Newland's Business Notes

Security for Sales of Businesses  

Volume 13 Issue 3 -- May/June 2009

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.

If you need help in this area, contact Newland & Associates.

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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