to ensure it is getting good value for its purchase (and that there are no unexpected liabilities or other surprises).
This process is called the “due diligence” process, and it typically begins with the purchaser sending a request for documents and other information. This usually includes corporate records, financial reports and information, material on key employees, an IP inventory, and data regarding key relationships and contracts. The buyer will also ask the eCommerce business to disclose any known liabilities, debts, or other risks.
The breadth and scope of due diligence will vary from transaction to transaction. In most situations, eCommerce business sellers should be prepared to provide a wide range of information and documents related to the following:
1. Corporate documents such as formation documents, bylaws and meeting minutes;
2. Shareholder information such as capital tables, option grants, and shareholder agreements;
3. Government permits and licenses relating to the eCommerce business’s operations;
4. Financial records including detailed balance sheets, profit/loss statements, and asset records;
5. Assets including a list of all equipment, inventory, and other business property of the eCommerce business;
6. Tax records for federal, state and local filings over the most recent several years;
7. Debts, liabilities and other obligations of the eCommerce business including loans and lines of credit, and any liens, security interests or other restrictions on the company or its assets;
8. Insurance coverage for all aspects of the eCommerce business;
9. Customer and supplier information, details of the business relationship, any contracts, and any orders in progress;
10. Other key contracts of the eCommerce business such as software licenses, independent contractor agreements, vehicle and equipment leases, etc.;
11. Real estate and leases including real estate owned as well as office and warehouse leases;
12. Intellectual property assets and licenses (see below for more detail on IP due diligence);
13. Employees, employee benefits and employment agreements;
14. Disputes and litigation including past, pending and anticipated issues;
15. IT, Cybersecurity and data privacy information is an area of increasing importance for all companies but is typically at the core of an eCommerce business ’s business.
Transaction Agreements
Following the execution of the term sheet, the eCommerce business seller and buyer will need to execute a purchase agreement. Depending on the deal structure, this could be an asset purchase agreement, or a stock purchase agreement. Although the term sheet identified key deal terms that form the backbone of the purchase agreement, there will likely be additional negotiations between the parties as the purchase agreement takes shape to address the details of the transaction.
In addition to the purchase agreement, ancillary agreements related to the transaction may be needed, such as employment agreements, releases, promissory notes, and assignments.
In addition to the deal-specific elements related to the equity or assets sale, most Purchase Agreements will contain a number of common provisions, such as:
Payment Terms. Likely the most obvious and well-discussed provisions of the Purchase Agreement will relate to the payment of the purchase price. That said, payment terms can be simple, or can be more complicated in an eCommerce business sale transaction.
The purchase price is sometimes a fixed number, and at other times can be tied to certain future events, such as eCommerce business revenue, continued employment, etc. Moreover, even where the purchase price is a single fixed amount payable in cash, the payment terms may involve a portion paid upfront, with the remainder to be paid in the future.
In addition to an upfront cash payment in full, the purchase price can also involve other valuable payment options, such as: payment of the seller’s debts, payment via a promissory note bearing interest, issuance of stock in the purchaser, or an “earn out” that connects the amount of future payments to the Seller to certain revenue, profit, or other benchmarks.
Typically, the total purchase price can be significantly increased if the eCommerce business seller is willing to accept less than the full amount at closing, with the remainder payable in the future, whether as a promissory note or as an “earn out”. But eCommerce business sellers must beware: any cash not paid to the eCommerce business seller at closing might prove expensive, if not impossible, to collect from the purchaser in the future.
One option to guarantee the payment of future payments to the eCommerce business seller involves the use of an escrow agent. In such instances, the purchaser will pay that portion of the purchase price to the escrow agent, who will hold it for a certain amount of time or pending the occurrence of certain events. If the eCommerce business seller satisfies its obligations, the escrow agent will pay the escrow funds to the eCommerce business seller. If not, the escrow funds will be returned to the purchaser.
Tax Implications. The eCommerce business transaction will likely have all sorts of tax implications. Although both the eCommerce business seller and purchaser will need to work with their respective tax advisors to discuss those implications, language should be included in the Purchase Agreement allocating responsibility for tax obligations to each party as appropriate.
Non-Compete. To ensure they receive their expected benefits of the eCommerce business purchase, purchasers will want to ensure that the eCommerce business sellers will not compete with the eCommerce business’s business after closing. As such, a key provision of the Purchase Agreement will be a non-compete, typically for three to five years. This non-compete would be separate and in addition to any non-competition obligations any key employees may have in their employment agreements. Although non-compete provisions restricting employees are often viewed very narrowly by courts, those entered into as part of a business sale are typically enforced.
