Security for Sales of Businesses
Who would not want a little
security in life? Yet a surprising number of people who sell their interests in
small business assets fail to get adequate security for their deals.
What kind of security are we
talking about? While “security” for business sales transactions can take a
number of forms, in this newsletter we will talk about one form of security —
“security interests.”
What is a security interest?
One can think of a security as analogous to a mortgage or deed of trust,
where the real estate being purchased provides a form of security to the lender
who provides the purchase money financing. If the buyer defaults on paying for
the property, the lender has a right to take the property to minimize the
consequences of the borrower’s default.
In many sales of small
business assets, the Seller will be asked to provide some form of
“Seller Financing,” such as by allowing for some form of deferred
payment or by taking a promissory note as part of the purchase price. If the
Buyer defaults, what remedies does the Seller then have?
The Seller could, and in most
cases should, insist on a security interest in the assets being sold. The
security interest would give the Seller the right to recover the assets
relatively easily if the Buyer defaults.
The security interest need
not be limited to the assets sold. It could include additional assets (i.e.,
“collateral”) to make sure that if the Buyer defaults the Seller can be made
whole. The value of the collateral or property subject to the security interest
should be at least as large as the amount of the Buyer’s debt to the Seller.
If
the Buyer of a business fails to pay the amounts due, a security interest can be
very valuable. If the Buyer is
buying land and an ongoing business using Seller credit, it is possible for the
Seller to have a mortgage on the land and what amounts to a mortgage
(“security interest”) on the tangible and intangible business assets such as
vehicles, operating equipment, and accounts receivable.
Just as mortgages or deeds of
trust must be recorded to be effective against third parties, security interests
must also be recorded to be effective against other creditors of the Buyer. The
correct method for recording a security interest, however, can vary depending
upon the type of collateral, i.e., the assets subject to the security interest.
In most cases, security
interest in tangible assets (like equipment, fixtures, vehicles) will be
represented by what is commonly called a UCC Financing Statement, which is then
filed in the appropriate government office, usually either the local courthouse
or a designated state registry, which in Virginia is the State Corporation
Commission. The purpose of the UCC Financing Statement is to provide notice to
other potential creditors that the Seller retains a security interest in the
designated assets.
Properly filing the Financing
Statement is important to protect the Seller’s position in relation to other
creditors, something which lawyers call “priority.” If a Seller provides
financing to allow the purchase of assets and the Seller properly obtains and
files her Financing Statement, the Seller will have first crack at those assets,
regardless of who else subsequently loans money to the Buyer and takes back
security interests to cover those advances.
A security interest is a far
more expeditious way of getting the assets back in the event of default than
having to sue the Buyer. Apart from the costs of obtaining an attorney and
filing the lawsuit, there are many disadvantages of going that route. Even if
the Seller obtains a judgment against a defaulting Buyer, at that point the
Buyer may have little or no assets with which to pay the judgment, and the
Seller will effectively have lost most of her business without adequate
compensation.
Even if the Buyer declares
bankruptcy, a Seller with a properly recorded security interest will likely be
in a vastly better position than a Seller without security.
Obtaining adequate security
for sales of business assets is particularly important for small businesses,
where, in our experience, the default rate is particularly high.
This of course is also why it is prudent to have a well-drafted Sales
Agreement. A sale of a business can be a very significant transaction for many
Sellers, and that is not the time to be penny wise and pound foolish.
Copyright 2009
Published by the law firm of Newland & Associates, PLC
9835 Business Way
Manassas, VA 20110
Call us at (703) 330-0000 for a full range of business law and
tax-related services.
While designed to be accurate, this publication is not intended to constitute the rendering of legal, accounting, or other professional services or to serve as a substitute for such services.
Redistribution or other commercial use of the material contained in Newland's Business Notes is expressly prohibited without the written permission of Newland & Associates, PLC.
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