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Ten Rules for the Sale of a Business (Part Four)

This article continues a series intended to assist readers who expect to one day sell their businesses — often as a prelude to retirement. Previous articles have discussed the importance of planning ahead, taking a complete inventory of the business, and hiring the necessary professional advisors. Now we turn to Rule Number Four: Use Non-Disclosure Agreements (“NDAs”) in Dealing with a Potential Buyer.

It is a mistake to begin moving toward a business relationship without some vision as to what will happen if the parties find that the relationship will not work. This truth applies even when the relationship is just beginning. At the start, the prospective business buyer and seller need to get to know one another. Does the buyer understand exactly what he is buying? Does he understand what contracts, sales warranties, leases, payroll tax rates, etc. may come with the business? Can the buyer afford to buy the business? Is the buyer capable of managing the business successfully? These are the sorts of issues that are explored in depth in the process known as “due diligence.”

Just as in a social relationship, a landlord-tenant relationship, or a university-student relationship, both sides in a sale-of-business relationship will need to begin making disclosures before they make any long term commitments. From the seller’s perspective, this means disclosing all sorts of information to a prospective buyer which the seller likely regards as confidential. Examples could include customer lists, tax returns, material sources, financial statements, and so on. Likewise, the buyer may be expected to reveal his business plans, financing terms, financial position, employment history, and so forth. The confidential information that is released by the prospective buyer and seller needs to be protected by an agreement that imposes confidentiality requirements on both sides. Such agreements are not foolproof due to the obvious problem of actually catching someone in the prohibited use of confidential information. But, NDAs can be designed in a way that will provide a strong deterrent to the misuse of confidential information disclosed in the pre-deal phase of negotiations between a seller and a potential buyer.

The importance of a good NDA is better understood by recognizing the scope of the disclosures the parties need to make. While both parties will naturally hope that both sides will be happy with the deal, that goal is sometimes unrealized. When that happens, the party suffering a loss will naturally want to “blame” the other party if there is any rational way to do so. The common route to such a conclusion is to argue that the other party to the deal “failed to disclose” some material fact concerning the business or the buyer’s ability to manage it, depending on which party is doing the complaining. This sort of analysis leads lawyers to look at possible fraud claims or, if the deal was structured as a stock sale, to look at securities law claims. The best way to avoid these troubling problems is to make sure that full disclosure occurs before the sale is final. But the chance that the deal might not go through must be recognized and the NDA can protect both parties from the danger of having disclosed information used against them if the deal collapses.

The content of a NDA ideally is designed to fit the parties’ circumstances, but they typically include an extensive definition of confidential information and limits on how that information can be shared by the recipient. The NDA will almost certainly describe what is to happen to shared information if the deal fails to go through and the penalties for a breach of the requirements of the NDA. Such agreements should be coordinated with the Uniform Trade Secrets Act, and deal with common contract terms such as the term of the agreement, a choice of venue for handling disputes, responsibility for attorney fees if disputes arise, notice, amendments, and the relation of the NDA to other agreements or representations made by the parties before or after the NDA is signed. This is hardly a complete list, so additional terms need to be added as the parties’ circumstances require.

If all prospective deals moved along to a happy conclusion, NDAs would not be needed. But the fact is that many deals don’t work out or can’t be made. So, a prospective buyer or a seller ought to consider non-disclosure agreements at the early stages of negotiations, and certainly before beginning any serious disclosures. The content of such agreements is best developed in concert with the parties’ legal counsel.