Representations and Warranties. The representations and warranties sections of the Purchase Agreement contain language whereby the parties – most importantly the eCommerce business seller – make specific legal guarantees about the truth of certain facts, the delivery of certain promises, and other critical elements of the transaction. Because of the high standards of liability these promises can create for the parties, these provisions are carefully written and negotiated. In addition, the purchaser will typically want to ensure that the eCommerce business seller’s promises as provided in the representations and warranties sections of the Purchase Agreement will continue for several years after the closing.
Clawback Provisions. In the event new liabilities are discovered after closing, or the value of assets turns out to be inflated, or for any number of other reasons, circumstances could result in the purchaser getting less of a deal than they bargained for. To address those situations, the purchaser will often include provisions in the Purchase Agreement to modify the purchase price to account for those surprise circumstances. These provisions, referred to as “clawback” provisions allow a mechanism for the purchase price to be modified after closing.
In addition to the agreements between the buyer and seller, before closing both parties may need to obtain the consent from various parties to approve the transaction. This may be lenders, shareholders, directors, key clients, or any contracts that may be affected by the transaction, such as those requiring consent in the event of an assignment or a “change in control” of the eCommerce business.
Closing the Deal
The closing date is typically stated in the Purchase Agreement, but very often will need to be moved at least once, so account for last minute challenges. In most instances, both the buyer and eCommerce business seller will agree to extend the closing date as needed. Once the actual closing date arrives and the buyer and eCommerce business seller are ready, the eCommerce business sale transaction will formally occur.
The Purchase Agreement will specify what each party is required to deliver to the other at closing. For an asset sale, the eCommerce business seller will typically deliver a Bill of Sale and other instruments of title to transfer the assets to the buyer. For an equity purchase, the eCommerce business seller will deliver stock certificates or other means of transferring their equity to the buyer. In addition, each party must deliver their respective consents and ancillary agreements as required by the Purchase Agreement.
The buyer will also need to pay the purchase price for the eCommerce business, although depending on the deal terms in the Purchase Agreement, only a portion may be payable in cash at closing. The cash portion should be paid to the eCommerce business seller, but the remaining amount owed may be satisfied by future cash payments, by delivery of funds to escrow, or by the buyer providing the eCommerce business seller with a promissory note.
Failure to deliver all required documents and payments as required at closing could jeopardize the entire transaction and could expose the breaching party to legal liability.
Often, closing is when payment is made to each party’s legal counsel, accounting firms, business brokers, and any other agents involved in the transaction. Finally, if a portion of the eCommerce business sale proceeds were to be paid to satisfy a debt of the eCommerce business seller, these funds are also paid at closing.
Post-Closing
After the closing, the buyer will have control over the assets or equity of the seller, and the deal is effectively completed. However, there are often a number of post-closing matters that need to be addressed, such as recording IP assignments, updating domains and addresses with various third parties, and other matters that could not have been accomplished prior to closing. In some cases, such as where the eCommerce business seller continues working for the buyer or when part of the purchase price is based on an “earnout,” the post-closing process may carry on for months or even years.
Although each deal will have its own elements and chronology, the above elements provide an overview of the typical steps involved in the sale of IP-based and professional services businesses. By understanding these steps, buyers and sellers can be better prepared, which should result in a smoother and more productive transaction.
There Are Key Elements to Every eCommerce Business Sale, But All Transactions Are Unique
As with all aspects of an eCommerce business sale, each closing deal is unique. The foregoing provisions represent an example of the elements involved in the closing of an eCommerce business sale. Of course, eCommerce business sellers should work closely with their legal counsel to facilitate a smooth eCommerce business sale transaction.
To view previous articles in this series:
Part 1: eCommerce Law for Internet-Based Businesses
Part 2: Privacy Law and Requirements for eCommerce Businesses
Part 3: Understanding and Protecting IP in eCommerce Business
Part 4: The Key Agreements Every eCommerce Business Should Have
Part 5: Legal Issues to Know for International eCommerce Businesses
Part 6: The Key Roles of Human Capital in eCommerce Business and Their Importance
ABOUT THE AUTHOR: Jim Chester is a 25-year technology business lawyer, professor and entrepreneur. He is a recognized authority in buying and selling technology businesses, global technology transactions, and providing strategic legal counsel for innovation-based companies. For more on Jim, visit his professional profile. You may email Jim at jim.chester@klemchuk.com.
For more information on eCommerce legal issues, see our Internet Law and eCommerce Legal Services and Industry Focused Legal Solutions pages.