How To Avoid Litigation When Selling A Business

by Willard Michlin-CPA, CBB, CFE
Kismet Business Brokers

Willard Michlin will help avoid litigation in buying or selling a business.

The Question

How to avoid litigation is one of the biggest concerns of brokers and clients who are selling their business. If they think “How do I avoid litigation after escrow closes for something I forgot or that I didn’t know I was supposed to disclose?” then they need a good broker.

The Answer

This is a very good question and it deserves a very direct answer. There are two main reasons sellers get in trouble.

  1. Some listing business brokers are not really interested in full disclosure. They are only interested in getting the deal closed. Doing this quickly and with a minimum of trouble will, in their mind, ensure they get the commmission. They push the buyer to drop doing the normal due diligence, and just close the escrow. This works when the buyer is inexperienced.  He can be be pressured into believing that the deal is going to be lost to another hot prospect unless he acts quickly. Another reason is the buyer really does not have a clue about what the standard due diligence procedures are. It is imperative that he hire a CPA and an attorney to look out for his interest. This is the buyer that will blame the broker and seller for his own ignorance.
  2. The other way sellers get into trouble is by trying to withhold information. Withholding information will not avoid litigation, it will almost ensure it. Sellers fear that when the buyer sees it, he might kill the deal. The fear is always worse than the reality, but people do not realize it. Some examples of seller fears that might kill the deal include:
    1. My five biggest customers control 80% of my business.
    2. The business lease ends in two years and the landlord told us he wants a 50% rent increase.
    3. My general manager who is second in command is going to retire within one year and there is no third in command.

    Trying to hide any of these facts will not avoid litigation.

The Solution

The buyer needs his own broker that will take the time and trouble to guide him through the due diligence process. The broker should help the buyer by encouraging him to hire financial experts. This will go a long way towards avoiding litigation after the escrow closes. Then the buyer will feel he has the facts. Any items discovered later will not upset the buyer and cause problems with the seller or his business broker.

The way to get around all of these issues and make the best deal possible—given the true facts—is to openly communicate. Give the buyer all the information he requests, if reasonable. If not reasonable, try to give it to him anyway. This does not imply you should give the buyer your list of customers or trade secrets. These are given up after escrow closes. It does mean give each client a letter or generic name and give the client information without actual names.

The Documents

Documents you should absolutely provide early in the discussion process include 3 years P & L plus any year-to-date information. This information will come from your QuickBooks or other accounting records, not from your best estimate or average month information. Estimates are not accurate and are never complete. Stay away from excel financial statements unless that is all there is.

Also, provide a current balance sheet from QuickBooks. Provide 4 quarters of the Federal quarterly payroll tax return. (State is not necessary). After you have a signed offer, also provide the most recent 3 years of Federal Tax returns. If there is any income or expenses not on the books, make a list on a separate document and have the buyer sign and date receipt of this information. These actions will prevent the buyer from claiming later you did not tell him something about the financials of the business, when you actually did. No matter how bad some information may seem to you, if you disclose it to the buyer and he closes the deal, you probably are in the clear.

You want the buyer to feel comfortable with your disclosures and that you are being above board. Sign and date all documents you provide buyer or broker. This will create credibility. Have the buyer sign & date a list of all the documents you provided him. This will help avoid litigation when you can document that you gave the buyer the requested documents.

Keeping Everyone Happy

Answer all questions asked by the buyer, directly to you or through the broker, only in writing. This gives you a paper trail on what you told him. Do not orally tell the broker and let him orally tell the buyer. If the broker changes, forgets or misses something, you could be blamed. A paper trail is your best prevention and defense for legal troubles.

In Conclusion

Do not withhold any information, especially financial irregularities from the buyer. Disclosing makes the buyer believe the books to be accurate.

Willard Michlin is a CPA, and Due Diligence and Business Evaluation Advisor. He has published many articles and is in demand as a public speaker in the Southern California business community. You can write to Willard and he will always answer your questions. He can also be contacted at his Seal Beach, California office by calling 805.428.2063. See other articles and information about his services at: Evaluate A Business